Quotable

I had the following quote ready to publish when the bill passed. The vote against the bailout bill was a pleasant surprise, but the House still has until Thursday to be bought off or to cave to pressure. Or maybe democracy is still alive in America?

"The bank was saved, but the people were ruined."
- Henry M. Gouge, circa 1830

Transaction Taxes and Transparency

The City of London is in a stir over the EU proposal of a financial transactions tax. The great and the good are uniformly arrayed against such a tax. I am not so sure that it wouldn't be a good thing.

Here in Britain we now pay 20 per cent Value Added Tax on virtually everything we buy, except food, medicines and children's clothing. Yet the financial sector is exempt of any similar tax on transactions. This is patently unfair since approximately 5 pence of the 20 is required to finance the state bailouts of the financial sector. As a regressive and unfair tax, that is hard to beat.

In addition to raising revenues from an investment banking sector which has decimated public finances for a generation to come, a transaction tax might be a very good thing from an accountability and transparency perspective.

Those opposing say it would be anti-markets and drive trading offshore. Markets clearly do not work properly anymore at price discovery, liquidity aggregation or trade transparency. I rather think markets would work better if those participating had an economic stake in the transaction longer than a nanosecond, and a trading objective more durable than front-running real investors with HFT gaming.

More than that, a transaction tax would recognise that the state adds value to the market and deserves to be recompensed for that value. A huge part of the operational value of developed markets is derived from the rule of law. Taxing transactions would be recognising that each transaction benefits from the legal system which makes such a transaction valid and enforceable.

In my view, the way to make the transaction tax workable and cost-effective is to incentivise the reporting of transactions and the payment of tax. The way to do this is to legislate that transactions themselves will only be legally enforceable if there is a record that the tax has been paid. Anyone might choose not to pay the tax, but if they want to enforce a trade or debt obligation they are on their own. If they want recourse to the courts, rights to exercise on margin/collateral or a valid claim in insolvency, then they pay the tax as their ticket to rely on the legal system.

In the United States we see that the MERS scandal boils down to the wholesale attempt by US banks to avoid paying the transaction taxes on land mortgage registrations with local counties and states. As a result, the very enforceability of millions of mortgages is being thrown into doubt as a matter of law.

Had originators, banks, investment banks and investors been forced to register interests in mortgages in compliance with the law, some of the great abuses of securitisation would have become much more difficult to sustain for so long. In that sense, transparency would have promoted greater accountability and helped curb abuse.

The public has an interest in the integrity of markets. That integrity has been undermined horribly over the past 25 years by demutualisation of exchanges and clearing houses, fragmentation of markets to off-exchange systems and derivatives, leveraged shadow banking, and information assymetries between highly concentrated market insiders and everyone else. We now don't know who owns what and who owes what, and that means that economies are operating with dangerous blind spots. Relaxed accounting rules and forbearance on capital mean that mis-pricing and mis-allocation of capital are endemic and worsening, making any recovery even more doubtful.

A transaction tax on trades, as a pre-condition to legal enforceability, might restore some integrity to markets. That would help restore more efficient functioning to economies with much greater promise than further bailouts to banks.

Learning from Rudi Bogni: The Thin Space of Financial Activity

Every good morality tale needs heroes as well as villains. In the past few weeks all we’ve seen are the villains raping and pillaging and despoiling all that we hold dear – rather like the first hour of the original and uncensored Mad Max.

I’ve made it pretty clear what I think about the villains that have got us into the current meltdown mess. Even I need a break from cynicism every now and then, however, to remind myself that better is truly possible. I thought I would take the opportunity of my post this week to reflect on a personal hero who epitomises what banking once was and whose philosophical writings can point us toward what banking should be again when the dust settles and we contemplate rebuilding our collapsed financial house of cards.

No one is perfect, and I’m sure he’s not either, but he’s shown consistently good judgement, intellectual curiosity and resistance to orthodoxy over the years. If we had a hundred bankers in the world like him, we wouldn’t have today’s crisis.

The bravest decision he took was in 1995, following the collapse of Barings Bank, as he explained in The Prospect:

I am a 47-year-old banker - chief executive of Swiss Bank Corporation in London, to be precise - and I have just decided that I need to go back to university for two years to study mathematics. Some of my friends think I am mad, and perhaps they are right. But perhaps something strange has happened to banking too.

