But every now and again people throw up a controlled experiment

TO BE NOTED: From Bronte Capital:

"A tale of two banking crises: Japan and Korea

Economics may be a “science” but it lacks controlled experiments. Especially in macroeconomics you can’t repeat an experiment with one variable changed and see how the single variable changes the outcome. Economists have lots of statistical tools to deal with this – but those make the discipline either incomprehensible or diabolically boring. [Apologies to all those who taught me econometrics.]

But every now and again people throw up a controlled experiment – two situations that are very similar and differ markedly only in one major element. Yet strangely these situations seem under-studied.

What I want to do here is give a stylised version of Japanese and Korean economic history and how it pertains to the banking crisis both countries had. My knowledge of this however comes the way much of my stuff comes – from the history of the banks backwards. So I am sure to offend people with deep understandings of the political/economic history and I welcome someone telling me I am just wrong.

First however I need a stylised history of Japan starting with the arrival of Commodore Perry’s black ships in 1853.

Before Perry Japan was almost autarkic. There was a relatively weak central government and about 300 “han” – being relatively strong feudally controlled districts. The emperor did not effectively speak for Japan when Perry came in, guns blazing.

The Meiji Restoration changed this. Japan was reformed as a centrally controlled empire – with a ruling oligarchy ruling through the Emperor who claimed dominion over all of Japan. The “han” were combined to form (75?) prefectures with a governor appointed centrally.

The view of the new oligarchs was that Japan would get rich through (a) industrialisation and (b) unequal trade treaties to match the unequal treaties imposed on Japan by Perry et al. To this end they invaded Korea and started the military industrialisation that ended eventually with World War 2. There were major wars in Korea and against an expansionist Tsarist Russia (especially 1904-1905).

Ok – that is your 143 word history of Japan from Perry to World War 2. Like any 143 word history it will leave out important stuff. I just want to focus on how this foreign policy adventurism was financed.

Financing Japanese expansionism - and that financial system until today

Firstly it is simply not possible to expand heavy industrialisation of the type required by an early 20^th Century military-industrial state without massive internal savings. Those steel mills had to be funded. And so they set up the infrastructure to do it.

Central to this was a pattern of “educating” (the cynical might say brainwashing) young girls into believing that their life would be happy if they had considerable savings in the form of cash balances at the bank (or post office). Japanese wives often save very hard – and are often insistent on it. The people I know who have married Japanese women confirm this expectation survives to this day.

Having saved at a bank (and for that matter also purchased life insurance from an insurance company loosely associated with the bank) the financial institutions had plenty of lendable funds.

The financial institutions by-and-large did not lend these funds to the household sector. Indeed lending to the household sector was mostly discouraged and was the business of very seedy loan sharks. To this day Japan has a relatively undeveloped credit card infrastructure with very high fees. These high fees are a throwback to the unwillingness of the institutions to lend to households.

Japanese banks instead lent to tied industry – particularly heavy industry. It was steel mills, the companies that built power plants, the big machine tool makers. Many of the companies exist today and include Fuji Heavy Industries, Kawasaki Heavy Industries and other giants such as Toshiba. Most of these super-heavy industrials were tied to the banks (and vertically integrated) called Zaibatsu.

Now steel is a commodity which has wild swings in its price. Maybe not as ordinarily wild as the last five years – but still very large swings. And these steel mills were highly indebted to their tied banks. Which meant that they could go bust.

And as expected the Japanese authorities had a solution – which is they deliberately cartelized the steel industry and used the cartel (and import restrictions) to raise prices to a level sufficient to ensure the heavy industry in question could service its debt.

The formula was thus (a) encourage huge levels of saving hence (b) allow for large debt funded heavy industrial growth. To ensure it works financially (c) allow enough government intervention to ensure everyone’s solvency.

When the Americans occupied Japan their first agenda was to dismantle the Zaibatsu. They were (in the words of Douglas McArthur) “the moneybags of militarism”.

Like many post WW2 agendas that agenda was dumped in the Cold War. The owners of the Zaibatsu were separated from their assets and some cross shareholdings were unwound – but the institution survived – and the Zaibatsu (now renamed Keiretsu) remained the central organising structure of Japan. Dismantling Japan’s industrial structure did not make sense in the face of the Korean War. The pre-war Zaibatsu had more concentrated ownership than post-war Keiretsu.

The point is that it was the similar structure before and after the war – and it allowed massive industrialisation twice – admittedly the second time for peaceful purposes.

Now the system began to break down. Firstly by 1985 steel was not the important industry that it had been in 1950 or 1920. Indeed almost everywhere you looked heavy industry became less important relative to other industrialisation. By the 1980s pretty well everywhere in the world tended to look on such heavy industries as “dinosaurs”. This was a problem for Japanese banks because they had lent huge sums to these industries guaranteed by the willingness of the State to allow cartelisation. You can’t successfully cartelise a collapsed industry.

Still the state was resourceful. Originally (believe it or not) they opposed the formation of Sony – because they did not know how to cartelize a transistor industry. Fifteen years later the UK Prime Minister French Prime Minister President would refer to his Japanese counterpart as “that transistor salesman” and he was not using hyperbole. Still the companies coming out of new Japan – technology driven mostly – did not require the capital that Japan had in plentiful supply. If you look at the companies coming out of Kyoto (Japan’s Silicon Valley) they include such wonders as Nintendo – companies which supply huge deposits to banks – not demand huge funds from them. [Incidentally in typical Japanese fashion the biggest shareholder in Nintendo is Bank of Kyoto. Old habits re-cross shareholdings die hard.]

The banks however still had plenty of Yen, and they lent it where they were next most willing – to landholders. The lending was legion and legendary – with golf clubs being the most famous example of excess. [At one stage the listed exchange for golf club memberships had twice the market capitalisation of the entire Australian stock exchange.]

Another place of excessive lending was to people consolidating (or leveraging up) the property portfolios of department stores. Think what Bill Ackman plans to do to Target being done to the entire country – and at very high starting valuations.

Meanwhile the industrial companies became zombies. I have attached 20 year balance sheets for a few of them here and here. These companies had huge debts backed by dinosaur industry structures. They looked like they would never repay their debts – but because they were so intertwined with the banks the banks never shut them down. As long as interest rates stayed near zero the banks did not need to collect their money back from them. As long as they made token payments they could be deemed to be current. There was not even a cash drain at the banks at low rates. The rapid improvement in the zombie-industrial balance sheets in the past five years was the massive boom in heavy industrial commodities (eg steel, parts for power stations etc). Even the zombies could come alive again… only to return to living dead status again quite rapidly with this recession.

Anyway – an aside here. Real Japan watchers don’t refer to the banks as zombies. They refer to the industrial companies as zombies. (Although most of the Western blogosphere does.)

Most of the banks had plenty of lendable funds and a willingness to lend them. They did not have the customers – and the biggest, oldest and most venerable of Japanese companies were zombies. So were the golf courses, department stores and other levered land holders. I get really rather annoyed when people talk of zombie banks in Japan – it shows a lack of basic background in Nihon.

Note how this crisis ended.

