Don't Trample The Green Shoots

So the Fed held fire on expanding the Treasury purchase program Wednesday - but there's one thing one shouldn't overlook: the program runs until the fall - ie September. So either at the June or the August FOMC, it'll have to make the decision whether to expand its buying.

In the meantime, there's plenty of bad news lurking that could prevent a full-blown, sustained sell-off in the long end of the Treasury market - even though the 10-year yield could well test the 3.25% mark before all is said and done. Right now, the market is obsessing with supply - no wonder, Treasury said Wednesday it plans to sell some $361 billion in marketable debt this quarter. That's after just over $450 billion or so were sold in the first quarter - $2 trillion is easily in our sights if we continue at this pace.

Among the risks still out there: the fate of the auto makers. The Chrysler negotiations are going down to the wire - and we're only talking $6 billion or so in debt involved. In the battle royal over GM, bondholders have just fired their first shot, according to Reuters. Investors may think that with GM bonds trading at just a couple of cents on the dollar, all the bad news should be already priced in. But last week's swift drop in the dollar against the yen, when the bankruptcy flag was raised for Chrysler, was a healthy warning against complacency.

More uncertainties: the banks. From Goldman Sachs to Deutsche Bank, their first quarter profits came overwhelmingly from trading - fixed income, currencies, commodities. Not even the banks themselves think that's a sustainable model of growth. Not to mention the stress tests, the release of which is turning into a painful farce.

The biggest question mark, though, hangs over the economy, and the consumer in particular. There's a lot stacked up against us (see above) domestically, while the economy slowly wends its way out of recession; the highs in the jobless rate have yet to be seen. Foreign demand won't be much help - the economies in Germany and Japan look likely to have a terrible year.

A closer reading of the Fed statement shows that while policy makers are less downbeat than in March, they remain closely attuned to the risks to the economy. Policy makers are determined to keep long-term rates, so important to consumers and the housing market, low. The consensus that the Fed will expand its Treasury purchases will likely prove right. Now all we need to work out is when they'll tell us.

Bank Stress Tests - What Took The Regulators So Long?

Treasury Secretary Timothy Geithner must be having a sense of deja vu when it comes to the stress tests that regulators are currently conducting on the 19 major banks in the U.S. Take a look at his speeches as New York Fed president from early 2005 onwards and one can't help but wonder why regulators didn't act earlier to rein in the banking sector.

Geithner didn't hold many speeches as Fed president, but when he did, from 2005 onwards, he was constantly - a bit like a Greek chorus - urging financial institutions to make sure their stress tests were based on sufficiently negative parameters (the tail risk) and that the tests were conducted across all asset classes, not just on a business by business line (contagion risk). Capital and liquidity cushions - he said time and again - should be appropriate to the most negative outcomes ("adverse scenarios where uncertainty is the highest") rather than just meet minimal regulatory standards. One presumes that if he said it publicly, he was saying something similar in private, both to his fellow regulators and the firms he oversaw.

Roll forward to 2009 and his recommendations four years ago look very much like the blue print for the Federal Reserve's stress tests - and while there's little point now in bashing the regulators - who clearly saw cause for concern even when the good times were still rolling in the credit markets - we should learn the lessons of the past and remember that leaving it to the banks, or any group of private sector agents (same would be true for energy companies or health insurers) to self-regulate and do the right thing out of enlightened self interest and an obligation to their shareholders is foolhardy and invites abuse.

There's no telling what would have happened had the Fed forced the banks in 2005 or 2006 to raise capital and liquidity cushions significantly above the regulatory requirements and conduct far more stringent stress tests. The investment banks would have remained outside this net, unless the SEC had joined in, so Bear Stearns and Lehman might still have gone under. But humans are by nature prone not to do what's best for them and easily swayed by short-term considerations. Which is why we have civil laws and which is also why regulators and politicians should not shirk their duty and institute tough rules for industries that have the power to sink our economy.

Is The PPIP Pure Piffle?

Pity Timothy Geithner - it seems that no plan that bears his imprint will ever meet the approval of the nattering nabobs. At least today, he has the comfort of having won the blessing - albeit temporary - of the markets.

But is his plan as bad as the critics claim? Does it really fail to address the key issue, as some say -namely that it's the state of the banks as a whole, not that of certain groups of assets (home loans, commercial real estate etc.) that needs to be addressed? That some banks are just in such bad shape that they need to be nationalized, then wound down - and that the Treasury's public-private investment program is just postponing the day of reckoning?

What the critics overlook is that the financial markets are still a train wreck. True, the stock market is up. Also true, investment-grade bond issuance is at a record for the current quarter. But equally true is that Asian investors have packed up and left the mortgage-backed securities market - and they aren't about to return. Private label mortgages - ones not guaranteed by the government in the form of Fannie Mae or Freddie Mac guarantees - are moribund, commercial real estate is in dire state - and a lot of those loans and securities sit on bank balance sheets. We aren't out of the woods yet; it's just that the markets that are visible have picked up some. And let's not forget the reason for that wasn't pontificating, it was vigorous government and central bank action. Meantime, starved of the oxygen of finance, the global economy is heading toward a full-scale recession this year.

So the Geithner plan is first and foremost a plan to help restart markets that, more than 18 months into the crisis, are still not working (remember, it was the early August 2007 admission by BNP that it was temporarily freezing three investment vehicles because it wasn't possible to value the asset-backed securities these vehicles held that got the ball rolling) and are doing untold harm to the economy. The key goal is to get private capital moving again.

Certainly, the signs are auspicious for the one leg of the Treasury's plan, the auction process for wholesale loans held by banks. As to the other leg, the one dealing with securities backed by home loans and commercial real estate loans, that will take a while to get going. But what the plan does do is get the credit machine rolling again. It will help the banks too, chiefly by buying them time to get their house in order.

