Funny Money:

So what is going on with financial markets?  Extreme volatility, US dollar going up, asset values going down. Feds still manipulating the Bond Market, and EU Bankers about to try another dose of the same, by propping up a monetary system desperately in need of repair. Only God knows what is going on in China and the German wunderkind seems to be loosing its luster. Small wonder Christine Legarde of the IMF (International Monetary Fund) has toned down the rhetoric that all is well with the World Economy.

I believe that the confusion within the markets,  maybe caused by a misunderstanding of the 2008 collapse, that was a credit crisis as opposed to  a recession. Traditionally a recession has been described  as a slowing of demand for goods and services, resulting in increased unemployment and all kinds of other misery. It has been the norm for this kind of correction to last no more than two years. With a credit crisis the whole monetary system is thrown into question bringing a new set of dynamics into play. Banks stop lending (even to each other) and spenders and savers lose confidence in the markets. This insecurity takes a long time (some say a generation) to correct, and in the meantime investors will be jumpy and nervous, a condition that fosters volatility. The experience of Japan  in the early years of twenty-first century (a classic credit crunch) is a prime example, to the point where the subsequent sluggish growth and modest deflation of the past twelve years is now called the Japanese Disease.

To avoid a repeat of the dreaded decease Central Bankers in the rest of the world are apparently now willing to tolerate a 2.5% annual rate of inflation with a target of 4.5% unemployment. (even bankers now admit they are not perfect) To get to this nirvana the bankers are printing money at alarming rates, hence the race to the bottom that I have written about.

But where are the legislators and fiscal policy in all of this?  Have they gone for good leaving it to the bankers to sort out? Well, it certainly seems like it.

When it comes to economics most politicians are Mugwumps those who sit on the fence with their mugs on one side and their wumps (sic) on the other. What they are really trying and do is to take the credit when things go well and avoid the blame when they do not. In their fantasy world stimulus is good, tax increases (heaven forbid) and bad. Only when faced with the harsh realities of the bond market will they act in a responsible manner, and then they blame the Central Bank.

There is one notable exception to this tendency is the righteous indignation shown by legislators  after the fact. The Keystone Cops racing after the bad guys laying down arcane regulations that attempt to legislate function and morality. (Dodd Frank Banking legislation in the US being a good example)

The trouble with retro-legislation is that it seldom works, and more dangerous, it drives huge amounts of capital into shadow banking. This is the world of derivatives, hedges and other arcane financial tools invented by ‘quants’  (mathematicians) to mimic the ownership of all kinds of other assets. I call these things ‘funny money’

We have heard a lot about ‘Too big to fail’  AIG a good example. of a giant that had to be rescued with an infusion of $180 billion to honor Credit Default Swaps (Derivatives) for fear a partial settlement in bankruptcy would bring down the whole system.

But what about all the other financial hedges  like the short straddle (whatever that means) that destroyed Barrings, the oldest merchant bank in the world. This is the case of Nick Leeson a rogue trader (another description of a crook) who hid his losses  of 827 million pounds and broke the bank.  Or the London Whale I wrote about last week who lost $6 billion before the keystone cops caught up with him.

Mega banks now make a great deal of money by trading in Funny Money, a process that few understand and even fewer can quantify. Even more scary most of the action takes place offshore in Hon Kong or Singapore where tax rates are benign. I have heard of one bank that is rumored to employ  5,000  traders in Hon Kong most of whom rely on quants for they’re highly leveraged pay packets.

So I suspect that these behemoths maybe causing many of the market gyrations that happen almost every trading day in European and North American markets. The markets for funny money are now so enormous they are driving, (rather than following) the values of other assets. In other words, the tail is now wagging the dog, and this tail is totally unregulated. If I am only half right we can expect more volatility and many more disasters.

Stay tuned.



Prosecutorial Disconnect:

The current trial in Federal Claims Court in the district of New York between 89-year-old Hank Greenberg, former head of A.I.G. and the US Treasury, Timothy Geithner,  et al, may, or may not, answer some questions about Government Bailouts in the last credit debacle. Whatever the outcome it is very doubtful if any testimony will provide an answer to the biggest question of all. Why is it that, with all the shenanigans laid bare, (AIG, Countrywide, Lehman et al) that not a single individual has been charged with criminal malfeasance.  Good question, especially in the light of many examples of prosecutorial excess in past cases of reckless business behavior and fraud.

