A Rising Dollar Lifts the U.S. but Adds to the Crisis Abroad

By PETER S. GOODMAN

 

Published: March 8, 2009

As the world is seized with anxiety in the face of a spreading financial crisis, the one place having a considerably easier time attracting money is, perversely enough, the same place that started much of the trouble: the United States.

American investors are ditching foreign ventures and bringing their dollars home, entrusting them to the supposed bedrock safety of United States government bonds. And China continues to buy staggering quantities of American debt.

These actions are lifting the value of the dollar and providing the Obama administration with a crucial infusion of financing as it directs trillions of dollars toward rescuing banks and stimulating the economy, enabling the government to pay for these efforts without lifting interest rates.

And yet in a global economy crippled by a lack of confidence and capital, with lending and investment mechanisms dysfunctional from Milan to Manila, the tilt of money toward the United States appears to be exacerbating the crisis elsewhere.

The pursuit of capital suddenly seems like a zero sum game. A dollar invested by foreign central banks and investors in American government bonds is a dollar that is not available to Eastern European countries desperately seeking to refinance debt. It is a dollar that cannot reach Africa, where many countries are struggling with the loss of aid and foreign investment.

“Virtually all of the low-income countries are in very serious trouble,” said Eswar Prasad, a former official at the International Monetary Fund and a senior fellow at the Brookings Institution, the liberal-leaning research organization in Washington.

He went on: “This is the third wave of the financial crisis. Low-income countries are getting hit very hard. The flow of private capital to the emerging market has dried up.”

Private money invested in so-called emerging countries plunged from $928 billion in 2007 to $466 billion last year and is likely to fall to $165 billion this year, according to the Institute of International Finance.

Not that the United States is enjoying a great influx of money. Globally, investors are holding tight to cash and extracting it as quickly as they can from risky ventures.

In the United States, investments by foreigners have slowed markedly. But as Americans eschew foreign deals and keep their dollars at home, and as foreign central banks — especially China — buy Treasury bills, the United States is absorbing money that used to be scattered around the globe. And that is making money tighter elsewhere in the world.

The most immediate crisis appears to be in Eastern Europe, where investors borrowed exuberantly in foreign currencies — notably the euro and the Swiss franc — using those funds to build office towers and factories. Their debts are growing as their currencies decline in value, leading to bank losses and requiring government bailouts along with aid from the I.M.F..

Economists liken this episode to the financial crisis that assaulted much of Asia in the late 1990s. Then, as now, investors borrowed in foreign currencies. When investment left the region, local currencies plummeted, particularly in Thailand and Indonesia, setting off defaults and sowing job losses and poverty.

“Eastern Europe looks incredibly similar to Asia in the 1990s,” said Brad Setser, an economist at the Council on Foreign Relations in New York.

In one key regard, this crisis is more problematic: In the 1990s, the rest of the global economy was growing vigorously. Once danger abated, Asian countries were able to resume growth by selling goods to the United States, Europe, Japan and China.

Indeed, the very plunge in currencies that precipitated the crisis also provided a fix, making Thai, Malaysian, Indonesian and Korean goods that much cheaper on world markets.

This time, as many low-income countries again see their currencies fall, they are confronting a world beset by recession, in which demand for their products is weak and falling.

In a report released Sunday, the World Bank predicted that the global economy would shrink in 2009 for the first time in more than half a century and forecast that global trade would decline for the first time since the early 1980s.

“Depreciation isn’t enough now to offset the global contraction,” said Mr. Setser, noting that export powers like Japan, Korea, Taiwan and Brazil have had rapid declines in sales in recent months. “Everybody’s looking vulnerable. All commodity exporters are potentially subject to currency crises.”

Fears are growing that a much broader group of countries will plunge into trouble. Mr. Prasad’s list of potential danger zones includes Vietnam, the Philippines, Malaysia and Indonesia, as well as Pakistan and Ecuador.

In the Asian financial crisis, countries at the center of the storm were particularly vulnerable because the values of their currencies were mostly pegged to the dollar. Once central banks ran out of dollars to exchange for their own currencies, they lost their ability to influence the exchange rate. As a result, their currencies fell, turning already large debts into impossible debts.

Many more countries now allow their currencies to float with the whims of the market, removing this grim chain of events. Still, as economic activity slows and banks are stuck with larger losses, the damage could swell beyond the ability of governments to finance bailouts, said Kenneth S. Rogoff, a former chief economist at the I.M.F. and now a professor at Harvard.

“Debt collapses are going to wreak havoc with exchange rates,” Mr. Rogoff predicted. “A lot of countries in Europe are already on the brink of default.”

Only two years ago, many analysts were suggesting that the I.M.F. — created more than 60 years ago to rescue countries in financial distress — no longer had a clear reason to exist. Now, the fund is scrambling for contributions from developed nations to bolster its $350 billion war chest. Mr. Setser suggested it needed $1 trillion for all that might yet unfold.

Because worries are deeper nearly everywhere else, the United States and the dollar have essentially benefited from the worldwide panic. In the last year, the dollar has risen 13 percent against major foreign currencies after adjusting for inflation, according to Federal Reserve data. Foreign holdings of Treasury bills rose by $456 billion in 2008.

“It’s a huge safe haven effect,” said William R. Cline, a senior fellow at the Peterson Institute for International Economics in Washington. “The basic assumption that people are making is that the U.S. government will never default on its debt.”

As the dominant flavor of money used in business worldwide, the dollar has once again been affirmed as the global reserve currency.

