Whose Fault Is It Anyway?

Now we know - courtesy of Rolling Stone magazine: it's all Goldman Sachs's fault. The destruction of untold wealth, jobs and all the global economic pain of the past two years? All down to one firm. So let's smash the evil empire and move on. But wait, this isn't a movie. This is real life. And in real life, nothing is simple and straightforward and there's very rarely an single scapegoat.

The financial crisis of 2008 was the culmination of a shift in Western societies toward financially-driven economies; a shift that began with the various Big Bangs of liberalization of financial markets in the 1980s, that was driven forward by central banks' success in taming inflation and that hit several small peaks - the S&L crisis in the U.S., the Russian default/Asian crisis, the dotcom bubble, the Enron/WorldCom collapse, the massive teleco debt accumulated in Europe - before exploding in our faces in late 2008.

At every turn, after every crisis, we as a society - here & abroad - had the chance to put a halt to the economy's inexorable progress toward the cliff's edge. Most recently in 2002 when credit markets froze after the Enron/WorldCom debacle. Had supervisors and regulators then done more than just fret over ratings agency incompetence, taken action instead of twiddle their thumbs over the dangers posed by off-balance-sheet vehicles, perhaps some of the more egregious abuses could have been prevented.

But they didn't and why should they have? We as a society decided that financial markets should rule unfettered, we voted into power the politicians who supported the view, we tuned into CNBC, we wanted to get rich by buying low and selling high - and the devil take the hindmost. Politics boiled down to tax cuts and the demonization of any kind of state action. And even when left-wing parties came to power, the kow-tows to the financial markets continued.

We're all responsible for what happened in the past year - not just the bankers. And getting out of this will the recognition that a stable, balanced economy comes at a price: higher taxes, bigger government involvement in the economy and far smaller profits - for all. Not just the bankers at Goldman Sachs.

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.

A High-Stakes Gamble, In China and the U.S.

A long post on China Financial Markets brings a timely reminder not to get too euphoric about the recent turbo-charged economic numbers - everything from bank lending to car sales took a big jump in the first quarter - regardless of the official cheerleading. Key to whether China's economy is really recovering is whether all that money is creating jobs. Hard to know - but as the blog points out, even among officials there is the realization that the stimulus plan's impact could be temporary and a second round could still be necessary.
Meanwhile, in the U.S., talk of a second stimulus package - mooted as recently as in February - has all but withered away as the economy appears to have stopped falling in a straight line. That's no grounds for complacency, though - while China might see a W-shaped recovery, the risk in the U.S. is an L-shaped one (though U remains the favored forecast, for now).
China needs, as CFM notes, to see more private than public sector growth - but that doesn't seem to be happening, if the numbers quoted are correct. It still needs a prospering export industry, even as it seeks to reduce its dependency on foreign demand and become more reliant on domestic consumption. All the while, there's the issue of its massive foreign exchange reserves and how to manage them.
The U.S. problems are just as daunting: it has to do the reverse of the Chinese - reduce consumer demand and become more competitive in the global market place; it also has to reduce the share of its financial industry (which even last year accounted for 28% or so of domestic corporate profits) in the overall economy and find something to replace the lost business with. As consumer demand shrinks, Americans' reliance on debt should also diminish - doing away with the need for the securitization markets which lie at the heart of the financial crisis and which the authorities seem hellbent on restoring - even though if we've learnt one thing, it's the fallacy of the grandiose notion of democratizing credit.
The point is this: the Leviathans of the global economy - China and the U.S. - are both facing wrenching structural changes. Both governments are working on making the changes bearable and limiting the pain to their populations, but let's be realistic: it's a high-stakes gamble - there are no blue prints; plus the sobering thought that the last time we got out of a similar economic desaster, the world was engulfed in warfare.