I recently read an exert from a PBS “Frontline”  interview with William Black former bank regulator, following the collapse of the S&L Banks in the 1980s. According to now Professor Black, the political nature of the failure and rescue of local Thrift Institutions, gave rise to the formation of numerous Government Task Forces ( a political answer to absolve presently elected officials). These  hastily convened bodies  resulted in referrals of some 1100 cases to various Justice Departments and over 800 convictions, and resulting jail sentences.

interestingly most of these convictions dealt with reckless lending practices, as opposed to the folly of borrowing short-term money to fund long-term fixed interest rate loans. (the real cause of the demise of the S&Ls)

Compare this to the ‘Liars Loans’ made by Banks and other agents under the Community Re-Investment Act for sub-prime mortgages,  that are estimated to have been 90% fraudulent. These players were certainly not ‘too big to jail’ So why have they escaped the righteous indignation of prosecutors?

My guess would  be an unstated conspiracy of the employers (the banks acting as agents for Freddie may and Freddie mac) to refrain from referring known cases of malfeasance to the FBI or the SEC. Many of these banks were small regional players where even the threat of scandal could bring the house down and cause even more problems for the New York Fed and Treasury.  I would also guess that the numbers would be staggering in that prosecution of the little guys could well exceed the capacity of the 2300 member Department of Justice.

So what about the big Fish? like the President of Countrywide, or the  Head of Financial Products for AIG. It was these people, along with their immediate subordinates, all making insane amounts of money,who were responsible for assuring the rating agencies that the bundles of sub-prime mortgages should remain rated triple A. It beggars credulity that no one in the whole chain of command knew of the precarious nature of the beats they were creating.

I believe the answer to this conundrum is a lot more complicated and relates to the whole nature of prosecution of white-collar crime in the US. It’s mostly all about egos and politics rather than the justice and the law. (there is lots of law but vwey little justice)

Some recent examples. Enron, the energy giant built on a house of cards and questionable accounting. The depth of righteous indignation  shown by prosecutors in Huston is breath-taking. In order to get to the big wigs, Ken Lay et al, they reached out and successfully extradited the ‘Natwest Three’  low level bankers from the UK for a non crime in their own country, and brow beat them into a plea bargain and jail terms in the US. ( a quite extraordinary tale “the Natwest Three” told by David Bermingham one of the three bankers involved).  Or how about the case of  the infamous Marc Rich, founder of trading giant Glencore in Switzerland. Here Federal Prosecutors indited a citizen of Switzerland and Israel (he had renounced his US Citizenship) for tax evasion (a very dubious claim normally settled by civil litigation) and trading with the enemy Iran (  a non crime in his own country). Extradition attempts having failed federal marshals tried, without success, to have him kidnapped and returned to the US.  Even more controversial Marc Rich was pardoned for non proved crimes by President Bill Clinton on his last day in office. Another incredible tale told by Daniel Ammann is his book “The Secret Lives of Marc Rich”

The common theme in all this is politics rather than justice with lots of congressman and ambitious persecutors along with a compliant press baying at the heels of the  accused.

Finally there may well be another factor in play, and this is the sheer complicated nature of crimes in business that make a successful outcome of a trial a very dubious proposition. The 2012 case of “the London Whale” and J.P. Morgan Chase is a prime example. The sheer size of the numbers staggers the imagination. The ‘Whale’ a fellow by the name of Bruno Itsil, a non US Citizen working out of the London Office of the Bank, apparently managed to lose $6.2 billion trading in complicated derivatives that were supposed to mitigate the risks involved with Credit Default Swaps (the same ones that caused the $180 billion bailout of AIG)  Jammie Dimon, the rock star President of the giant bank, did not have a clue how much his trader had lost, or how he lost it . (So whats’ a billion) So Bruno’s boss has been allowed to beat hasty retreat and Bruno himself has apparently escaped prosecution. Meanwhile other scapegoats are being sought, no doubt for lesser crimes such as lying to bank regulators.