Only last year, some analysts said that as the American economy sagged, foreign central banks would be reluctant to sink national savings into the dollar. That has been soundly debunked.

In ordinary times, the rise of the dollar would provoke American worries that it would crimp exports by making goods more expensive on world markets. But for American policy makers, what matters now is attracting enough buyers of American debt to finance the rescue plans, and if the dollar must rise along the way, that is a cost worth paying.

“The fact that we can still borrow at lower interest rates is saving us from much more severe adjustments,” Mr. Rogoff said. “We’re really still staring down an abyss.”

 

Julia Werdigier contributed reporting

Subprime Europe

By LIAQUAT AHAMED

 

Published: March 7, 2009

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.”

Global Financial Assets Lost $50 Trillion Last Year, ADB Says

By Shamim Adam

March 9 (Bloomberg) — The value of global financial assets including stocks, bonds and currencies probably fell by more than $50 trillion in 2008, equivalent to a year of world gross domestic product, according to an Asian Development Bank report.

Asia excluding Japan probably lost about $9.6 trillion, while the Latin American region saw the value of financial assets drop by about $2.1 trillion, said Claudio Loser, a former International Monetary Fund director and the author of the report that was commissioned by the ADB. The report didn’t give a breakdown of asset declines in other regions.

“The loss of financial wealth is enormous, and the consequences for the economies of the world will unfortunately commensurate,” said Loser, now the Latin American president of strategic advisory firm Centennial Group Inc.. “There are serious economic and political stumbling blocks that may well cause the recovery to be costly and slow to consolidate.”

Some of the world’s biggest financial companies including Lehman Brothers Holdings Inc. and Merrill Lynch & Co. have collapsed as banks and other financial institutions reported almost $1.2 trillion of losses and writedowns since the start of 2007. Global stock markets lost about $28.7 trillion in 2008, and another $6.6 trillion has been wiped from the value of world equities in 2009.

“Poor macroeconomic and regulatory policies allowed the global economy to exceed its capacity to grow and contributed to a buildup in imbalances across asset and commodity markets,” Loser said. “The previous sense of strength and invulnerability is now gone.”

Global Recession

The global economy is likely to shrink for the first time since World War II, and trade will decline by the most in 80 years, the World Bank said yesterday. Its assessment is more pessimistic than an IMF report in January predicting 0.5 percent global growth this year.

Developing nations will bear the brunt of the contraction and they will face a shortfall of between $270 billion and $700 billion to pay for imports and service debts, the Washington- based World Bank said.

“This crisis is the first truly universal one in the history of humanity,” former IMF Managing Director Michel Camdessus said at an ADB forum in Manila today. “No country escapes from it. It has not yet bottomed out.”

Growth in 2009 may drop by half in developing and emerging countries, and a recovery in the global economy may only begin late this year or in early 2010, Loser said. Developing nations, which mostly escaped the earlier effects of the credit crisis, are facing more problems as the downturn worsens, the report said.

‘Mounting Difficulties’

“Emerging economies were initially able to absorb the initial impact of the crisis on account of the considerable progress in recent years in consolidating economic performance,” Loser said. “This group of countries is experiencing mounting difficulties. Policy makers will thus need to find a balance between economic stimulus and financial stability.”

Asia is likely to recover with “vibrant” growth once the crisis recedes in 2010, Manu Bhaskaran, the Singapore-based head of economic research at Centennial Group, said in a separate report for the ADB released today. South Asia’s growth prospects “remain good,” he said.

“Asia is mainly suffering a cyclical slowdown because of problems in the developed economies, it is not suffering a structural economic breakdown,” Bhasakaran said. “There is no reason to think that the growth engines that have been unleashed in many parts of Asia are likely to weaken.”

Capital Flows

Net capital flows to emerging markets may fall to $165 billion this year, from $470 billion in 2008 and a record $930 billion in 2007, Loser said, citing estimates from the Institute for International Finance. Net flows to emerging Asian economies may drop by 80 percent from the peak in 2007, he said.

Protectionist measures by countries to prevent a deeper fallout from the global downturn won’t work, Loser said.

“There is no room for denial or populist policies,” Loser said. “Otherwise the crisis will become even deeper and harder to reverse.”

To contact the reporter on this story: Shamim Adam in Singapore at sadam2@bloomberg.net

AIG Told U.S. Failure May Cripple Banks, Money Funds (Update2)

By Hugh Son and Scott Lanman

March 9 (Bloomberg) — American International Group Inc. appealed for its fourth U.S. rescue by telling regulators the company’s collapse could cripple money-market funds, force European banks to raise capital, cause competing life insurers to fail and wipe out the taxpayers’ stake in the firm.

AIG needed immediate help from the Federal Reserve and Treasury to prevent a “catastrophic” collapse that would be worse for markets than the demise last year of Lehman Brothers Holdings Inc., according to a 21-page draft AIG presentation dated Feb. 26, labeled as “strictly confidential” and circulated among federal and state regulators.

“What happens to AIG has the potential to trigger a cascading set of further failures which cannot be stopped except by extraordinary means,” said the presentation by New York-based AIG. “Insurance is the oxygen of the free enterprise system. Without the promise of protection against life’s adversities, the fundamentals of capitalism are undermined.”

Regulators revised AIG’s bailout last week to ease loan terms and extend $30 billion in fresh capital after the firm posted a $61.7 billion fourth-quarter loss, the worst in U.S. corporate history. Lawmakers are reluctant to give more support beyond the package already in place, worth about $160 billion, because they say regulators haven’t given enough detail about how the funds are being used or when the bailouts will end.