1). The bank made lots of bad loans – firstly to heavy industrial companies and secondly to real estate related companies (golf courses, department stores etc).

2). The loans could not be repaid.

3). The system was never short of funding because the Japanese housewives (the legendary Mrs Watanabe) saved and saved and saved – and the banks were thus awash with deposit funding.

4). The savings of Mrs Watanabe went on – indeed continued to grow – with zero rates.

5). Zero rates and vast excess funding at the banks made it unnecessary for the banks to call the property holders and (especially) the industrial giants to account for their borrowings. Everything was just rolled.

6). Employment in the industrial giants of Japan thus never shrank (Toshiba alone employs a quarter of a million people). The economy continued to sink its productive labour force into dinosaur industries and dinosaur department store chains.

7). The economy stagnated – but without collapse of any of the major banks and without huge subsidies to the banking system. [The number of banks – mostly regional banks – that failed during the crisis was not large given the depth of the crisis.]

Now lets look at Korea.

Korea was occupied by Japan until the end of WW2. They chose to industrialise in the pattern they understood – a Japanese pattern. For Keiretsu substitute Chaebol and you have the idea. The Chaebol were private heavy industrial conglomerates tied to financial institutions and with intense government support.

And the Chaebol suffered the same fate (slow irrelevance of heavy industry) as the Japanese heavy companies except they were called to account and many of them failed.

The reason is the different banking structure. Korea started its Chaebol industrialisation later than Japan – and the one multi-generational part of the formula (educating young women that they should save and save and save) was just not done as well. This is a multi-generational process.

The result is that the Korean banks – unlike their Japanese counterparts – were short funds. Endless funding at zero interest rates was simply not possible. Given that the banks eventually collapsed – with many becoming government property and with the government winding up as the largest shareholder in almost all banks. This was a spectacular crash – as opposed to a slow-burn malaise. Chaebol failed. In some instances their founders were imprisoned. The strongest Chaebol is the one most associated with new industries (Samsung). It survived and prospered – but others did not.

Korea had a much worse recession than Japan. Vastly worse. Japan was just low growth for a very long time. By contrast the Korean economy crashed and burned. But it also recovered very fast and at one point (1999-2000) the Korean Stock market was 1932 Great Depression cheap. It bounced.

It is my contention that the main difference between the Korean and Japanese crashes (and Korea’s case recoveries) was the funding of the banks. In this view Korea’s was so sharp because the banks simply ran out of money – and that caused massive liquidations across the economy – systemic failures.

The recovery was also sharp because the systemic failure meant that businesses that shouldn’t have failed (because they were profitable worthwhile businesses) got into deep distress. Real companies died not because they deserved to die but because the system in crisis killed them. There was a case for bailing out those companies – and the rapid recovery told you this was something systematic – not business specific. The massive upward movement in the stock market at the end of the crisis was the secondary proof that good businesses were killed. It was also probably the best investment opportunity globally in the last twenty years.

The economic decline in Japan was so gradual and so sustained precisely because there was no systemic failure and no reason to reallocate resources from bad businesses to good businesses. Zombie companies could exist for decades – and there was no renewal. A little bit of failure would have been a good thing – creative destruction. And the survival of bad businesses in Japan is part of the reason the stock market never bounced there. No investment opportunities.

Policy question: how do you ensure the creative destruction without putting the good bits of the real economy to the sword?

Investment question: what bits of the USA (and the rest of the world) will wind up looking like Korea and providing the best investment opportunity in two decades? And what bits will look depressed for two decades before going into a bit of a decline?

For discussion. And thanks for bearing with a long post.

John

Posted by John Hempton "

Sheila Bair confiscated a solvent bank encouraged by lying bankers

TO BE NOTED: From Bronte Capital:

"JP Morgan lied to regulators

I purchased preferred shares in Washington Mutual when it was in distress and lost money when it was confiscated by Sheila Bair. I have argued that it was the most extraordinary action made by government during this crisis and that an essentially solvent bank was confiscated.

In anger I posted my response to the WaMu takeover the day after it happened. I also purchased adwords on Google so that when you google Sheila Bair’s name you will get an advert linking to my blog and explaining why she should resign. It is no secret I dislike Sheila Bair.

Moreover there are law suits (whose basic premise I agree with) that JP Morgan whilst doing due diligence on Washington Mutual was also badmouthing them in the press and encouraging the regulator to take them over. [It is easier to sue JPM than the Federal Government.]

That said – we have a fairly comprehensive proof that JP Morgan did lie to regulators. The only issue is did they lie to regulators when encouraging them to confiscate Washington Mutual or did they lie when they were conducting the stress test? If they lied to Sheila Bair to get them to confiscate WaMu and she believed them then she must resign. But the alternatives I see are worse.

Detailing the JP Morgan lies

First you need to look at the document that JPM released when it took over WaMu.

Here is – with what they think the losses will be in the various stress scenarios.

JP Morgan is predicting $36 billion in losses in WaMu's book in their base case and $54 billion in the "severe recession" case.

These losses are measured since December 31 2007. The losses as estimated in the stress test are from the end of 2008 – and to get the numbers consistent you need to take about 8 billion dollars off these numbers as about 8 billion in losses were realised during 2007.

It already looks like we are in the severe recession. Unemployment is well over 8 percent. On these numbers – numbers that were presented by JP Morgan to the market and to regulators – JPM has to take a further $46 billion in losses on the Washington Mutual book alone. (46=54-8).

Almost all of these losses come from mortgages. Indeed in the presentation JP Morgan made when it merged with Washington Mutual all the losses except about a billion dollars came from the mortgage book.

The only problem is that the losses estimated on mortgages by the regulators (including Sheila Bair) in the stress test include only $39 billion in losses – being 12 percent of the entire mortgage book. Here are the results of the stress test on JPMorgan.

The implication is that there are negative losses in the rest of JP Morgans very large book. This is unlikely.

So we are left with two possibilities both of which involve JP Morgan telling porkys:

1. The losses as estimated by the JP Morgan and told to regulators when they were manipulating Sheila Bair into confiscating Washington Mutual were lies – indeed were so grotesquely over-estimated as to be absurd criminal lies or
   
2. The losses as estimated by JP Morgan and the regulators in the stress test are grotesque under-estimates – which – in order to be that grotesquely wrong had to involve major misrepresentations of their book by JP Morgan.
   

It is possible that both sets of losses were grotesquely mis-estimated - though the differences here are so stark that a simple and honest "bit of both" is not possible.

I prefer the first choice. The losses at WaMu as suggested by JPM never made any sense – and I prefer the idea that – encouraged by JPM’s lying – Sheila Bair confiscated a solvent bank.

The second choice suggests the stress tests were totally phoney and allowed JP Morgan to lie at will. If that is correct the regulators have a duty to confiscate JPMorgan as its embedded losses (using similar ratios as they used in arguing for the Washington Mutual takeover) leave it desperately and diabolically insolvent.

The idea that Sheila Bair confiscated a solvent bank encouraged by lying bankers should not surprise anyone familiar with big-bank lobbying prowess. Most the bears in the blogosphere would prefer believe the stress test was phoney without any real assessemnt of likely losses.

