The Rocky Horror Picture (PPIP) Show

FEAR FACTOR OR NONSENSE? Equities show us the way to recovery by Alan Greenspan

"A recovery of the equity market, driven largely by a receding of fear, may well be a seminal turning point of the crisis.

It is the rate of decline of product, labour and financial markets that generates much of the uncertainty that, in turn, fuels fear.

The key issue is when. Certainly by any historical measure, world stock prices are cheap... The pace of economic deterioration cannot persist indefinitely. ... The current pace of deterioration is bound to slow and with it there should come a lessening of the level of fear. ...

As the level of fear recedes, stock market values will rise. Even if we recover only half of the $35,000bn global equity losses, the quantity of newly created equity value and the additional debt it can support are important sources of funding for banks. As almost everyone is beginning to recognise, restoring a viable degree of financial intermediation is the key to recovery".

I note that in the galaxy of Transylvania there is a tendency to think that the financial and banking crisis can be solved just propping up the value of assets, including toxic ones, by thinking positive and being more optimist. Then self-fulfilling prophecies should do the rest...

On the other hand, the recently announced US Treasury Geithner Plan II is simply the follow-up to the Rocky Horror PIPP Show against the US taxpayers.
The basic idea is to help, artificially and by means of a subsidy, to keep prices of the troubled securities, or toxic assets, higher than they would be otherwise.
Treasury argues that these prices are artificially depressed because of illiquidity due to simple pessimistic and fear factors...Yet banks are sinking faster than the Governments are bailing them out.

Social norms versus market norms: how to screw the economy up

Nobel Prize Krugman is not yet convinced that further stimulus is "the road to hell" that EU governments must avoid. He continues to suggest to "make it bigger" with the same viagra metrics used for the US stimulus.
On the other hand he does see some market mistique and failures in the financial system. Securitization is definitely one of those.
Somebody suggests also that the culture of the financial sector has to change, while others would like to say goodbye to the homo economicus.
I suggest to read an interesting article about "Why money messes with your mind".
It's apparent that the money culture messes up in the minds of people working in finance and in some degree in economics. It's about behavioral rules - social norms versus market norms and moral hazard.

When some market norms and moral hazard prevail with the characteristics of the downstairs in the picture below, we tend to screw the economy up and take the stairway to hell.



SOCIAL NORMS










MARKET NORMS

Polluter pays principle in financial markets

In environmental economics, the polluter pays principle makes the party responsible for producing pollution responsible for paying for the damage done to the natural environment.

It is now quite clear that toxic assets and the related derivative products have polluted the credit and financial markets in general. In fact, they are called toxic!

Now that the US Treasury Plan, which will try to "cleanse" the market of toxic assets" has been put forward, I note that the polluter pays principle is not actually applied in the financial markets. Financial institutions which created the mess, together with their shareholders and bondholders, are not really being asked to get their haircuts. Moreover the underlying assumption is that financial institutions can continue to gamble. US blogging community and stock markets (who cares about stocks?) appear quite positive about the Geithner plan with few exceptions.

I would not like here to offer some moral sentiments about gambling in capitalism, but I find ironic that to solve a financial crisis borne out from too much securitization and inappropriate use of derivative products, we have again much of the same and with the same market participants.

Those polluting the market instead of being taxed, along the line of Pigovian tax for negative exernalities (particularly in the credit market), or made anyhow to pay as polluters, get some subsidies.

I do not know if all now see light at the end of the tunnel and feel more optimist, but it would be a pity if somebody instead of admitting to have screwed it up just say do not worry we were just screwing around (signori abbiamo scherzato).

Let's go back to business as usual.

Securitisation and the integrity of online gambling

The financial crisis is pushing many economists to question the benefits of securitisation, once considered a form of financial innovation with only positive externalities. However the use of some derivative products, particularly the Credit Default Swaps (CDS), is now being questioned in terms of its insurable risk and legitimate trade. In practical and simple terms, the question is whether these derivative products constitute and are being used for betting and gambling instead of managing risk. This financial crisis should have given a clear answer to taxpayers and laymen, but somebody is still debating on the need of regulations, or any other safeguards, and if these are necessary and sufficient to avoid other financial crisis and reduce systemic risk.