The Fed is “asking for an open-ended check” and is “not going to get” it, Senator Robert Menendez, a New Jersey Democrat, said last week in Congressional hearings.

Global Impact

AIG warned of turmoil around the globe if the government allowed the insurer to fail, adding “it is questionable whether the economy could tolerate another shock to the system that a failure of AIG would produce.” The value of the U.S. dollar might fall, Treasury borrowing costs could rise and the agency would face “doubts about the ability of the U.S. to support its banking system,” according to the presentation, parts of which were reported earlier by the New York Times. The municipal bond market would be stressed and Boeing Co. could lay off workers if AIG’s plane-leasing unit folded, the company said.

Under the scenarios sketched by AIG, European banks that bought credit-default swaps might need to raise $10 billion in capital and could face rating downgrades. Life insurance customers, their faith shaken in the industry, would redeem some of their $19 trillion in U.S. policies, overwhelming firms already weakened by the credit crisis, AIG said.

The $38 billion in support provided by the firm to money- market funds would be in jeopardy, AIG said, possibly forcing some to “break the buck.” The term refers to a money fund that suffers losses so large that it must pay investors less than the traditional $1-a-share value that gives the short-term funds their reputation for safety.

Overseas Seizures

Outside the U.S., where AIG operates in more than 140 countries, a collapse could lead to the “immediate seizure” of its businesses by regulators and could impair “the entire insurance industry within certain regions,” the presentation said, which added that its conclusions were “speculative” and a matter of judgment.

“Who knows if what they’re saying is true?” said Phillip Phan, professor of management at the Johns Hopkins Carey Business School in Baltimore. “A lot of it sounds like conjecture, that if AIG collapses the rest of the industry will, too. It’s a way of creating a crisis atmosphere and the sense you have to respond quickly.”

If AIG were forced to liquidate its investments, it would have “enormous downward pressure” on asset classes including municipal bonds, the firm said. The company’s commercial insurance division owns more than $50 billion in muni bonds.

Aircraft Industry Impact

AIG’s International Lease Finance Corp. is the world’s biggest aircraft lessor by plane value, and its failure would jeopardize $12.5 billion in orders, causing job losses at Chicago-based Boeing. ILFC would have to sell its 1,000 planes at distressed prices, “severely impacting” the aircraft industry. Banks and pension funds holding about $30 billion in ILFC debt would take losses, the company said.

AIG’s latest rescue package includes equity, new credit and lower interest rates on existing loans designed to keep it in business. Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Timothy Geithner have said the government must prop up AIG to avoid damaging the financial system.

Fed spokeswoman Michelle Smith said the central bank “came to its conclusions based on our own analysis.” Christina Pretto, an AIG spokeswoman and Isaac Baker of the Treasury didn’t immediately have a comment.

Billionaire Warren Buffett, appearing on CNBC today, said the bailout of “quasi-financial” firms like AIG was necessary, even if everyone dislikes what had to be done to salvage it.

Bailout Beneficiaries

New York Insurance Superintendent Eric Dinallo said at a March 5 hearing he’d received the presentation.

The document doesn’t say which other companies have benefited from AIG’s repeated rescues. Goldman Sachs Group Inc. and Deutsche Bank AG were among at least two dozen financial institutions that were paid $50 billion from the bailout funds received by AIG, the Wall Street Journal reported, citing a confidential document and people familiar with the matter whom it didn’t identify.

Goldman and Deutsche got about $6 billion each between September and December, the Journal said. Merrill Lynch & Co., Societe Generale SA, Morgan Stanley, Royal Bank of Scotland Group Plc and HSBC Holdings Plc were other counterparties that also received payments, the newspaper said, citing the document.

Taxpayer Wipeout

AIG’s presentation said that without more U.S. help, investment losses would mean “AIG will not be able to repay its obligations” and that cash previously provided by the U.S., which controls a 79.9 percent stake in the insurer, could be lost. Chief Executive Officer Edward Liddy, who took over the top job in September, has vowed that AIG will repay all of its debts to taxpayers.

At AIG itself, failure could have led to dismissals from its workforce of 116,000, the document said. At that level, the staff is unchanged from the end of 2007 before AIG’s bailout. The global credit crunch has led to at least 284,000 job cuts at the rest of the world’s financial companies, according to Bloomberg data.

The insurer’s first bailout package, crafted last September, later grew to $150 billion. After failing to sell enough subsidiaries to repay the government, AIG had to turn to U.S. taxpayers again. The company may need more support if financial markets don’t improve, the Treasury and Federal Reserve said last week in a joint statement.