John

Technical accounting note the losses in the stress test page were before 20 billion in purchasing adjustments. Those purchasing adjustments were JPMorgan over-estimating the losses at WaMu so - as the loans come in a little better than expected JPM shows better-than-real earnings.

POST SCRIPTS: The first response I got to this suggests a third possibility - that JP Morgan (and presumably all the other banks) were ASKED to give the regulators the information that they wanted to hear for the stress test - that they were asked to lie. That I suspect stretches reality. It is hard to keep things like that quiet - and also some banks (notably Wells Fargo) are very unhappy.

Posted by John Hempton "

I can’t think of anything more market sensitive than stress test results

TO BE NOTED: From Bronte Capital:

"Stress test results: Who is leaking?

The FT has yet another story about the stress test results – this one being that Bank of America and Citigroup have to raise $10 billion each. Apart from the obvious which is that Citi appears to need more than Bank of America the whole story (and most of the competitor stories) have left me perplexed.

It’s not the numbers. There are too many assumptions in bank accounting to make their capital position anything other than an educated guess.

It’s the source of the leaks that perplexes me.

We have had a (minor) scandal about Bank of America being instructed by Paulson (then Treasury Secretary) to consummate their marriage to Merrill Lynch.

We know that somebody breached disclosure laws. But in this case the somebody was Ken Lewis under instruction from his political overlord.

I can’t think of anything more market sensitive than stress test results. If some banks get massively diluted and other banks do not then some stocks will fly and others might languish. This information is incredibly valuable.

Leaking is a market regulation breach of the first order. Prison time. And there is the odd State Attorney General prepared to investigate.

And yet the leaks seem to come thick and fast.

I have no really good theory (though lots of bad ones) as to who would be breaching fair disclosure regulations on this scale and why they would be doing it?

And if you are going to be taking that risk why wouldn't you do the obvious trades and get filfthy rich?

Suggestions?

Posted by John Hempton"

the confiscation of Washington Mutual was perhaps the single most destructive government action of this cycle

From Bronte Capital:

"Mixed up policy responses and liquidity preference

I frequently get emails suggesting that governments should force banks to lend and that would solve the recession. I tend to agree but it would be difficult – and the government actions to date have exacerbated the lack of lending.

As it is, there is little to no balance sheet growth at any major bank in America and aggregate bank lending is falling. Excess cash at the Federal Reserve is building up fast. The economy is still sour (and getting more so) and bank credit losses are continuing to rise.

Meanwhile banks sit on cash.

Bank of America (for recent and topical example) is carrying $173 billion in cash and cash equivalents – a number which immunises them against many but not all ills and is about $140 billion higher than normal.

This excess cash inhibits BofA profitability by maybe 5-7 billion per annum (pre-tax). They don’t really want that profit drain – but – in a telling comment – they thought it was worth it to have that negative carry because the cost to running short of liquidity was too high.

The excess cash across the entire banking system probably exceeds a trillion dollars. If only it could be spent – then we would have the stimulus we need.

Alas – that is what is meant by being at the zero constraint of monetary policy. We have banks with a seemingly endless liquidity preference. It is not that there is no demand for loans (though demand is much ameliorated). Banks are rapidly tightening lending criteria too and indeed some banks are just not lending to new customers.

Now lending standards needed to tighten. 2006 was insane. But early 2009 is also insane– and if it were a perfect world lending would have moderated much slower so as to displace maybe 200 thousand workers per month. (The economy can usually generate new jobs that fast.) Indeed the whole idea of stimulus is to slow the rate of job loss in the economy down to a level where normal functioning of the labour market can deal with it.

That is not where we are. We have an extraordinarily rapid change in liquidity preference for banks, an extraordinary tightening of standards and an extraordinary recession.

Now some people are into forcing the banks to lend. Willem Buiter (who is often clever and sometimes wrong) suggests confiscating banks that will not lend. Useless as tits on a bull he says.

That would be fine if he did not want to confiscate marginally insolvent banks too. A bank that is stretched for capital or liquidity would usually preserve both by restricting lending. You restrict lending so as not to be confiscated – except in Willem Buiter’s world where you lend to avoid being confiscated.

Now I thought that the confiscation of Washington Mutual was perhaps the single most destructive government action of this cycle. That was a minority view – and remains one. Felix Salmon thinks I am alone – but a paper from the New York Fed makes it clear that the confiscation of WaMu very rapidly increased the liquidity preference of mainstream banks and hence spread the crisis from the Wall Street Banks to Main Street.

The lesson of Washington Mutual – learned hard – was that you could have adequate capital but a minor run and be confiscated. The only way to cope was to have massive excess liquidity.

And so we are in an unusual liquidity trap. In the Japanese liquidity trap the general populace had massive excess cash savings. The liquidity preference was the preference of the legendary Mrs Watanabe who liked sitting – in cash – on three years of Mr Watanabe’s salary.

In America the liquidity preference belongs to banks. Mr and Mrs Middle America are not swimming in cash. Indeed all the evidence suggests that they are over-indebted. It’s the banks that are swimming in cash. And it is the bank’s excess demand for liquidity that makes monetary policy ineffective.

Now Paul Krugman has argued that it doesn’t really matter why we are at the zero bound in monetary policy – but I think it does. If we are at the zero bound because Mrs Watanabe wants to save to excess then we should target Mrs Watanabe. If we are at the zero bound because Bank of America is scared of arbitrary government action (as evidenced in the confiscation of WaMu) then we should address Bank of America’s concern.

The first way to address Bank of America’s concern is for Sheila Bair to fall on her sword. She should resign because – through confiscating Washington Mutual – she spread the crisis to Main Street. But regular readers should know I have a very low opinion of her and will not be surprised by that comment.

But I have a second proposal. It is floated for discussion only as it is obviously risky. The idea is that the bank capital adequacy requirements be dropped a couple of percentage points – but only if their genuine third party loans fully owned on the balance sheet are growing by more than say five percent per annum.

Posted by John Hempton "

Me:

Don said...

OK. I agree that WaMu was a mistake. But Figure 2 still supports my contention that Lehman started the crisis. You can only interpret the WaMu seizure within a context of a Calling Run having begun. However, I believe that the government should have intervened to save WaMu, given its circumstances. Or, at the very least, given WaMu more time. This still supports my view that government intervention was expected and depended upon. I don't know if you agree.

Absent Lehman and a Calling Run, I don't think WaMu would have been seized. However, remember, you're for consolidation. I'm not.

Don the libertarian Democrat

April 23, 2009 5:43 AM

the party selling the assets (presumably a large and stressed bank) is also subsidized

TO BE NOTED: From Bronte Capital:

"A little bit of careful thinking – and why Krugman’s despair is misplaced

I am not an economics academic. I gave that game away for the lure of lucre and funds management. But this job throws up more than a few ideas for publishable economics papers – whereas when I was a student I was desperately short good ideas.

Here is one – a pure throwaway – for anyone that wants it. (It’s a nice paper for a masters thesis.)*

It has also explained neatly the problem of not getting banks to bring assets to the Geithner Funds – and in a way which I suggest is surprising.