On March 10th, the European Parliament adopted a resolution on the integrity of online gambling. If one reads this resolution and its background reports (substituting the word gambling with credit default swaps or similar derivative product) would come quickly to the conclusion that some of the derivative products would fall under the regulation on gambling activities, which have traditionally been strictly regulated at national level to protect consumers against addiction, fraud, money-laundering and fixed games. I believe that the dangers of derivatives like credit default swaps are proven but the debate is unfortunately still surreal.

European banks and the market for lemons

It is quite clear that European banks have nothing to apologise for over AIG bailout since contracts and financial obligations need to be honored. I assume that payments to European banks were made against valid contracts after the decision to bail AIG out. It's definitely always a pity that taxpayers' money, either American or European, is being used to support a private company, directly or indirectly, no matter its nationality. This is particularly so when there is not an economic compelling case and it could be avoided.
From the Nobel Prize economist George Akerlof we know that the market for lemons occurs when the seller knows more about a product than the buyer (information asymmetry). However, in the world credit markets something special occurred: no market participants knew exactly what they were doing and what and where their products were exactly. On one side AIG was concentrating all risks and correlation of its activities defying the basic finance rules of a portfolio diversification and differentiation and pooling of similar but uncorrelated risks. On the other side, some European banks were either protecting their portfolio of activities (again not diversified or too risky) through credit-default swaps or doing other credit and securities "risky" business with AIG. While one could think that European banks did not know that they had only one and common counterpart in AIG thus having all the same insurer, no doubt that this entanglement could eventually create the so called systemic risk as things turned sour. Nobel Prize Akerlof had warned of the lemons principle applicable to the credit market, but he was referring to "Credit Markets in Underdeveloped Countries" sic! Could market participants imagine such an adverse selection where potentially responsible parties not only are less informed than others about the transactions made and respective creditworthiness, but nobody was making informed investment decisions as no information at all was circulating or being duly considered and analyzed.
To say now that people thought that underlying assets could only go up add insult to the cost of dishonesty in the market of lemons. Moreover nobody has yet shown that the cost of allowing the over-leveraged major banks to fail or to be broken up, including cost of managing the systemic risk, would be greater economically than the cost of saving them through bailouts.

UPDATE - BREAKING NEWS: US Treasury Secretary Timothy Geithner said that the government would work with AIG chief executive Edward Liddy to "wind down" the troubled insurer "in an orderly way." That's definitely good news as one of the systemic risk originator is "gone". Now they can also work on the famous list of counterparts and possibly do the same in a systematic and orderly way. I also wonder if it could have just been done before. It's the present decision which counts for the credit markets and the financial system to resume working properly.

My name is BOND, European Union BOND

Never say never again:

On March 11th, EU Parlament lawmakers made their case for a single European sovereign bond.
They "invite the Member States, and in particular those belonging to the euro area, to examine the possibility of a major European loan guaranteed jointly by the Member States".

The case for a single European sovereign bond was made recently by Wolfgang Münchau on the Financial Times.

Yet, the idea of borrowing money via the issue of EU bonds is not new and was first launched by former Commission President Jacques Delors via his 1993 plan for growth, competitiveness and employment. Delors initially wanted EU bonds to fund the European budget. But the majority of member states opposed the idea, fearing it would ultimately increase their expenditure on the Community budget or raise the cost of borrowing for some Member States.

In 2000, then Commission President Romano Prodi re-proposed the idea. A report prepared by a group of financial experts led by Alberto Giovannini explained the technicalities of issuing common bonds to attract foreign capital.

It appears that the benefits of a single European Bond outweigh its costs and the timing is now right on the financial markets as bonds are safe haven and Asian countries may need to diversify away from US Treasuries and dollar.