– Editors: Rick Green, Sharon L. Lynch

Economists React: Treasury Announcement Fails to Satisfy

09 02 10 Real Time Economics Blog

Compiled by Phil Izzo

February 10, 2009, 1:47 pm Economists React: Treasury Announcement Fails to Satisfy Economists and others weigh in on the Treasury Department’s latest proposal to prop up the financial system. # A major disappointment. The new plan discussed some of the ideas that have been floated in the media over recent days, and delivered some cosmetic re-labelling of existing programs, but many of the fundamental questions that former Secretary Paulson encountered last Fall remain unanswered. In particular, the terms at which troubled assets are purchased from banks are still being “explored.” –Michael Feroli, J.P. Morgan Chase # The speech and accompanying fact sheet leave open many questions about the timing of these interventions and the terms of asset purchases and recapitalization. Much of the program clearly remains to be worked out over the coming weeks and months… Rather than a fully government-funded bad bank, the Treasury will attempt to catalyze private sector investment via a “public-private partnership.” … It is clear from Geithner’s remarks that this is a concept at this point, rather than a fully designed entity — Geithner mentioned getting public comment on the potential structure. Supposedly, private sector investors will determine the prices (perhaps with the benefit of cheap financing or partial loss protection from the government). –Goldman Sachs # While sounding aggressive, the lack of details on the asset buying plan was disappointing. –Michelle Meyer, Barclays Capital # Perhaps the centerpiece of today’s announcement is the commitment up to $1 trillion to revivify the collapsed market for securitized debt that previously allowed unprecedented levels of lending in the home, auto, student, and credit card sectors. Geithner makes the false assumption securitization is a prerequisite for healthy markets. Our nation’s short history with widely securitized debt has simply shown that the process can lead to massive mispricing of assets and risk. But, in the worldview of Geithner and his fellow economists, credit, rather than savings, is central figure in the economic equation. In his mind, anything that eases the process of lending is an end in itself. in so doing this plan guarantees that the U.S. economy will be pushed farther and farther out on a leveraged limb, until no amount of market medicine can prevent a total economic collapse. –Peter Schiff, Euro Pacific Capital # It’s really not clear what the plan means; there’s an interpretation that makes it not too bad, but it’s not clear if that’s the right interpretation. The plan deserves praise for what isn’t in it, at least as far as I can tell. There doesn’t seem to be provision for mass purchases of toxic waste at premium prices; there also doesn’t seem to be a massive “ring-fencing” guarantee against private losses on bad assets. In that sense the plan is better than what the last few weeks of leaks led us to expect… So what is the plan? I really don’t know, at least based on what we’ve seen today. But maybe, maybe, it’s a Trojan horse that smuggles the right policy into place. –Paul Krugman, Princeton University # With the U.S. and global recessions intensifying , pressure on banking system remains huge, notwithstanding the injection of close to $276 billion in capital to the U.S. banking system under the first phase of the TARP program. With further large write-downs to banking system assets pending, that will put additional severe downward pressure on banking system capital. Unless that void is filled fairly quickly — we estimate that the banking system will require an injection of between $250 and $300 billion of additional capital in the first half of 2009 — we will continue to see very tight lending conditions, and the unlocking of the credit markets that is essential for securing a recovery will simply not happen. The biggest risk is that the massive fiscal stimulus program that is rolling through Congress will be stillborn as a result of not dealing up front with these critical capital adequacy issues in the financial markets… The bottom line from the Geithner speech is that it was too general, and it lacked the specifics needed to it to be credible. The speech had too many political overtones and the politically-charged preamble by Senator Chris Dodd did not set the stage appropriately for what was a communication that was directed to mainly a technical audience from a key administration technocrat. –Brian Bethune, Global Insight # The size and breadth of the package show that the government recognizes the scale of the problem and suggests that it will be prepared to do more if necessary. And the terms of the new cash injections appear to have a greater chance of boosting lending than those seen in other economies. Overall, while the FSP may not be perfect, it is likely to have a beneficial impact on the financial system and increase the chances that the US economy sees a decent economic recovery in 2010. –Paul Dales, Capital Economics # The concept of a public/private investment fund sounds intriguing, but there is no plan – the Treasury Secretary “seeks input” how to achieve this. There simply is no fair way to take bad assets off the books of financial institutions. The sooner policy makers not just recognize it, but embrace it in their strategy, the better… We did not see convincing evidence that the government is moving away from its Band-aid approach to helping banks. By now, the only viable solution left may be to nationalize the financial institutions that are deemed to big to fail; it’s then a political decision whether depositors should carry part of the cost. –Axel Merk, Merk Investments # I think the markets’ disappointment is excessive, and reflects overblown expectations more than weaknesses in the strategy. Geithner’s overall assessment of the gravity of the situation was realistic and candid, the strategy is sound, the government’s determination inspires confidence and the commitment to transparency and direct support to households and firms should ensure public and political support. The new Administration is moving in the right direction, but the markets will need to see more concrete steps before they can believe in this change. –Marco Annunziata, UniCredit Group # The “comprehensive” financial rescue plan — Financial Stability Plan — released by Treasury Secretary Geithner this morning is still missing significant detail, including an implementation date. There are far too many missing details to make this a satisfying announcement. Nonetheless — at first blush and without the benefit of key detail — the plan does appear to address the key problems of the financial markets at this point in time. –Ward McCarthy, Stone & McCarthy # The bad bank, which will be fleshed out over the next several weeks, will be extremely tricky to design effectively. At best, it will be modestly inferior to the solution of providing a guaranteed floor value for toxic assets without requiring banks to sell them to gain the protection. At worst, the plan may fizzle by failing to achieve a large volume of purchases or may prove considerably more expensive for taxpayers than anticipated. On the positive side, continuing to offer substantial capital injections to banks, despite the intense political unpopularity of those done under the Bush administration, shows a measure of political courage. –Douglas J. Elliott, The Brookings Institution

Do not destroy the essential catalyst of risk

Un artículo sobre como mejorar el funcionamiento de las “middle offices” (lugar donde tipicamente les podría tocar trabajar) de bancos y fondos. Escrito por el director de Goldman Sachs, uno de los pocos bancos de inversión que se salvaron; pero con pérdidas, por no hacerle caso a lo que estudiaron en macroeconomics 2.