Some banks could still fail - we are still in the thick of the woods. It's to be hoped that Congress makes good use of the room that Treasury has created to come up with a legislative framework for the bankruptcy and unwinding of a large financial institutions. It's been a year since Bear Stearns hit the skids - and the absence of such a framework became painfully obvious.

Enron, Bear Stearns & Treasury's Financial Stability Plan

The government is set to present the heart of its financial stability plan - how to deal with the toxic assets clogging up banks' balance sheets - a stark reminder how little progress has been made in dealing with the root of the financial crisis a year after the Bear Stearns bailout.
There's no harm in thrashing out the pros and cons of this plan yet again. But what is urgently needed - and what we are highly unlikely to get - is a sober debate of the big picture, the plan's framework. Transparency will once again fall by the wayside. The taxpayer will be asked to pay up, without being told what it is that we're taking on all this debt for, let alone being involved in the debate whether this is the best solution.

The arguments against the Financial Stability plan are easy to list and most involve practicalities. Private investors will be reluctant to lend because they fear arbitrary changes to the ground rules by populist lawmakers, no matter how cheap the funds are the government will offer them. Valuing these assets so that banks will be willing to sell them without overpaying for them remains a tricky issue. The mood right now is for solutions that work immediately - yet this plan is nothing if not complex and will take time to implement.

But of far greater importance is an issue that we seem to have lost sight of as the crisis has progressed: the need for transparency. We as taxpayers, whose full faith and credit are on the line, have a right to know what these purchases are that we are funding. The Treasury has a web site www.financialstability.gov. It should post the assets that are going up for sale there, including the prospectuses that the government will send out to investors. And please, spare me the "nobody would understand them, they are so complex" argument. It's irrelevant - all that matters is that anyone who is interested has the option to find out more.
What we can't have is a replay of Maiden Lane I - remember the $30 billion facility set up in June last year to take over Bear assets that JPMorgan's Dimon washed his hands off? It's faded into the mist of the financial crisis, but it's still there - just a bit diminished: at the end of 2008, the $30 billion - of which JPMorgan had put up $1 billion - had shrunk to $26 billion. Yet nobody except the New York Fed, JPMorgan and the portfolio manager Blackrock have any idea what's in that portfolio. What harm could come of making these assets public?

This insistence on obscurity is the biggest problem we face. The taxpayer must be treated as equal partner in the resolution of the financial crisis. Officials have decided that the best way to rescue the banking system and the economy is by reviving the shadow banking system - those obscure markets that allowed lenders to repackage loans and sell them on to third parties. But they have yet to explain how they arrived at this decision; they have yet to involve us, the taxpayers, in their discussions.

Off-balance sheet vehicles were instrumental in allowing banks to circumvent capital rules and take on far more risk than they should have - in a replay of what brought down Enron. They should have been banned in 2002, we are now paying for regulators' inability to act forcefully seven years on (we won't even ask where Congress was all those years. Those Congressmen baying for bonus recipients' blood should take a long, hard look at their own record.) These same regulators have now embarked on a strategy that revives those markets that allowed us to live beyond our means, borrow more than we could afford.

Is that the best plan we can come up with?

Downsizing The Global Economy

Reading about AIG bailout number 3, I was struck by the end to a column by BusinessWeek's Diane Brady, who wrote: "The former $100 billion-a-year giant will be smaller, humbler, and less of a force in the marketplace." AIG is in good company - what we are currently seeing is a downsizing of the global economy as a whole. This is not just a temporary phenomenon; the explosion of growth and consumption of the past decade was just as unsustainable from a financing perspective as it was from a climate-change viewpoint.

Here's what I mean: The chief economist of CIBC wrote Monday in a note that the problem with the U.S. carmakers is not that they make the wrong cars, but that they make too many of them. He thinks that in five years time, there will be 25 million fewer cars on the road in the U.S. and that the companies need to shrink to reflect that much smaller market.
Same thing with housing: prices keep declining because there is too much housing stock around, while the pool of people who can and want to buy keeps shrinking. It's similar on a global scale: Chinese textile factories are making too many socks and T-shirts, Swiss watchmakers too many watches, everybody wants more, expects better living standards, more consumption. We have long known that this life style is not sustainable, now we are learning that it isn't financeable either.

Recovery will come when supply and demand find a balance again, but that will be at a much lower level than policymakers appear willing to accept (though planet Earth for one will probably heave a great sigh of relief.) At the moment, all efforts are aimed at restoring what we had before by helping to restart lending. Those trillion-dollar efforts are aimed, particularly in the U.S., at restarting home and consumer lending; at silencing the populist cry that the banks must be fixed so that they can lend again. Credit card companies and shaky auto finance companies turned themselves into bank holding companies and got TARP money - all in the name of restarting lending and helping the economy back on its feet.

These efforts will all be in vain: the grand credit machine of the pre-August 2007 world cannot and should not be resuscitated. It died because it was unsustainable. We should not seek to bring it back to life; the democratization of credit - as one banker once boasted - is nothing but a chimera. The global economy will shrink, and the shrinkage will be led by the developed world, because it was the developed nations that gorged on too much easy credit. Those in the developed world that didn't - the Germans and the Japanese - allowed their addiction to exports to blind them to the necessity of structural reform. Moreoever, much of the developed world's credit addiction was fueled by the surplus funds that other, more frugal countries, had piled up. They too will discover that hoarding reserves cannot replace sustainable domestic development.

Much has been made of the wealth that has been destroyed by the Dow's downward spiral which took the index today back to levels not seen since 1997. We should remember that much of this wealth was not real, but conjured out of the thin air of securitization plus leverage. That funny money is gone, and the world might be better off if it never comes back.