Fragile Stability

We talk about the signals the economic data are sending out, but this is also a financial crisis that has to be resolved for there to be a broad-based recovery. As with the economy, the major panic of end-2008 has subsided somewhat, giving way to a fragile stability that will need a lot of TLC and a firm hand from the Fed and the government

1) Investors (mind, I say investors, not bank executives - that's another matter) have started to grumble about government and Fed involvement in markets. It's hard to hedge against government action - particularly given Congress' populist bent and limited attention span. Yet the mutterings are a massive shift from last year, when the cry "They (the administration or the Fed) must step in; they must do something" arose any time there was even a mere whisper of trouble. The patient, in other words, is out of intensive care, but still requires major attention. With the worst behind him, the patient is eager to leave the hospital and go home. But the doctors should refuse to discharge him - it will take a while longer to ensure a full recovery - and there is always the danger of relapse.

2) The bond market vigilantes this week stuck their heads over the parapet: punishing the BOE and the U.K. government for sending mixed messages and sending a warning signal to the U.S. and the Fed that there is a need to spell out the exit strategy. The bond market's early warning system is up and running - that's a good sign - but it bears remembering that the safe-haven bid remains an underlying support for government debt. The market's animal spirits remain subdued.
And, by the way, the exit strategy planning is well underway - in a little noticed joint press release issued by the Treasury and the Fed, the last sentence states that at some point, the Treasury will take over the three Maiden Lane vehicles that sit on the Fed's balance sheet - which would indicate that preparations are underway to rid the Fed off any credit exposure. Treasury also committed to helping the Fed achieve the tools it needs to fight inflation - i.e. withdrawing the trillions of dollars it is pumping into the system. One way to do that would be to sell Fed bills to mop up those dollars - which will require legislative action and where the Treasury's support will come in handy.

3) The Obama Administration's plan for regulatory reform. That was the most heartening of actions so far - the administration clearly has a plan and presented it forcefully this week: first on Wednesday, in testimony by Treasury Secretary Timothy Geithner, Fed Chairman Ben Bernanke and New York Fed President Bill Dudley, then again on Thursday in testimony by Geithner alone. It's a year since the downfall of Bear Stearns first made it clear that the regulatory system was woefully inadequate to deal with the turbo-charged financial industry - that we finally have an energetic administration that recognizes the need to address these deep-seated problems and isn't shy in tackling them is in my mind the most encouraging sign one could hope for.

Spring Blandishments

Spring's here and with it comes talk of "green shoots" and "small signs of hopes" when it comes to the economic data - February brought the second month in a row of rising retail sales and personal spending, durable goods orders were up as were existing and new home sales. And bank chiefs talked about a good start to the year for the first two months.

But it pays to remember that the on-month gains came after the economy well and truly tanked in the fourth quarter - it fell so steeply, there had to be some kind of leveling off in the pace of decline. That's no doubt a good sign; a continuation of the fourth quarter's precipitous drop across all sectors of the economy would have been highly alarming. But when things stabilize, there's still a possibility they could resume their decline - it's in no way a given that the only path from here is upward. And in a worrying sign, some bank chiefs, including JPMorgan's Jamie Dimon, are warning that March was a tough month.

The coming week brings the first inklings of this month's data in the form of the ISM's national reports on the manufacturing and non-manufacturing sectors. The headline numbers will show more stability, but it's the components such as inventories, shipments and orders - particularly export orders - that will be the most insightful. Global demand outside the U.S. has collapsed - the major export nations, from Japan to Germany to China, have all reported dire export numbers. Chinese officials believe they have averted crisis with their stimulus package and that the vital signs of their economy - such as bank lending - have improved. Germany says it has done enough to stimulate its economy and that given its high debt levels - left over from the country's reunification in the 1990s - it doesn't have the fiscal flexibility to spend more.

But demand will have to come from somewhere for the U.S. economy to start growing and not just bump along the bottom of the trough for an extended period. The domestic stimulus package is one source - but that won't come into full force until 2010. Foreign demand will take even longer to surface - China's recovery will to some degree depend on a recovery in the U.S. as one of its largest trading partners; Germany needs the rest of the world to recover so it can start exporting again, and Japan's economy remains in a blue funk. A hopefully more immediate source of demand will come from the funds that the Fed is creating and throwing by the armload at financial markets to revive gun-shy capitalist spirits and the broader economy.

Spring crocuses notwithstanding, the economic outlook continues to hang in the balance. It will take longer than one season for the rescue efforts to work their way through the 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?