Es un artículo de administración de empresas, pero es relevante acá porque muestra que vale la pena atenerse a los fundamentos económicos: estos fundamentos, a pesar de la oposición basada en el sentido común de sus colegas de otras disciplinas, les van a dar la razón a mediano plazo. Lo difícil, como ustedes  ya saben,  es que pueden pasar un par de años antes de eso.

Mientras tanto hay que aceptar que las empresas tomen decisiones equivocadas y que le toque a usted tomarlas. A veces porque otras personas pueden entender otras cosas mejor, a veces porque las ganancias suyas y de sus compañeros no van a depender de que a la empresa le vaya bien sino de que parezca que va bien (recuerde el problema del principal y el agente) y a veces porque la miopía y el subsiguente comportamiento en rebaño son más comunes que la gripa; así que la verdad muchas veces es irrelevante. y usted no va a poder hacer nada al respecto más que  jugar con la “cuchara”. Pero es bueno dejar sentada su posición y mantenerla porque eso mejora la racionalidad del sistema.

Quiere quitar un supuesto clásico? quite la racionalidad de los agentes. Muchas veces no hay nada más equivocado, irracional e incontrolable que una muchedumbre. No importa si son consumidores de television en horario prime,  traders alrededor del mundo o cultos votantes alemanes por un presidente de probable origen judio y apellido Hitler. Por eso en el Top Ten de Billboard o de La Mega la música es tan mala, y por eso el sistema financiero es tan irracional . También es más “irracional” que los demás mercados por razones relacionadas con la información, su complejidad y velocidad.

Esto hace que la economía como un todo sea bastante irracional muchas veces por dos razones. La menos importante es que el sector financiero es el que maneja la plata de los demás y por lo tanto incide en la riqueza de los demás agentes. La más importante es que el sector financiero esel que más señales económicas emite junto con el gobierno y cuando se equivoca hace equivocar a todos.

Financial Times | Last updated: February 8 2009

By Lloyd Blankfein

Since the spring, and most acutely this autumn, a global contagion of fear and panic has choked off the arteries of finance, compounding a broader deterioration in the global economy.

Much of the past year has been deeply humbling for our industry. People are understandably angry and our industry has to account for its role in what has transpired.

Financial institutions have an obligation to the broader financial system. We depend on a healthy, well-functioning system but we failed to raise enough questions about whether some of the trends and practices that had become commonplace really served the public’s long-term interests.

As policymakers and regulators begin to consider the regulatory actions to be taken to address the failings, I believe it is useful to reflect on some of the lessons from this crisis.

The first is that risk management should not be entirely predicated on historical data. In the past several months, we have heard the phrase “multiple standard deviation events” more than a few times. If events that were calculated to occur once in 20 years in fact occurred much more regularly, it does not take a mathematician to figure out that risk management assumptions did not reflect the distribution of the actual outcomes. Our industry must do more to enhance and improve scenario analysis and stress testing.

Second, too many financial institutions and investors simply outsourced their risk management. Rather than undertake their own analysis, they relied on the rating agencies to do the essential work of risk analysis for them. This was true at the inception and over the period of the investment, during which time they did not heed other indicators of financial deterioration.

This over-dependence on credit ratings coincided with the dilution of the coveted triple A rating. In January 2008, there were 12 triple A-rated companies in the world. At the same time, there were 64,000 structured finance instruments, such as collateralised debt obligations, rated triple A. It is easy and appropriate to blame the rating agencies for lapses in their credit judgments. But the blame for the result is not theirs alone. Every financial institution that participated in the process has to accept its share of the responsibility.

Third, size matters. For example, whether you owned $5bn or $50bn of (supposedly) low-risk super senior debt in a CDO, the likelihood of losses was, proportionally, the same. But the consequences of a miscalculation were obviously much bigger if you had a $50bn exposure.

Fourth, many risk models incorrectly assumed that positions could be fully hedged. After the collapse Long-Term Capital Management and the crisis in emerging markets in 1998, new products such as various basket indices and credit default swaps were created to help offset a number of risks. However, we did not, as an industry, consider carefully enough the possibility that liquidity would dry up, making it difficult to apply effective hedges.

Fifth, risk models failed to capture the risk inherent in off-balance sheet activities, such as structured investment vehicles. It seems clear now that managers of companies with large off-balance sheet exposure did not appreciate the full magnitude of the economic risks they were exposed to; equally worrying, their counterparties were unaware of the full extent of these vehicles and, therefore, could not accurately assess the risk of doing business.

Sixth, complexity got the better of us. The industry let the growth in new instruments outstrip the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.

Last, and perhaps most important, financial institutions did not account for asset values accurately enough. I have heard some argue that fair value accounting – which assigns current values to financial assets and liabilities – is one of the main factors exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.

For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in instruments that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions.

As a result of these lessons and others that will emerge from this financial crisis, we should consider important principles for our industry, for policymakers and for regulators. For the industry, we cannot let our ability to innovate exceed our capacity to manage. Given the size and interconnected nature of markets, the growth in volumes, the global nature of trades and their cross-asset characteristics, managing operational risk will only become more important.

Risk and control functions need to be completely independent from the business units. And clarity as to whom risk and control managers report to is crucial to maintaining that independence. Equally important, risk managers need to have at least equal stature with their counterparts on the trading desks: if there is a question about the value of a position or a disagreement about a risk limit, the risk manager’s view should always prevail.