It is hard to imagine that there is anything really new in banking. The tools of the trade have been around and in use, pretty much unchanged, for hundreds of years. Yet within the span of my own career, the world of international finance has enjoyed a renaissance-a spurt of creativity in the 1970s and 1980s, when new techniques emerged which have transformed the conduct of many banks and bankers. These techniques-collectively known as derivatives-have spawned a new jargon (would you know what to do with a Jellyroll, or an Alligator Spread?), huge new sources of profit, and mystifying new types of risk.

Imagine devoting yourself to the study of advanced mathematics in your mid-40s from the lofty heights of CEO of a Swiss bank! I wouldn’t be so noble, from more modest altitudes.

SBC had acquired O’Connor Associates, a Chicago derivatives trading partnership. The O’Connor partners were soon installed as senior executives throughout SBC, and changed it from a sleepy private bank to a powerhouse of aggressive power trading in the newly emergent global derivatives markets. Rudi needed to go back to school to know the business he was managing. He stepped down from the top job and got a degree in advanced mathematics at Imperial College, London.

That made Rudi an instant legend in the City and was the first I heard of him. He returned to finance as the Chief Executive of UBS Private Bank and Member of the UBS Group Executive Board. Since then I have followed his writings. For some years past I have enjoyed his friendship.

One year into the course, he emphasised again the importance of executives confronting the changing requirements of banking:

IC Reporter (10 February 1997)

Despite holding a degree in economics and business administration, Mr Bogni really did go back to basics under the tutelage of the Centre, sitting mock GCSEs and A levels in maths and statistics. Probability theory, calculus, algebra and stochastical modelling are also on the programme. “It’s a course not really designed towards a degree,” said Mr Bogni, “but towards the specific mathematics required for my type of business.”

Not all of those who share Mr Bogni’s business of derivatives are convinced of the benefits to be gained from the study of modern applied mathematics. However Mr Bogni believes that those who do not recognise its importance are avoiding the changing nature of financial markets. “Among the people that I respect there is a genuine understanding of what the issues are. It’s not a question of derivatives being a part of the financial markets, they are the financial market now.”

Rudi Bogni wasn’t afraid to admit that his bank had become unmanageable within the limits of his traditional banking background and understanding, and to take a hard look at his own qualifications to wager the bank’s capital on derivatives. If more CEOs had done that, then the proprietary dealing desks would never have gained the leverage that leaves the banking system so woefully undercapitalised today. If more CEOs pondered the philosophical basis for creating and allocating wealth, and the political means of asserting or coercing state power in the cause of more wealth accretion, then perhaps the destruction of jobs, savings and security would be less threatening to the investors, pensioners and taxpayers facing systemic financial failure this week.

In June of this year, Rudi published a piece in Wilmott Magazine (subscription only – the most expensive monthly on either side of the Atlantic, according to Forbes). At the risk of stretching fair use, and with the author’s consent, I’m going to quote it extensively here as it gets to the heart of the crisis we now face:

The Thin Space of Financial Activity

Those of you who may have read Bill Bryson’s A Short History of NearlyEverything will certainly recall his thesis that life on earth as we know it is an exceptional event and a possibility that materialized only within very small boundaries.

I wish you to consider how much smaller those boundaries are for the existence of financial activity.

First of all, you need a thinking species that lives and prospers in a cooperative environment. Second, you need a reasonably developed economy. Third, you need the ability to save and do more than survive only hand-to-mouth on a daily basis. Finally, you need reciprocal trust and a framework of law, as well as accepted customs and rules.

. . .

We have just witnessed last year—and we are still witnessing this year—how a relatively minor breakdown in trust and information has brought two markets, the interbank money market and the CDO market, to either display strong anomalies or freeze. Worse could come if we do not all learn to respect the boundaries within which financial activity can exist and thrive.

Investment bankers have to learn that if you have ambitions to act as an agent for an issue of a financial product, you should also have the means to make a market in that very same product in good and bad times—and investors should hold you to that. Regulatory walls between origination and trading have solved some problems, but they have also become an easy alibi for not standing behind one’s responsibilities.