The thought of trying to get FBI agents up to speed on the complexities of financial derivatives reminds me of the keystone cops madly rushing around after the bad guys, without a clue as to what is going on. So I think the problem may be around for a while.

Stay tuned.





A Question of Degree:

I wrote some time ago of “The Race to the Bottom” wherein the four mega currencies of the World, namely the US Dollar, the Yen the Euro, and the Pound Sterling were being manipulated by their central banks in a race to inflate (as opposed to deflate) relative values and stimulate consumer demand. The strategy is accomplished by ‘quantitative easing’ new words for printing money.

Now it appears as though the US Dollar may have lost the race and is now increasing in value compared to Gold and the Euro. The currency markets seem to be telling us that,compared to everyone else, (that is with the exception of China where nobody really knows) the prospects for the US Economy are better than say Europe and Japan.

The World is awash in trillions of US Dollars that have now been the International medium of exchange for seventy years.  During the later part of this period, these dollars have been recycled by immense balance of payments deficits run by the US, and by the issuance sovereign (or national) debt to finance America’s wars of retribution. Its’ all rather like a huge bathtub, lets call it the ‘tub’, with the dollars all sloshing around,and the taps always on. The dollars in this tub are extremely volatile and will seek safe haven and yield in the blink of an eye.

The ‘Tub’ is the playground of the traders, more particularly the commodity and currency traders. This is where the action is that sees trillions of dollars change hands every single day. Commodities, led by oil, have been linked to US Dollar in a global economy where buyers and sellers now try to lock in returns on future sales. It was not always so.

Back in the good old days of dollar hegemony, just about all commodities were the subject of long-term agreements, that relied on fixed exchange rates, that were pegged in a narrow band. Then came the NIxon Shock (the de-indexing of gold) and the stagflation of the 70’s and all hell broke loose. Marc Rich, founder of what is now called Glencore, the largest trading company in the World, almost singlehandedly started the spot market for oil and things have never been the same. Hence the ‘tub’

In the past eighteen months two very significant events have occurred that have had the effect of tightening the taps in the bathtub and thereby raising the value of the US Dollar when compared to the Yen, the Euro, and gold.

First and most significant, domestic oil production in continental USA had increased by nearly two million barrels a day.This marginal production has displaced imports of the same amount ( a $200 million credit/ day to the balance of payments) At the same time China, having nearly filled its strategic reserve, has cut back on purchases thereby creating a temporary glut of crude oil on the spot market.

The possible knock-on result of converting the US Economy from a net importer to net exporter of oil maybe enough by itself to defer, for now, the  re-evaluation of the Dollar. Despite the utopian desire to reduce carbon emissions, and oil consumption, it is still very much all about ‘oil’; those that have it will prosper, while those who do not will struggle. Oil is still priced in US Dollars so the effect on net pricing will be even greater.

The second event is an enormous reduction in military spending by the US, as the Wars in Iraq and Afghanistan are wound down, allowing for a one-third reduction in the current account deficit (or the need to borrow the same amount) This again, if continued, can have a salutary  effect on the value of the dollar.

So right now the future looks bright for the dollar, but it is very much a matter of degree. If the Fed screws up and does not start to raise interest rates soon enough, inflation or more likely stagflation, can quickly ruin the party. And what of the promise to re-purchase the trillions of dollars in US Treasury Bonds involved in ‘quantitative easing’. Will the Fed resist pressure from Congress, to keep the good times coming, and actually start to shrink the money supply.

Stay tuned.

Founders and The System:

The story of Bill Gross and PIMCO that I scooped in my last post appears to be abating,  for now anyway.

The spin, worked furiously by owner Allianz, the German Giant Insurer, was that the departure of Bill Gross, founder and long time chief, was the result of a ‘palace revolt’ that had been brewing for some time. In other words the board of directors, was reacting to unease among the ranks of management rather than, for instance, increased fund redemptions or, heaven forbid, falling profitability.

I find this explanation very difficult to swallow, because it flies in the face of the enlightened self-interest, that rules the conduct of business in most of the free world.

