Tuesday, May 12, 2009

When Interests Collide

I followed the rules as I always have. Stephen Friedman, on his purchase and previous holdings in GS

2500 years ago Euripides observed, Whom the Gods would destroy, they first make mad. Having risen beyond the confines of the rules of men, big finance, forgetting that the rules of true finance and economics apply to all, will fall by their own hand.

The case of Stephen Friedman, who, while owning a stake in GS, chaired the NY Fed Board which approved their application to become a bank holding company and thus have access to government bail out funds- a shift denied to Lehman Brothers- is a perfect example of the "rules don't apply to me" perspective.

This perspective doesn't end with Mr. Friedman. Fed Vice Chairman Donald Kohn, according to the WSJ, The Fed's logic was that the conflict wasn't created by any action of Mr. Friedman, the financial system was in crisis, and the New York Fed needed a new president if Timothy Geithner became Treasury Secretary. So Fed officials say Mr. Kohn concluded that the benefit from the continuity of keeping Mr. Friedman outweighed the conflict of interest.

The virtues of continuity outweighed the conflict of interest, eh? In other words, maintaining the status quo- a policy which doesn't seem to comport with creative destruction- is more important than the judgment clouding effects of a large monetary stake in the outcome of a bureaucratic decision.

On the topic of the virtues of continuity, the big banks appeared to pass their "stress tests" with satisfactory grades, although they'll need to raise some extra capital because the rest of the economy isn't pulling its weight. I wonder if the policy of maintaining the status quo in finance, or even more mundane issues like a large financial stake in the outcome, might have influenced that assessment.

To wit, according to the Fed Report: At the end of 2008, the 19 BHCs held $1.5 trillion of securities, more than one‐half of which were Treasury, agencies, or sovereign securities, or high‐grade municipal debt, and so are subject to no or limited credit risk. This is, I sense we are to assume, a good thing. If there was any credit risk in sovereign securities (including Treasuries), agencies, or hi-grade munis the BHCs would have to raise a couple $100B more in capital. We'll leave aside the obviously silly concern that there actually is credit risk in such securities. No government has ever defaulted or devalued nor has mortgage debt ever led to a loss.


The other thorny issue of such an assessment- marking to market securities which few apparently hazard to value- was easily ignored with these words: The adherence of SCAP to current practices is important because the majority of assets at most of the BHCs participating in the SCAP are loans that are booked on an accrual basis. As a result of the loss recognition framework for assets in the accrual loan book, the results of this exercise are not comparable with those that would evaluate such assets on a mark‐to‐market basis.

In other words, if we marked these loan books to market the BHCs would need to substantially raise capital levels, far beyond those recommended by the Fed. The virtues of continuity must be great indeed- outweighing the concerns of sovereign credit risk and virtues of marking to market- all in one report, mind you.

I wonder if our foreign creditors are aware of continuity's great virtues. Given recent talk about changing the global financial architecture, I suspect they aren't, mainly because the virtues are not universal.

Sometimes interests collide.

To wit, theft is virtuous for the thief but not for he from whom the goods were stolen. The owner's interests are not aligned with the thief's. Nor, it seems to me, are our foreign creditors' interests aligned with our BHCs'.

Continuity is only in the interests of those within the system in question in the event that different, more efficient modes of thought and action cannot be implemented for less than the cost of maintaining that continuity- a view which seems to have escaped the men at the Fed.

Perhaps the Financial Powers That Be have, as is the wont of those who use econo-metric models, gotten confused by recent history. In the early 90s, during the last reliquification of Big Finance- remember the job-less recovery- Japan was in the role China plays today. If Japan had a Army, instead of a US military base on Okinawa, they too might have called for changes to the global financial architecture.

China, unlike Japan, has an Army. Like Japan, China sees the virtues of trading internationally in one's own currency. Unlike Japan, whose talk of "internationalizing" the Yen never came to much, China is internationalizing the RMB.

Returning to the early 90s experience, the resolution had 3 main facets: 1) raise capital 2) use the capital to take non-performing assets off bank balance sheets 3) maintain a large spread between short and long rates for an extended period of time to raise bank profits. In my view, global economic growth during that period was sluggish, in part, because the banks increased the "vig."

I suspect a similar strategy is in play in the sense that the BHCs will need a wide spread for an extended period of time. Thus the key question arises. Will our foreign creditors, who might (or might not) be willing to purchase an equity stake, also agree to pay the increased "vig" in the form of a wider than normal spread, to use US$s?

Side note: Would we be willing to sell an equity stake big enough to make a difference, can sufficient capital be raised without loss of control?

Perhaps, but only if the Fed is right about the lack of credit risk in Treasury Securities. If inflation returns, as I suspect it will, the cost benefit analysis of continuity in the global financial system changes radically.

At some point the cost of a devaluation would exceed that of creating a new system, although the cost of creating a new system increases dramatically if a war is required to "align everyone's interests."

I truly hope the powers that be can manage this mess, for it seems to me a collision of interests is imminent. The more success China has in RMB based international trade, the less willing they will be to use US$s and thus the longer will recovery take. In a sense, expansion of US$ use in the 90s dug the BHCs out of a hole. A decline in US$ use while trying to dig out of a much deeper hole seems to me a desperate situation.


Hombre said...

Dude, two comments/thoughts.

1) I'm not convinced that China is going to supplant the US as the dominant world power just yet. I'd say there's a reasonable probability of it, but it's not certain. My biggest concern at the moment is the epic credit bubble (sound familiar?) that China is now pursuing. As Jun Ma of Deutsche Bank put it:

Chinese banks issued a total of yuan CNY4.58 trillion ($670bn) in new loans in the first quarter, CNY3.25 trillion more than issued in the same period of last year, the central bank said on Saturday.

“Q1 new lending was equivalent to the total new lending in the first 11 months of last year, and was three times the level during the same period of last year,” Ma said.

Let's see how they manage the political and economic fallout once that bursts before we hand them the crown.

2) It seems to me that the three main goals of policymakers -- restoring the banks to profitability/cleaning up their balance sheets, increasing credit flow to the system, and boosting the housing market -- are inherently contradictory. How does you increase the amount of credit in the system? By forcing banks to make unprofitable loans. How do you clean up bank balance sheets? By forcing asset sales, which is inherently deflationary. How do you increase bank profitability? By increasing the vig, raising the cost of credit to borrowers (which means higher mortgage rates, hurting housing). How do you boost housing? By forcing banks to make unprofitable loans.

The only real remedies, time and pain, seem to be unacceptable to all.