It started as I tried to pick apart Rortybomb’s analysis of the Geithner Plan. Rortybomb does – in more formal form what Krugman does – analyse the non-recourse financing of the plan as a subsidy. He suggests that the non-recourse nature of the funding is a put option to the Treasury/FDIC of the assets – and that the correct way to model it is using (standard) option pricing models. Rortybomb’s posts are here and here. Krugman is a little more simplistic – but the idea is the same. Krugman produces a two-outcome model (rather than the range implicit in the option pricing model) and demonstrates there is a subsidy. Krugman’s post is here.

Anyway if you use a standard option pricing model and assume some volatility of outcome it is not hard to quantify the subsidy implicit in the plan. I have borrowed Mike’s (ie Rortybomb’s) diagrams. I hope he doesn’t mind.

The subsidy is dependent – as Rortybomb would acknowlege – on the leverage of the fund, the diversification of the fund and the variability of outcomes (particularly stress outcomes). All of this is standard option theory.

Now this is all fairly convincing until you work out that the party selling the assets (presumably a large and stressed bank) is also subsidized. The policy of the US Government (stated many times) is that there should be “No More Lehmans”. You may argue with this policy (reasonable people myself not included) think that this is the wrong policy. But you can’t argue that it isn’t the policy. The demonstration is that any bank that gets into any kind of liquidity trouble gets a “Sunday Night Liquidity Fix”. The availability of that Sunday Night Fix is a subsidy for the bank – just as surely as the non-recourse funding is a subsidy for the Geithner Fund.

So the issue is whether the Geithner Funds reduce the tail risk for the government – not whether the funds are themselves subsidized. After all the assets being sold are from non-recourse finance banks (losses beyond capital borne by the taxpayer) to non-recourse financed funds (losses beyond capital borne by the government). It depends on the relative solvency of the banks and the Geithner funds.

Thinking carefully there should be four broad outcomes:

• Both the bank and the Geithner fund is solvent

• Both the bank and the Geithner fund is insolvent

• The Geithner fund is insolvent but the bank is solvent

• The Geithner fund is solvent and the bank is insolvent

When both the bank and the Geithner Fund is solvent ex-poste there was no cost to the government. Sure there was an ex-ante subsidy but it didn’t cost anything. This case should not worry us.

The second case – when both the banks and the Geithner funds are insolvent the government will lose money – but it will lose less money than it would without the Geithner Plan. After all there was some private money in the fund – and that reduced the end loss borne by the government. In other words subsidy be damned - the plan reduced government losses.

The third case is problematic. If the Geithner Fund is insolvent and the bank is solvent then the Geithner plan cost the taxpayer real money.

The fourth case where the fund is solvent and the bank is insolvent is also problematic – but in a different way. The fourth case is where the banks sold good assets to the fund (presumably for liquidity) and kept the bad book for itself (because it could not sell it). Now in this case the subsidy to the Geithner Funds is not a problem – rather it is the desperation of the banks to sell assets, any assets and only being able to sell good assets. The more subsidy you give the Geithner Funds and the more competition between Geithner Funds you have (bidding up the price of the asset) the lesser the end problem for the banks. Either way however we shouldn’t be that stressed about the subsidy to the Geithner Fund.

Indeed the only place that we should be really stressed about subsidy to the Geithner Funds is the third case – where the fund is insolvent but the banks are solvent.

Oops. The people that are really stressed about the subsidy to the Geithner Fund (Krugman, Felix Salmon, Yves Smith of Naked Capitalism, Mike of Rortybomb) are also worried about or even convinced that the banks are insolvent. Indeed several of these people just advocate nationalisation now.

This is illogical. It is the second time I have accused Krugman of gross illogic – but it is simply illogical to believe that

(a). The banks are largely insolvent,

(b). The right or actual government policy is guarantee big banks (ie no more Lehmans) and

(c). The subsidy to the Geithner Funds is a real problem.

If both (a) and (b) applied the Geithner Fund MUST save the government money - so the subsidy is irrelevant.

This illogic extends to several of the bloggers I admire most. That is why I think there is a good academic paper in there. Krugman actually expresses “despair” over the subsidy. His despair is misplaced.

I guess the extension is to model it with many Geithner Funds, some of which are solvent, and some of which are insolvent. The situation might wind up more nuanced. Indeed my rough modelling (Monte Carlo rather than rigorous maths) suggests that it is more nuanced – but only slightly. The nuance disappears if the diversity of the Geithner Funds matches the diversity of the banks.

Success of the Geithner Plan

One concern with the Geithner plan is that the banks won’t actually come to the party and sell assets. It’s a concern taken up by Charlie Rose when he interviewed Timothy Geithner and dismissed in the Bronte Capital submission on administration of the plan.

Now – thinking about it I am not quite so sure. There are simple explanations as to why banks won’t bring assets to the plan – see for instance this post from Accrued Interest. But the most obvious reason is that the relatively good assets logically belong with the party with the biggest subsidy. And that might be the banks. The fact that banks won’t bring assets to the Geithner funds is in fact a measure that the relative subsidy of the Geithner funds is too low.

John Hempton

*At one stage I tried to contact Brad DeLong possibly about being involved in a PhD program at Berkley (ideally with him). We managed never to connect. And I have since given up that goal."

There is a serious conflict of interest problem with the Geithner Plan.

TO BE NOTED: From Bronte Capital:

"Sheila Bair is either a criminal or a grotesquely incompetent stark raving idiot

It is no secret that I do not like Sheila Bair. My original reason for dislike was posted here.

But now she is open to deliberately allowing massive fraud against US Taxpayers.

There is a serious conflict of interest problem with the Geithner Plan. These problems were first outlined by Steve Waldman in his “dark thoughts” post. I noted that the application terms for the Geithner funds seem guaranteed to maximise conflict of interest.

In short – if you have a small interest in a fund (kindly levered to be large by the US taxpayer) and a big interest in a bank you have a massive incentive to overpay for the assets purchased from the bank sticking the losses to taxpayers and thus increasing the value of your bank holdings.

The defence of course is to have strict separation between the banks selling the assets and the Geithner Funds buying the assets. Arms length separation is thus a basic and minimal requirement of the Geithner Plan.

However Sheila Bair is now open to letting banks selling assets participate in the Geithner funds. This was reported in the WSJ – hat tip to Clusterstock.

I guess Sheila Bair can’t see a conflict of interest – only a “convergence of interest”.

However designing the plan to maximise theft is designing the plan to fail. This is American politics – and rampant deliberate tampering with government procurement (ie criminality) is a possibility – but in Sheila Bair’s case I see only incompetence.

I am naturally attracted the Geithner plan. I have stated that many times – but now I am plain sickened. Sheila Bair should be removed from office if the Obama administration is to have any chance of succeeding. This statement potentially maximising conflict of interest – and the possibility that criminal fraud is the driver – should be enough to impeach her. Her defence – and in her case it is a solid defence – is incompetence. And that determines the right outcome. She should resign.