Bill Gross is, or was, an Ikon of the Bond World. He founded and built PIMCO into an institution, with enormous clout and his pronouncements could, and did, move markets. His concept of the Total Return Fund was quite brilliant and formed the core of thousands upon thousands of IRA Plans held by the ‘little guys’ who vote with their hard-earned money.

All of this brilliance came at a price. Like many clever people Bill, obviously did not suffer fools, and was likely wont to let others know his feelings. (rather like Steve Jobs at Apple) It may have been this trait that instigated the beginning of the end when Mohamed El-Erian, the popular second in command  at PIMCO,  left in a huff. But I doubt it, because the intransigence of the leader was not new, ( it had been going on for 20 years) and there was a great deal of money ar stake for all concerned. If I were a betting man I would look elsewhere, for the real reason for the upheaval, namely at the Federal Reserve Bank of New York.

Its one thing to chastise your co-workers, but quite another to take on the mighty Federal Reserve Bank of New York, as Bill Gross did in his very public spat with the US Treasury, run by a former powerful Fed Banker Timothy Geithner.

For those with short memories it was Bill Gross who rattled the cages of the bankers and the Treasury by forbidding his funds from purchasing Long US Treasury Bonds, because of a likely downgrade in ratings for the US Bonds by the Credit Rating Agencies. ( The united Sates Congress lacked the political will to put its house in order)

The Federal Reserve is an immensely powerful club made up of the regional reserve banks and the thousands of regional banks all over the US. Working with the US Treasury, The Federal Reserve Bank of New York can act alone, without any Congressional approval, to lower the boom on transgressors, whenever it feels that the ‘system’ is at risk. (If PIMCO as one of the largest bond funds in the world does not buy US Treasuries the “System’ might well be at risk)

By strange coincidence there is another example of this immense power on display in a New York court room as I am writing this post. This is the case of Hank Greenberg, former founder and head of AIG (American Insurance Group) who is suing the Federal Reserve Bank of New York, along with Timothy Geithner, and Hank Paulson, former Secretary of the Treasury over the terms of the bailout of AIG following the financial collapse of 2008.

There are some serious points at law in the case concerning the Fifth amendment and the seizure of assets under  the US Constitution and also the powers of the Fed under the Federal Reserve Act. Much more interesting is the sub-plot that the Fed acted improperly in favoring the large Wall Street banks in the payout on Credit Swaps issued by AIG against the credit of Sub Prime Mortgages.

In 2008 it was very obvious that AIG would not be able to pay out the full amount of the insurance coverage on sub-prime mortgages.  As in many bankruptcies, the creditors( The Wall Street Banks) would have to take a ‘haircut’ But defying the conventual wisdom this did not happen and, at the instigation of the New York Fed, the banks (Goldman Sachs et al) received one hundred cents on the dollar.

The reason given for this ‘special treatment’ is the same old cliché. It was done to save the ‘system’

And so you have it. Look no further This  banker’s ‘club’ is where the real power rests in the largest economy in the World. Whenever some untoward event occurs, you can be sure that the Bankers will close ranks and protect the ‘system’ ahead of all else.

Maybe this is where the saying “whats good for Wall Street is good for maintstreet”comes from.

Game of Thrones, The Wire, and the New York Fed

You are so right You can and did write a book about the New York Fed that is above all a club of bankers

The Baseline Scenario

By James Kwak

I wrote a column that went up this morning at The Atlantic about the ProPublica/This American Life story about the New York Fed. The gist of the argument is that we all knew the New York Fed was captured; for people like Tim Geithner, that’s a feature, not a bug.

There was a paragraph in my original draft that I really liked, but I can completely understand why the editors didn’t want it:

“When Tyrion Lannister wants his son killed, he sentences him to death in public. When Avon Barksdale wants potential incriminating witnesses killed, he obliquely lets his lieutenant know that he’s worried about loose ends—because he doesn’t want his fingerprints (voiceprints, actually) visible. When senior New York Fed officials want their staff to go easy on Goldman Sachs—well, they don’t need to lift a finger. The institutional culture takes care of it for them.”

This is…

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