Understandably, compensation continues to generate a lot of anger and controversy. We recognise that having troubled asset relief programme money creates an important context for compensation. That is why, in part, our executive management team elected not to receive a bonus in 2008, even though the firm produced a profit.

More generally, we should apply basic standards to how we compensate people in our industry. The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.

For policymakers and regulators, it should be clear that self-regulation has its limits. We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us – especially when exuberance is at its peak. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.

Capital, credit and underwriting standards should be subject to more “dynamic regulation”. Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates up to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated. To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk.

The level of global supervisory co-ordination and communication should reflect the global inter-connectedness of markets. Regulators should implement more robust information sharing and harmonised disclosure, coupled with a more systemic, effective reporting regime for institutions and main market participants. Without this, regulators will lack essential tools to help them understand levels of systemic vulnerability in the banking sector and in financial markets more broadly.

In this vein, all pools of capital that depend on the smooth functioning of the financial system and are large enough to be a burden on it in a crisis should be subject to some degree of regulation.

After the shocks of recent months and the associated economic pain, there is a natural and appropriate desire for wholesale reform of our regulatory regime. We should resist a response, however, that is solely designed around protecting us from the 100-year storm. Taking risk completely out of the system will be at the cost of economic growth. Similarly, if we abandon, as opposed to regulate, market mechanisms created decades ago, such as securitisation and derivatives, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.

Most of the past century was defined by markets and instruments that fund innovation, reward entrepreneurial risk-taking and act as an important catalyst for economic growth. History has shown that a vibrant, dynamic financial system is at the heart of a vibrant, dynamic economy.

We collectively have a lot to do to regain the public’s trust and help mend our financial system to restore stability and vitality. Goldman Sachs is committed to doing so.

Are AAA ratings bad for firms’ health?

09 02 05 – The Economist

JUST as straight-A students have been drawn to exotic areas of finance over recent decades, so have several firms with AAA credit ratings. General Electric (GE) relentlessly expanded its finance arm which handles everything from credit cards to property. American International Group (AIG) diversified from plain insurance into credit derivatives. And even Warren Buffett’s Berkshire Hathaway was tempted to write a book of equity-derivative contracts that has recently created a big mark-to-market liability in its accounts.

Just as plenty of AAA banks have been taken to the cleaners, so these non-bank firms have suffered too. AIG is now state-controlled, after huge derivative losses. Standard & Poor’s (S&P) says GE now faces a one-in-three chance of losing its rating, which it has held since 1956, largely due to problems at its financial arm. Berkshire Hathaway’s credit-default swap spreads are far above those of AAA non-bank firms, such as Exxon Mobil (see chart).

Rock-bottom borrowing costs undoubtedly created moral hazard at banks. Might AAA ratings have also tempted non-banks to take foolish risks? Not in general. The number of industrial firms with S&P’s highest credit score has dropped from over 60 in the 1980s to just six today, but this largely reflects shareholder pressure on firms to gear-up core businesses, or a dimming of their industry’s prospects.

A few firms do seem to have sought exposure to finance precisely because they wanted to exploit their high ratings, however. “My gut told me that…this business seemed an easy way to make money,” wrote Jack Welch, GE’s former boss. It was about “finding smart and creative people and then using GE’s strong balance-sheet.” When AIG set up its credit-derivatives arm in the 1980s it hired specialists from the junk-bond shop Drexel Burnham Lambert, who were attracted partly by the potential to piggyback off AIG’s excellent rating.

Such instincts are not always wrong. Risky activities can create losses and should eventually raise a firm’s overall cost of borrowing—but that is acceptable if the profits compensate.

Ajit Jain, an executive at Berkshire Hathaway, has said that with its AAA rating the firm has toyed with entering the bond-insurance market for the past 20 years. Only recently, after the collapse of the industry, have prices risen to a level that Berkshire finds attractive.

Even if the prices are right, depending on being AAA-rated for survival is a treacherous strategy. This has little to do with the small rise in borrowing costs a lower rating might prompt; the real danger is from the collateral calls that counterparties can demand. Like some banks, AIG found that downgrades fed a fatal liquidity crisis. Reassuringly, Berkshire Hathaway says most of its equity derivatives do not require collateral postings. GE, meanwhile, insists that a downgrade would have no “major” impact. Although an AAA rating is nice and exploiting it can make sense, nobody should become its slave.

World Faces Deepening Crisis, IMF Chief Warns

22 01 09 / FMI

• IMF head says economic prospects even worse than previous projections
• Warns of risk of social unrest in some hard-hit countries
• Says more governments expected to access IMF lending

The world faces a deepening economic crisis, with the slowdown in advanced economies now spreading to major emerging markets such as China, India, and Brazil, Dominique Strauss-Kahn, IMF Managing Director, warned.

He said the IMF would significantly adjust downward its forecast for world growth for 2009 when the 185-member international institution announces a revised assessment of the global economy on January 29. In an update released last November, the IMF had said that advanced economies would see a contraction in output in 2009—the first since World War II—but that growth in major emerging markets would still enable the global economy to advance by 2.2 percent in 2009.

Deteriorating outlook

But Strauss-Kahn said in an interview with the BBC’s Hardtalk program, broadcast on January 21, that economic prospects had worsened over the past few months and the IMF would announce lower numbers at the January 29 press conference in Washington DC.

“So 2009 will not be a good year for the world economy, even if we see recovery at the beginning of 2010,” he said.