Posted by John Hempton at 12:13 PM "

It is unequivocal that a policy of “no more Lehmans” requires an effective guarantee of all the large US financial institutions.

From Bronte Capital:

"Financial chauvinism

There is a lovely comment on the last post accusing me of financial chauvinism – suggesting it is wrong to guarantee all bank liabilities.

This gets to the nub of the issue.

The current US policy is – pretty close to officially – that there should be “no more Lehmans”. Bernanke said it this week. Geithner has said similar.

It is unequivocal that a policy of “no more Lehmans” requires an effective guarantee of all the large US financial institutions. When one of them threatens to become the next Lehman it needs to be bailed out. The US government tips $30-300 billion in and gives us a Sunday evening press release – just for me to read in my Asian time zone before our local market opens!

Face it – the current policy is to issue the broad guarantee. That is what we have done. That is what “no more Lehmans” means. It means losses are covered when they are incurred by the taxpayer.

Once we have done that there is no real argument against a non-recourse funded troubled-asset program. That is just another form of non-recourse funded financial institution. The argument really is “how much capital should we demand the private sector put in, and on what leverage and confiscation terms?” It is the same argument for regulation of a bank.

But it is not universally accepted that the right policy is “no more Lehmans”. Chris Whalen (who I respect) thinks the right model for the dismantling of large financial institutions is Lehman. As he says the model is easy to determine – just go down to the Southern District of New York and talk to the trustee.

I think the consequences of allowing several uncontrolled large bank failures would be catastrophic – and the cost to the taxpayer of the effective guarantee will be huge (but probably less than a trillion dollars by the end of the cycle) – but lower than the cost of the great-depression event that would follow from a cycle of mega-bank collapses.

In Sweden the right policy was the guarantee – and selective nationalisation – precisely because the cost of the guarantee was not large. The institutions were not very insolvent. In Iceland the institutions were so large that the guarantee just was not feasible.

It is however very hard to tell what is insolvent in advance. Svenska Handelsbank was brimming with solvency and the market wrote it off for dead. It was a rapid 20 bagger when the crisis ended. If it were easy to tell how insolvent then there would be no big banks that were rapid 20 bagger stocks when financial crises end.

And it would be easy to tell the right policy.

The most important policy question is whether you issue the blanket Swedish guarantee. I think the answer is an unequivocal yes in the US – and a probable no in the UK. Krugman is edging towards a yes as he says in this post.

If it is a yes (open for debate) then the non-recourse finance model for the troubled asset funds does not pose any further problem.

The facts on the ground are that the policy is a de-facto guarantee – as officials regularly say that there will be “no more Lehmans”.

Krugman’s current position (probable yes on the Swedish position, blanket opposition to new capital on a non-recourse basis) is untenable.

John

PS. I have stated before - and it is reiterated in the comments

The problem with the ad-hoc guarantee is that nobody really thinks that it is a guarantee – and the generalised wholesale run on financial institutions will continue until they are sure. In other words we are effectively guaranteeing the liabilities without getting the policy benefit of that guarantee (which is the restoration of faith in the financial system).

Posted by John Hempton "

Me:

Don said...

You've got it right. As soon as Debt-Deflation became a real possibility, we were stuck with a guarantee, but we hoped not everyone would notice, or, even sillier, that we could issue the guarantee to stop the run, and at the same time scare the bondholders into folding. This was my game, for sure.

Instead, these bondholders, including countries and insurers, keep calling my bluff. They're like the mortgage lenders and servicers, more than happy to play the hand out until the very end, betting we'll fold. And that's what we have to do.

China's telling us today that defaults aren't wise. If they go down, they'll take us with them. That's what all the bondholders have been saying. The spreads have delivered the message clearly and effectively. Enough with defaults and implicit guarantees. You've shown your hand. It's time to play it.

See, the bondholders are countries and insurers, the guys now calling for a bailout. We'll pay these insurers now or later, but we'll pay. As for the countries, they'll start demanding higher interests going forward if we default. They're going to get paid eventually as well.

Let's move on. Our one consolation is that, if we have to seize a few monsters, this should make it easier.

Just one more point. If you look at what the B of A, Citi, and even AIG have been saying, you'll notice that their "crown jewels" and profit centers are foreign holdings. Don't ask me how we keep them solvent without letting them keep these assets. Maybe somebody else can tell me.

Don the libertarian Democrat

March 14, 2009 6:07 AM

what parts of the banking structure you are going to either guarantee or effectively guarantee

From Bronte Capital:

"Paul Krugman’s false logical step

To my way of thinking Paul Krugman has finally nailed the question as to bank nationalisation that matters. This the money quote:

That said, some decision must be reached on bank liabilities. Sweden guaranteed all of them. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership. And I’m ready to be persuaded that some debts should not be honored — this is a deeply technical question.

He is absolutely right that this is the critical step in the decision making process is what parts of the banking structure you are going to either guarantee or effectively guarantee. The critical question is not nationalisation.

Sweden could guarantee all banking liabilities because – frankly – their banks were not that deeply insolvent.

We know they were not that deeply insolvent for a few reasons – the best of which is that ex-post the Swedish bailout cost very little (and the Norwegian bailouts were actually profitable for the government).

However it is fairly easy ex-post to tell how insolvent the banking system was. It is not very easy ex-ante to tell. If it were easy then banks that were not at all insolvent (such as Svenska Handelsbank) would not become 20 bagger stocks quite quickly after the crisis. The stock market would not have marked them down so much.

The US Government’s stated position – Bernanke yesterday as well – is that there will be "No More Lehmans". What that means is that there will be no more uncontrolled liquidations of large financial firms.

The only way that the government can say that there will be no more Lehmans is to effectively guarantee large parts of the financial system. That is what the statement “no more Lehmans” means. If you want to make that statement operational you either (a) need to guarantee the banking system or (b) pour money in continuously whenever a bank (Citigroup. AIG or otherwise) threatens to become the next Lehman Brothers.

The state of US policy at the moment is nothing more sophisticated than (b) above – which is whenever an institution threatens to become Lehman the US Government tips in another 30-300 billion. We are still in the world of the ad-hoc guarantee - of the Sunday press release.

The problem with the ad-hoc guarantee is that nobody really thinks that it is a guarantee – and the generalised wholesale run on financial institutions will continue until they are sure. In other words we are effectively guaranteeing the liabilities without getting the policy benefit of that guarantee (which is the restoration of faith in the financial system).

Krugman has nailed the right question. The right question is whether the correct policy is “No More Lehmans”. I am pretty sure it is. I think the revisionist history about how bad the Lehman failure was is simply revisionist crap. I am convinced that at least in some instances the “no more Lehmans” policy will be operationally expensive in some instances and will leave the taxpayer with an enormous hangover*. The alternative is simply to allow big institutions to be pulled apart by the FDIC. Chris Whalen by contrast is convinced the other way – he says the model is easy to determine – just go down to the Southern District of New York and talk to the Lehman Trustee.