However the devil is in the details, for which I would consider carefully the above mentioned report by Giovannini. Euro bond can't solve all problems, like national interest spreads and premia, but common, joint and/or coordinated issuance and uses (including recapitalization of banks, European budget, common guarantee funds, EU projects, rescue loans and packages, IMF resources, etc.) could create an efficient and effective bill or bond euro zone market. Different arrangements could then be studied concerning the issuing institution (single issuer) or coordinated agencies and its guarantees. A bond clearing house, i.e., a vehicle for sharing information to improve coordination could also be set up. Securitization of national government bonds should not be construed as a problem. Some of the technicalities and arrangements are the same as for the introduction of the Euro as a common currency.

Update: it appears that some economists are more worried about the status of the EU economy rather than US. They also say that the EU should do more. While these arguments are being debated also by politicians on both sides of the Atlantic, I think that an immediate and pragmatic response could come with the coordinated issuance of EU bonds for appropriate purposes (starting for instance and immediately from the original idea of funding over 120 billions of EU budget, whose resources come in any case annually from treasuries of member states). Then let's see the market reaction...and other purposes could be gradually implemented and extended to. It will show that the creation of the euro, and its bond, was not at all a mistake...

Economic An-ALPHABET or meta-economics

Reading economists' articles can be confusing if you are not familiar with Lego constructions, Bob-the Builder and buzzwords.



Consider Nouriel Roubini’s latest “The Deadly Dirty D-Words: “Deflation”, “Debt Deflation” and “Defaults”. It seems you are watching a movie in 3D...

Last year he also wrote: The Shape of the US Recession: V or U or W or L-Shaped?

Then recently: "We could end up ... with a 36-month recession, that could be "L-shaped stagnation, or near depression," Roubini said. He puts the chance of a severe U-shaped recession at 66.7 percent, and a more severe L-shaped recession at 33.3 percent".


The entire Roubini piece on bank nationalization -- or Plan "N" as he calls it -- is worth a close read: "So while Plan A is now underway today’s very negative market response to this Treasury plan suggest that it will not fly. Markets were expecting a more clear plan but also a plan that would bail out shareholders and creditors of insolvent banks. Unfortunately that is not politically and fiscally feasible. It is thus time to start to think and plan ahead for for Plan N (“nationalization” of insolvent banks)".

"So, the current strategy – Plan A - may not work and the Plan B (or better Plan N for nationalization) may end up the way to go later this year. Wasting another 6-12 months to do the right thing may be a mistake but the political constrains facing the new administration – and the remaining small probability that the current strategy may by some miracle or luck work – suggest that Plan A should be first exhausted before there is a move to Plan N. Wasting another 6-12 months may risk turning a U-shaped recession into an L-shaped near depression but currently Plan N is not yet politically feasible".

We have also Nobel Prize economists:
"The Good Bank proposal has the advantage of avoiding the N-word: nationalization. Some believe a more polite term, "conservatorship" as it was called in the case of Fannie Mae, may be more palatable. It should be clear, though, that whatever it is called, the Good Bank proposal entails little more than playing by longstanding rules, a variant of standard practices to deal with firms whose liabilities exceed their assets".

or "if the experience of the last 20 years is any guide, the prospect for the economy isn’t V-shaped, it’s L-ish: rather than springing back, we’ll have a prolonged period of flat or at best slowly improving performance".

Update:

You have also economists questioning the J-curve. J-curve. Noun. Economist jargon.

Euthanasia of the banking system

naked capitalism: Quelle Surprise! Who Gained From AIG Rescues? Goldman (and Deutsche) Tops the List (and Willer Buiter is REALLY Angry!)