Prospects were worse than expected not just in the United States and Europe but also in major emerging market economies such as China, India, and Brazil, which would experience very low growth compared with recent historical trends.

Stimulus key to recovery

The IMF has recommended a combination of measures to get the world back on track, including

• action already taken by many governments to stabilize financial markets and get credit flowing again;

• fiscal stimulus through a combination of increased government spending and tax cuts to revive consumer demand;

• liquidity support for emerging market countries to reduce the adverse effects of the widespread capital outflows triggered by the financial crisis; and

• help for low-income countries harmed by fallout from the crisis and the lingering impact of last year’s spike in food and fuel prices.

The IMF has proposed that governments in a position to do so should act together to inject a global fiscal stimulus equivalent to about 2 percent of world GDP—$1.2 trillion.

More on spending side

A number of governments around the world have announced stimulus plans, including in the United States, Japan, Europe, China, and India. But Strauss-Kahn said he did not think enough had been done so far. “In Europe especially, they are still behind the curve,” he said. “There needs to be more done on the spending side, especially because the reaction of the economy to more spending is quicker than the reaction to a decrease in taxes.”

The European Commission said on January 19 it expected that the 16 countries using the euro would see their economies shrink by 1.9 percent in 2009.

Strauss-Kahn warned of the risk of social upheaval and unrest in some countries worst affected by the downturn and said he expected additional countries to seek IMF help, not just in Eastern Europe, but elsewhere in the world, including Latin America where some countries were “just on the edge.”

The IMF has so far committed $47.9 billion in lending to a number of economies affected by the crisis, including Belarus, Hungary, Iceland, Latvia, Pakistan, Serbia, and Ukraine. It announced a precautionary loan for El Salvador this month and an IMF team is also in negotiations with Turkey.

Meltdown avoided

Strauss-Kahn said the world had avoided a total meltdown of the financial system as a result of coordinated intervention by major central banks last October. “We were very close in September to a total collapse of the world economy,” the former French finance minister revealed.

He defended the IMF’s different prescriptions for different economies, arguing that while major advanced economies could afford to boost spending and run up larger deficits to help get out of the recession, other crisis-hit countries, particularly the emerging markets of eastern Europe, do not have the same budgetary room to maneuver because inflows of capital had dried up and their currencies were under pressure.

Strength of the dollar

Strauss-Kahn said that even though the financial crisis had started in the United States, the recent strength of the dollar showed that people around the world still had confidence in the U.S. economy.

As long as that confidence remained, the United States would be able to finance its large deficit. Even though the Chinese economy was on the rise, the United States would still remain formidable. Through globalization, both economies would remain dependent on the rest of the world.

A longer-term issue was to fix the serious imbalances in the global economy.

IMF funding

Asked if the IMF has sufficient resources to cope with the crisis, Strauss-Kahn said that the Fund had enough money for the immediate future. “If the crisis goes on, which is most probable, then down the road—say six months from now—we will need more money.”

Before the crisis erupted, the IMF had around $200 billion in available resources and access to a further $50 billion. Since then, Japan has offered to lend the IMF an additional $100 billion. Strauss-Kahn has said that the IMF may need an extra $150 billion to help emerging markets and low-income countries get through the crisis.

Better regulation

Strauss-Kahn said that the crisis highlighted the need for better regulation and supervision of the banking sector, especially in countries such as the United States.

Member governments expect the Group of 20 industrialized and emerging market economies to make significant progress in boosting transparency and tightening supervision in the financial sector when they meet in London in April. The London meeting follows the meeting in Washington last November when leaders agreed an action plan to combat the growing crisis.

Was There Ever a Default on U.S. Treasury Debt?

23 01 09 / RGE Monitor

As the bailouts in the current bust inexorably mount, financed in rapidly increasing U.S. government debt, one might wonder whether a default on Treasury debt is imaginable. In the course of history, did the U.S. ever default on its debt?

China Losing Taste for Debt From U.S.

New York Times, 7 de febrero del 2009

HONG KONG — China has bought more than $1 trillion of American debt, but as the global downturn has intensified, Beijing is starting to keep more of its money at home, a move that could have painful effects for American borrowers.

The declining Chinese appetite for United States debt, apparent in a series of hints from Chinese policy makers over the last two weeks, with official statistics due for release in the next few days, comes at an inconvenient time.

On Tuesday, President-elect Barack Obama predicted the possibility of trillion-dollar deficits “for years to come,” even after an $800 billion stimulus package. Normally, China would be the most avid taker of the debt required to pay for those deficits, mainly short-term Treasuries, which are government i.o.u.’s.

In the last five years, China has spent as much as one-seventh of its entire economic output buying foreign debt, mostly American. In September, it surpassed Japan as the largest overseas holder of Treasuries.

But now Beijing is seeking to pay for its own $600 billion stimulus — just as tax revenue is falling sharply as the Chinese economy slows. Regulators have ordered banks to lend more money to small and medium-size enterprises, many of which are struggling with lower exports, and to local governments to build new roads and other projects.

“All the key drivers of China’s Treasury purchases are disappearing — there’s a waning appetite for dollars and a waning appetite for Treasuries, and that complicates the outlook for interest rates,” said Ben Simpfendorfer, an economist in the Hong Kong office of the Royal Bank of Scotland.

Fitch Ratings, the credit rating agency, forecasts that China’s foreign reserves will increase by $177 billion this year — a large number, but down sharply from an estimated $415 billion last year.