There is a reason why the right policy might not be "No More Lehmans". Its about cost. If the cost of making that promise operational was $12 trillion then you probably should just let the financial system burn. Why – because it is so much money the taxpayer could not plausibly absorb it without decades of higher taxes. If the cost is $1 trillion then hey – just suck it up - a fast rebound to the US economy as per Sweden after its crisis is worth more than a trillion dollars. The cost depends on the size of the banking system and the size of the losses relative to GDP. Iceland had to let its system burn because it could not plausibly bail out its banks. The UK banks started with very little capital and with very big balance sheets relative to GDP. They are also problematic. The US banks by contrast started with lots more capital and smaller balance sheets relative to US GDP. The upper-end estimate of losses (Roubini) is $3.4 trillion. If that is the case the upper limits to cost of the "No More Lehmans" policy is less than $3.4 trillion.

My long post has some indication of how you might estimate the costs of making a “No More Lehmans” promise operational. I have a forthcoming post which explains quite carefully what the least cost way of making that promise operational is. (The costs are however potentially very large - and whilst I think substantially less than the Roubini number I can't dismiss the possibility the costs could be large indeed.)

Anyway – if you have made the decision to have “No More Lehmans” then you have made the important decision – you are going the Swedish Route and guranteeing stuff - whether by Friday evening crisis or whether by design. I think America will go the Swedish Route – I am just waiting. The Swedish route is guarantee and selective nationalistion. I have never been afraid of the Nationalisation word – and anyone who buys money center banks now can expect a few of them to be nationalised. I have small positions - which would be larger positions if I knew the rules.

But the second part of Krugman’s paragraph contains a deeply troubling false logical step. He says: “but of course we can’t do that unless we’re prepared to put all troubled banks in receivership”.

To see why this is a false logical step you need a little history. A long time ago most the liabilities of almost all banks were deposits. The government guaranteed the deposits by creating the FDIC – it hence stopped crisis driven bank runs. It increased stability in a crisis. However it also allowed financial firms to take huge risks or even be looted (as per Charles Keating). The solution which was adopted (and let lapse of late) was that banks got the guarantee – but were heavily regulated to protect taxpayer interests. There was no need to nationalise the banks simply because you guaranteed the bulk of their liabilities. There was however a requirement to (a) regulate them, (b) assess their capital and (c) take “prompt” corrective action when that capital was inadequate. Prompt corrective action included confiscation. You did not take over banks because they had runs (the purpose of the FDIC guarantee was to stop runs), you took over banks when they inadequate capital.**

Nowadays a lot of banks have the bulk of their assets funded by things that are not deposits. Indeed at many banks deposits constitute less than half the balance sheet.

The old FDIC guarantee can’t stop runs because the run that happens is wholesale – it happens outside FDIC guarantee limit. If you want to stop bank runs the way that the original FDIC stopped bank runs you need to bite the “Swedish Bullet” – that is you need to effectively guarantee everything.

However just as the creation of the FDIC did not require you to be “prepared to put all troubled banks in receivership” a Swedish guarantee also does not require you to put all troubled banks into receivership.

What the FDIC guarantee required – and what a Swedish Guarantee will require – is you be prepared to (a) regulate banks heavily on an ongoing basis, (b) test the capital of banks, (c) force them to be adequately capitalised (rasing money if they can), and (d) nationalise the banks that cannot raise adequate capital.

When the good times return you probably need walk away from this general guarantee. In other words you have to regulate banks in such a way that they can’t become large enough to destroy the whole economy - so that you reduce the systemic risk at the cost of stifling "financial innovation". That means that the recidivist Citigroup – a bank that seems to blow up every cycle – will never be allowed to become as big and nasty again. It would be a terrible policy outcome if we did not learn from this crisis and did not regulate in such a way that it was less likely to happen again. Willem Buiter's call for "over regulation of banks" looks right to me.

Krugman’s illogic however does not help the debate. There is a need to guarantee all banking assets – and it should be done provided it is affordable. There is no consequent need to nationalise the whole system – though there will be a need to have a process which will result in nationalisation of some institutions – what I call “nationalisation after due process”.

Oh, and the number of losses in the system is not fixed. If the ability to borrow to fund risk assets is not restored then commercial property for instance will fall until its yield becomes attractive to an unlevered buyer. My guess is that is about 15%. As the economy will be in a slump at the same time and rents will also fall that might mean a top to bottom move in commercial property of 80%. If the move is that big then all the banks (good, bad, otherwise) are insolvent. However if the banks had guaranteed funding then (a) they could lend so the slump in the economy would not be so bad and (b) people could borrow to buy commercial property so its price does not need to fall until the yield is 15%. The top to bottom fall might be 35%. The system losses would be smaller.

If we do not guarantee all bank funding then I am afraid that Christopher Whalen will be right - the macroeconomic wave going through the economy will just smash up everything fast.

The longer we wait before biting the Swedish bullet the larger the system losses will be - and hence the higher the cost of biting that bullet. Either do it now or give up saying that there will be "No More Lehmans". If you wait too long everything becomes Lehman.

It took Krugman a long time to realise that the "Swedish Guarantee" is the important question. And it is. Nationalisation (which should happen for some institutions) is only the secondary question.

John Hempton

Some post scripts

*The instances in which I think the “no more Lehmans” policy will be operationally expensive are (obviously) AIG (almost certainly) Fannie and Freddie and speculatively a few others that are properly insolvent. My biggest problem child is Barclays – which is technically a UK institution – but it is too big for the UK to bail out – and which has a lot of its operations in the US. I suspect that the US can – as a technical thing – let Barclays be the next Lehman – saying – hey – its not one of ours! But that is a post for another time.

**This is one of the things that most annoys me about Sheila Bair’s confiscation of Washington Mutual. WaMu had a run. The old role of the FDIC was not to make banks fail when they had runs – it was to stop runs. I would have no objection to confiscation of WaMu if it was demonstrably insolvent. However it was not demonstrably insolvent – and Sheila Bair’s own press release said it was capital adequate when confiscated. It was a very strange interpretation of her role indeed that she should close a bank because it had a run. "

Me:


Don said...

Actually, I realize now that I agree with you. In the last post, I said that we had already agreed to guarantee everything, if we have to. But, from my point of view, the main reason to announce the guarantees is not to have to spend the money, but to stop the panic, which would allow for a more orderly unwinding of these investments, saving money in the long run. So, I was wrong. Even though we have signaled that we have guaranteed everything, an explicit statement, in theory, would help.

Also, since, from my point of view, we've guaranteed foreign bondholders implicitly by our actions with Citi, we might as well make it explicit. It could be huge, but there's really no other good choice.

Don the libertarian Democrat

March 11, 2009 12:52 PM

Whether Buffett and I are fools – well I will leave that for others to decide.

From Bronte Capital:

"Fools seldom differ

Warren Buffett was on CNBC last night. Maybe he is getting old and vain and likes to be on TV. Maybe he is falling for the (considerable) charms of Becky Quick – but he allowed himself to be interviewed for three hours starting at 5am Omaha time.

That made it good evening TV for me in Sydney Australia.

I was amused to hear my own views – parroted back to me in a more articulate and folksy manner than this blog.