I think that we knew, at least since September 2008, the list of banks which would "benefit" from AIG's bailout. And we knew that tops of the list were primary European banks, too big too fail. Definitely it's not a breaking news!
Does it matter where the money went, really? I am not sure that it does at this stage. While it's true that AIG's guarantees allowed European banks to circumvent minimum capital requirements, which means the AIG salvage operation was a backstop to European financial firms, it is also true that the purpose of providing regulatory capital relief rather than risk mitigation should not be construed as an accusation to European banks or a moral issue.
While there is no doubt that any bailout set a moral hazard problem, in the insurance business the first thing one should consider is to honor a contract. Now it appears clear that counterparties of AIG's business were European banks. So what? Yes, the Fed offers banks an outrageous subsidy via AIG.
We are simply saying here that AIG has insured an enormous amount of corporate loans and prime residential mortgages that are on the balance sheets of banks, mostly European banks. The latter have bought this insurance (called credit default swaps) to protect themselves against the risk that these loans would go bad, that borrowers would default. What's wrong with that? We can certainly say that AIG and its counterparts either European or Goldman Sachs had really bad assets and liabilities management (for instance by concentrating all their insurance contracts, or CDS, at one insurer - sic!), but can we say that AIG must not honour the financial commitments it has made through these insurance contracts, no matter the reason why they were taken out? It's like saying that tomorrow the United States of America are simply defaulting on its Treasuries... Can you imagine that? The people who lose biggest out of the collapse of AIG are probably the European banks but from a certain perspective, it is very much in the interests of the U.S. to pay for the rescue of AIG.

I conclude that what is called a systemic risk or counterpart risk is just the reflection of a lack of transparency and disclosure in the full process and bailouts which create mutual distrust in the credit system. The shame the name with a list of "concerned" banks, but not necessarily in trouble, is welcome and it's no surprise. Now what next? In a previous post, I suggested an induced, orderly and systematic, bank run on some primary U.S. institutions in trouble to test if they are solvent (without waiting a "useless" stress test and further stress, also psychological, for the financial markets). I am glad to read that a Nobel prize-winning economist, who helped financial engineers to make this mess, is suggesting now to “blow up or burn” over-the-counter derivative markets to help solve the financial crisis. In parallel we can create the good banks. It will be the euthanasia of the rentiers or simply of some bankers and insurers.

BANK RUN or how to set up a new ‘good bank’ and solve all problems

My ‘Good Bank’ proposal launched in October 2008 has got some attention and elaboration by academic and econ bloggers. However there appears to be still some unresolved issues: a) how to convince bankers and policymakers; b) how to set up a new good bank.

Time passes but nothing happens, except that all get stressed by stress tests and stock markets keep plunging. The debate is still hot on false dilemmas like to nationalise or not and solvency or liquidity.

At this stage there is one way to force the creation of new "good banks": a few bank runs.

It is now quite clear that bankers have enriched themselves at the expense of taxpayers and banks have "simply lost" the money that depositors, and also bondholders, have given to them. I do not mention shareholders as their stock market values can be seen on stock markets.

As there is a compelling case not to rely anymore on some bankers, an orderly and systematic bank run on would-be insolvent banks, seems an appropriate solution to set up parallel new good banks and strengthen also good ones.

Particular attention should be put on the orderly and systematic character of the induced bank run, because the modern fractional-reserve banking is indeed and de facto "a giant Ponzi scheme in which a few people can redeem their deposits only because most depositors do not follow suit" and loans, in which depositors' and bondholders money was invested in, were securitised and sold to other financial institutions and other banks to become troubled assets of unknown originator and value (systemic risk).

The Unbearable Lightness of Being economists

In his book The Unbearable Lightness of Being, Milan Kundera makes an interesting case that kitsch is the absolute denial of shit. I contend that during these days many economists are in this respect kitsch. Some aren't like Prof. Buiter. Here Maverecon Willem Buiter makes an interesting case for the unfortunate uselessness of most ’state of the art’ academic monetary economics. I am not sure that is unfortunate but I would extend this uselessness analysis also to most of state of the art academic fiscal economics and engineering finance.