China’s voracious demand for American bonds has helped keep interest rates low for borrowers ranging from the federal government to home buyers. Reduced Chinese enthusiasm for buying American bonds will reduce this dampening effect.

For now, of course, there seems to be no shortage of buyers for Treasury bonds and other debt instruments as investors flee global economic uncertainty for the stability of United States government debt. This is why Treasury yields have plummeted to record lows. (The more investors want notes and bonds, the lower the yield, and short-term rates are close to zero.) The long-term effects of China’s using its money to increase its people’s standard of living, and the United States’ becoming less dependent on one lender, could even be positive. But that rebalancing must happen gradually to not hurt the value of American bonds or of China’s huge holdings.

Another danger is that investors will demand higher returns for holding Treasury securities, which will put pressure on the United States government to increase the interest rates those securities pay. As those interest rates increase, they will put pressure on the interest rates that other borrowers pay.

When and how all that will happen is unknowable. What is clear now is that the impact of the global downturn on China’s finances has been striking, and it is having an effect on what the Chinese government does with its money.

The central government’s tax revenue soared 32 percent in 2007, as factories across China ran at full speed. But by November, government revenue had dropped 3 percent from a year earlier. That prompted Finance Minister Xie Xuren to warn on Monday that 2009 would be “a difficult fiscal year.”

A senior central bank official, Cai Qiusheng, mentioned just before Christmas that China’s $1.9 trillion foreign exchange reserves had actually begun to shrink. The reserves — mainly bonds issued by the Treasury, Fannie Mae and Freddie Mac — had for the most part been rising quickly ever since the Asian financial crisis in 1998.

The strength of the dollar against the euro in the fourth quarter of last year contributed to slower growth in China’s foreign reserves, said Fan Gang, an academic adviser to China’s central bank, at a conference in Beijing on Tuesday. The central bank keeps track of the total value of its reserves in dollars, so a weaker euro means that euro-denominated assets are worth less in dollars, decreasing the total value of the reserves.

But the pace of China’s accumulation of reserves began slowing in the third quarter along with the slowing of the Chinese economy, and appeared to reflect much broader shifts.

China manages its reserves with considerable secrecy. But economists believe about 70 percent is denominated in dollars and most of the rest in euros.

China has bankrolled its huge reserves by effectively requiring the country’s entire banking sector, which is state-controlled, to take nearly one-fifth of its deposits and hand them to the central bank. The central bank, in turn, has used the money to buy foreign bonds.

Now the central bank is rapidly reducing this requirement and pushing banks to lend more money in China instead.

At the same time, three new trends mean that fewer dollars are pouring into China — so the government has fewer dollars to buy American bonds.

The first, little-noticed trend is that the monthly pace of foreign direct investment in China has fallen by more than a third since the summer. Multinationals are hoarding their cash and cutting back on construction of new factories.

The second trend is that the combination of a housing bust and a two-thirds fall in the Chinese stock market over the last year has led many overseas investors — and even some Chinese — to begin quietly to move money out of the country, despite stringent currency controls.

So much Chinese money has poured into Hong Kong, which has its own internationally convertible currency, that the territory announced Wednesday that it had issued a record $16.6 billion worth of extra currency last month to meet demand.

A third trend that may further slow the flow of dollars into China is the reduction of its huge trade surpluses.

China’s trade surplus set another record in November, $40.1 billion. But because prices of Chinese imports like oil are starting to recover while demand remains weak for Chinese exports like consumer electronics, most economists expect China to run average trade surpluses this year of less than $20 billion a month.

That would give China considerably less to spend abroad than the $50 billion a month that it poured into international financial markets — mainly American bond markets — during the first half of 2008.

“The pace of foreign currency flows into China has to slow,” and therefore the pace of China’s reinvestment of that foreign currency in overseas bonds will also slow, said Dariusz Kowalczyk, the chief investment officer at SJS Markets Ltd., a Hong Kong securities firm.

Two officials of the People’s Bank of China, the nation’s central bank, said in separate interviews that the government still had enough money available to buy dollars to prevent China’s currency, the yuan, from rising. A stronger yuan would make Chinese exports less competitive.

For a combination of financial and political reasons, the decline in China’s purchases of dollar-denominated assets may be less steep than the overall decline in its purchases of foreign assets.

Many Chinese companies are keeping more of their dollar revenue overseas instead of bringing it home and converting it into yuan to deposit in Chinese banks.

Treasury data from Washington also suggests the Chinese government might be allocating a higher proportion of its foreign currency reserves to the dollar in recent weeks and less to the euro. The Treasury data suggests China is buying more Treasuries and fewer bonds from Fannie Mae or Freddie Mac, with a sharp increase in Treasuries in October.

But specialists in international money flows caution against relying too heavily on these statistics. The statistics mostly count bonds that the Chinese government has bought directly, and exclude purchases made through banks in London and Hong Kong; with the financial crisis weakening many banks, the Chinese government has a strong incentive to buy more of its bonds directly than in the past.

The overall pace of foreign reserve accumulation in China seems to have slowed so much that even if all the remaining purchases were Treasuries, the Chinese government’s overall purchases of dollar-denominated assets will have fallen, economists said.

China’s leadership is likely to avoid any complete halt to purchases of Treasuries for fear of appearing to be torpedoing American chances for an economic recovery at a vulnerable time, said Paul Tang, the chief economist at the Bank of East Asia here.

“This is a political decision,” he said. “This is not purely an investment decision.”