There is a saying – usually ironic – that “great minds think alike”. I immediately think of the come-back that “fools seldom differ”.

Whether Buffett and I are fools – well I will leave that for others to decide. However Joe Kernan (and not the dulcet Becky) got out of Buffett what I believe to be the money quote of the whole interview:

BUFFETT: Yeah, the interesting thing is that the toxic assets [of American banks is] if they're priced at market, are probably the best assets the banks has, because those toxic assets presently are being priced based on unleveraged buyers buying a fairly speculative asset. So the returns from this market value are probably better than almost anything else, assuming they've got a market-to-market value, you know, they have the best prospects for return going forward of anything the banks own. The problems of the banks are overwhelmingly not toxic assets, you know. They may have been one or two at the top banks, but they are not going to do in--if you take those 20 banks that are subject to the stresses, they're not going to do those banks in. Those banks have the earning power which has never been better on new business going out of this to build capital positions if they pay low dividends which they're starting to do now.

JOE: Hm.

BUFFETT: Toxic assets really are not the problem they were. Now, when I said it was contingent--I didn't remember being exactly contingent on TARP, but it was contingent on the government jumping in.

JOE: Right.

BUFFETT: The government needed to act big time in September, I will tell you that.

JOE: So...

BUFFETT: And they did act big time.

JOE: So you are OK with the shift to providing the banks with capital as opposed to the original intention of the TARP for actually getting the toxic assets off the books?

BUFFETT: Yeah, and interestingly enough, they don't need to supply the banks, in my view, with lots of capital. They need to let almost all of--I mean, the right prescription with most of the banks is just let them pay very little in the way of dividends and build up capital for awhile, and they will build up a lot of capital. The government has needed to say--what the government needs to say is nobody's going to lose a dime by having their deposits in these banks. They're going to make lots of money with the deposits.

JOE: Hm.

BUFFETT: The spreads have never been wider. This is a great time to be in banking, you know, if you just get past the past and they are getting past the past. I mean, right now every time a loan is made to somebody to buy a house--and we're making, you know, making millions of loans--four and a half million houses will change hands this year out of a total stock of less than 80 million. So those people are making good mortgages. You want those assets on your books and you get a great spread in putting them on now. So it's a great time to be in banking, but you do have to get past this past. But the toxic assets, in my view, you know, if they've been written down to market, I'd rather buy those assets from the bank than any other assets they've got.

JOE: Hm. OK...

Lets pick this apart: Warren Buffett has been saying that the toxic assets are the best assets of the bank (provided they are marked to market). This is precisely what I have been saying. Moreover he says it for precisely the same reasons that I do – which is that they are being priced based on “unleveraged buyers” buying a fairly speculative asset. Compare this to my explanation in the “long post” – which was that they had large yields because you could not borrow to buy them.

Then Buffet says that the returns from the toxic assets are better than almost anything else. Several people (including some high profile academic economists) disagreed with me about the spread on those assets. That is fine – they are also disagreeing with Warren. He is wrong fairly regularly too.

Then he says the problem of American banks are not overwhelmingly toxic assets. This is a radical view – but it is in my view correct. The problem with the banks is that nobody will trust them and they have not been able to raise funds. The view that this is a liquidity crisis – and not a solvency crisis – has long been a staple of the Bronte Capital blog. It is radical though. Krugman, Naked Capitalism and Felix Salmon think alike – asserting – seemingly without proof – that the problem is solvency. Buffett doesn’t even think the US banks (on average) require capital – a view that most people would find startling (though again I think is correct provided appropriate regulatory forbearance is given).

Moreover Buffett thinks it is not solvency for the same reason as me. To quote: “those banks [including presumably most of the big 20 banks in the US] have earning power which has never been better on new business going out of this to build capital positions even if they pay low dividends which they're starting to do now.” I have been criticised endlessly for pointing out that on pre-tax, pre-provision earnings American banks can quickly regain solvency provided they can maintain funding. This was the point of my Voodoo Maths post – and also the point of much of the long post.

Moreover he goes on to repeat that the opportunities in banking are simply wonderful now – so long as you can get past the past. This was the point in my series of posts on Bank of America’s quarterly numbers. To anyone that looks at the American numbers it is self-evident that the margins in banking are going up sharply and that the opportunities are large right now. However this simple observation set my inbox on fire – to the point that I felt I needed four posts (links 1, 2, 3, and 4) to defend the obvious.

(Incidentally the margin expansion is not evident in the UK – where the banks are properly insolvent – and it is not evident in France where the banks are almost certainly highly solvent. I can’t work out why it is not in evidence in France but if someone wants to explain it send me an email. I would be pleased.)

There were other parts of the interview where Buffett simply agreed with me. For instance he thinks that bank liabilities should simply be guaranteed at this point (at least for the large banks) and that guarantee should carry the personal weight of the President. The alternative is either endless government injections costing as much as the guarantees or uncontrolled liquidation –a dozen Lehmans - as the banks run out of funding. They did issue guarantees in Sweden – and I was hoping and praying that the US would become Swedish.

Krugman is finally coming to the view that the important technical question is whether to issue that guarantee. He is right. Provided the guarantees can be issued at reasonable cost they should be issued. Both Warren and I think the cost would be reasonable in the USA. By contrast I am not sure the UK has the blanket guarantee option because the UK banks are very large relative to the UK economy and they started highly capital inadequate. US banks by contrast started with a lot of capital.

Buffett did not approach the issue of how you treat banks after you have issued that guarantee. I think you should have a process for assessing their capital and require that they have sufficient. Those that do not have sufficient and can't raise it you should nationalise (by diluting the shareholders and preference shares out of existence). That was the point of my “nationalisation after due process” post. Though the nationalisation question is entirely secondary to the question of whether you treat this like a liquidity crunch (by guaranteeing liquidity) or whether you treat it like a solvency crunch (by forcing insolvent banks to liquidation). I know which side I am on – and it is the same side as Warren.

Now it is all very nice to be demonstrably thinking the same way as Warren Buffett. I should have an operating funds management business after I get through complexities of Australian licensing and similar hurdles. If people widely believed that I thought like Warren I would be inundated with money – and that would be a good thing – at least for me.

But I have to note that Warren was not entirely straight forward in the interview. Warren did not think he could get the preference share deals he got from GE or Goldman Sachs now. That might be true with Goldies – but it was unequivocally false with GE. With GE you could construct a better deal on market.

This blog (painfully) admits its mistakes and tries to analyse them. A money manager should be brutally honest with himself. Warren however is an old man and his credibility is harder to question that mine. But Warren was wrong with his GE preferred (if only because he could get a better deal later). He should have admitted that (at a minimum) his timing on that one was awry.

It would be inordinate vanity to hope that I will be better than Warren. But I hope at least to think clearly and rationally like him. Oh, and to hold myself to a decent standard of self-analysis and criticism when I stuff up.

John

Posted by John Hempton at 3:48 PM

Me:

Don said...

Just a few points:

"The government has needed to say--what the government needs to say is nobody's going to lose a dime by having their deposits in these banks."

"For instance he thinks that bank liabilities should simply be guaranteed at this point (at least for the large banks) and that guarantee should carry the personal weight of the President."

In order to end Debt-Deflation, the government has to issue such a guarantee. I believe that they have done that. It's not a question of the guarantees any more, but the cheapest and best way to spend our money. We're going to spend whatever is necessary. In my mind, their actions, if not their words, prove that.

"Moreover he goes on to repeat that the opportunities in banking are simply wonderful now – so long as you can get past the past."

Buffett is a follower of Graham, I believe. I'm not a big investor, but I follow most of Graham's views. There is no doubt that there are good investments in Toxic Assets, Corporate Bonds ( Junk ), Distressed Equities, and that a downturn is generally a good place to buy. But it is awfully hard to do, and you do need to look at each specific case.So, given his investment philosophy, Buffett is saying what I would expect him say, more or less.

"Yeah, and interestingly enough, they don't need to supply the banks, in my view, with lots of capital."

I know that you went to great pains to discuss insolvency, but most people assume that, if you NEED money or a loan, you're insolvent. Otherwise, why in hell is the government giving them money? To the extent that the government provides funds or subsidies, taxpayers will assume that the borrowers are insolvent, otherwise, they shouldn't be getting any money from us.This is especially true if they don't use the money for more loans, even if that's not a good idea. In other words, I don't think that you can get away from selling this aid as a solvency crisis, even though that has the effect of making calls for nationalization stronger.

Don the libertarian Democrat

Only post this if you think it adds anything to the debate.

March 11, 2009 6:38 AM

"The broad outline of the Satyam fraud was that B. Ramalinga Raju produced fake accounts"

Here's John Hempton:

"Satyam - what were the lenders thinking?

I remember once having a very serious look at a particular (non-US) mortgage lending operation owned by Citigroup. I came from a banking culture where the first question you asked someone who wanted a loan was "why?"

Citigroup lent money in this operation purely against assets.

It was a great place to go if you wanted to borrow money no questions asked. It was "asset based lending".

Margin loans are always "asset based lending". You borrow against seemingly good security and they sell the security if the collateral isn't sufficient. Nobody asks you what you want the money for.

But perhaps they should. At least sometimes...

The broad outline of the Satyam fraud( FRAUD ) was that B. Ramalinga Raju produced fake accounts - with fake profits. The auditor however didn't pick up the fake accounts because the fake accounts accorded with actual cash flows.

The actual cash had to come from somewhere. It was injected by B. Ramalinga Raju and he obtained it by margining his shares.

He margined his shares for a billion dollars. A billion. Its a lot of money to just about anyone in the world.

And because they were margin loans nobody asked what he was doing with them.

But think about this rationally. Was he borrowing a billion dollars to spend? Well he didn't seem to live that lifestyle - and besides it probably really is impossible to spend that much.

So - presumably he was borrowing to invest...or so the bankers thought. The bankers should have asked for collateral - even secondary collateral - against what he was investing in.

But because it was a margin loan they didn't think to ask!

If only they had asked what B. Ramalinga Raju wanted a billion dollars for? No good answer probably means that there was no good reason to lend the money."

Here's the deal: There was a lot of stupid and negligent investing leading up to this crisis, but nothing justifies Fraud. We have laws not to protect the careful and diligent, but to protect the gullible and careless. There is a moral and legal imperative in Trust. It's all well and good to mock idiotic and foolish investors, but financial crime must be investigated and prosecuted. Otherwise, let Raju go, because someone else will just fill his shoes.

" Now how do you organise a new French Revolution? "

Bronte Capital and John Hempton also get it:

"Credit Agricole SA is a bank which obsesses me – and on which I have lost some loot.

The problem is that it is a bank with very good bits and very bad bits. And the good bits are excellent (and mostly outside Paris) – and the bad bits are atrocious.

Charlie Munger observed that if you mix turds with raisins you still have turds. Charlie was right and it shows in Credit Agricole SA’s stock price.

The bank is controlled by a bunch of regional mutual banks who – for reasons that are not apparent to me – have never got around to closing the bad bits. Those regional mutuals are in turn controlled by five million voting mutual certificate holders – a reasonable proportion of French households.

The super-bad bit is their investment bank. It’s a mathematical finance type investment bank in the French mould. As has been noticed by more than a few people – the market recently has not been too kind to mathematical finance.

I just want to extract the results – quarterly – for just investment banking business. Please click for detail...

These numbers really deserve looking at. The first observation is that revenue can go very strongly negative at an investment bank. That is nothing that Lehman et al have not discovered before – but the trading revenue was negative for several quarters in a row. You might conclude the traders were not much better as traders than say the average French farmer.

The second thing is that the costs line doesn’t seem to move much. Now when I was young and naïve – say 2006 – I thought the investment banks would have a very rough trot – but that the staff would take a fair bit of it in the hip-pocket. The argument being that the very high salaries were at risk – and you could at least assume that when time got rough for an investment bank the staff would be paid salary without bonus. Capital risks were lower than it would appear because at least variable expense would go close to zero.

Now I read lots of stories about how children are getting less allowance due to the credit crisis. Such stories always seem to wind up high in big-media’s “most read” and “most emailed” lists. And that is only because we – dear readers – are doing it to our own kids.

And if it is good enough for our kids it is surely good enough for our investment banker!

Anyway – it is noted that Wall Street bonuses remain stubbornly high – but this is France with all its equality and fraternity. And they can’t control this crap either.

But with numbers like these – if the investment bank were not owned by the rich French parent (Credit Agricole SA) then it would be bust – and the children (sorry investment bankers) would be out on the street.

But bust is better than it would have been in 1792. In those days – faced with a class as egregiously and hypocritically greedy as investment bankers they would have set up the guillotine in the Place de la Concorde and we would be treated to the public spectacle of mass beheadings.

These days of course it is easier. The French farmers and middle class all have a vote – its their mutual share. Executing a vote may be less grizzly than executing investment bankers – but it might be just as effective (though somewhat less theatrical).

Now how do you organise a new French Revolution?"

Hempton's not far wrong. Now you know why I sound like a certain Whig who's trying to prevent himself from having to write a book about Major Social And Economic Changes wrought by this crisis. Only, in this case, I'm getting more help from my own party than the opposition. This need not happen. It's a remote possibility as of now.

A True Burkean would be thinking about the Pragmatic and Effective Policy Decisions that will allow us to keep our system intact, and yet deal with the crisis before us. Paradoxically, we need more government intervention in the short run to prepare the possibility of less government intervention in the future. We also, and I know I'm sounding Quixotic here, need to root out Fraud, Negligence, Fiduciary Mismanagement, and Collusion, and deal with it strictly and publicly, in order to forestall a collapse in the belief among many voters that this system is worth preserving, and that this presevation will not come at their expense.

Do I agree with everything Burke says? No. I see him as a Whig with a distaste for Radical Change, which often strays very far from its stated goals. So say I. Political Economy and Politics dictate that we deal with this crisis in a way that both appears and is benefitial to all parts of the citizenry. I'm fine with looking towards Keynes for help, but a quick but focused glance towards Burke is seldom, if ever, amiss.