Furthermore, they must understand that a revaluation of financial assets because the cost of capital has sharply decreased is not due to their genius. It is a physical law as much as conservation of energy, and therefore they do not deserve bonus payments for that. They should also realize that when they push bonus expectations beyond the moral threshold of 50/55 percent of net revenue, they are forcing their employers to take unacceptable risks to meet such expectations and that such a course of action can only end in tears.

Rating agencies have to learn about financial history and free thinking, not only about ticking boxes. Furthermore, they have to learn that the theory of overcollateralization differs from the historical experience, if you dig long enough into the past.

Regulators must learn that any new rule is a starting point for regulatory arbitrage and the mother of unintended consequences. Hence, there should be a few good rules, not thousands aimed at covering each potential circumstance. Most governments seem to have understood the lesson that the pursuit of inflation as an easy solution will bring them down in due course and for a long period. They seem to be deaf, however, to the fact that corporate taxation above 30 percent and personal direct taxation

over 40 percent, as well as an overall tax take including indirect taxation of over 50 percent, will either cripple both financial and economic activity, force people to take excessive risks, or push them elsewhere.

Retailers of financial products and solutions must realize that they are dealing with people’s lives and families’ futures. They cannot behave as street peddlers. Clear ethical boundaries must be the first line of defense, even before any legal framework is considered, because the law is unlikely to be as clear-cut as morality.

Finally, investors must be realistic about expectations. The best you can hope through financial activity is to preserve your wealth. If you want to create it, become an entrepreneur. If you want to gamble, stop whining when you lose.

If we do not all learn to be guided by such simple principles, financial activity as we know and need it will be put at risk. Trust will be eroded, impossible expectations will be created, and we will look back to the past 60 years as a golden age of economic development and financial maturity that may not be replicated any longer.

. . .

Politicians and regulators must stop hectoring and accept responsibility for having unintentionally pushed financial activity beyond sound boundaries by meddling without really understanding. Basel 2 in particular requires a very critical new look, if not a recall, as you would do for a line of cars when you realize that the brakes do not work as expected.

. . .

An excess of CO2 may be a major threat to civilized life as we know it, but the malfunctioning or freezing of the financial system could happen much faster, and we would have no control over it, as it depends on the psychology of literally billions of individuals. The consequences of such a malfunctioning do not bear thinking: breakdown in trade and investments, freezing of savings and pensions, advent of totalitarian regimes, war, and so on.

The financial system is a delicate mechanism and an essential one. Let us all treat it with some respect.

The thin space of financial activity requires a carefully calibrated commitment to balance by all parties participating in defining the sphere and scope and framework for financial interaction. In trying to deliver ever-increasing profits all around by growing the pie with inflationary monetary policies, executive excess, heightened investor expectations, regulatory and rating agency forbearance and other unrealistic and unsustainable policies, we have each and every one of us contributed to the current collapse.

Soon we will be doing a forensic analysis of what went wrong, and then look to craft new policies as a basis for rebuilding. We could do worse than look to Rudi Bogni’s analysis of the thin space of financial activity as providing the template.

___________________________________________

More excerpts from Rudi’s writing over the years:

Re: Excessive Liquidity, Self-Indulgence and Self-Deceit (1 March 2007)

I read Dr Malmgren’s submission to ATCA with great interest. As in the Middle Ages and early Renaissance, there is an increasing risk in our less and less enlightened and less and less educated societies for the financial operators to be blamed for all economic evils, the same way that unfortunately the Jewish and Lombard bankers used to be blamed for the disasters caused by the excessive indebtedness of the European monarchies of the time.

Reality is much simpler. Take a bathtub and fill it to 1/3, then throw a stone into it. It may cause waves, but it might not flow over. Take the same bathtub and fill it to the brim, then throw a stone into it. It is most likely to flow over.

What we are experiencing is an unusually long period of extreme liquidity. Whatever the motivations for it, they are essentially political motivations, driven by political intents. Whether it is to finance wars without increasing taxation, whether it is to make people feel good about the inflated value of their assets so that they are going to spend more and promote GDP growth, whether it is to buffer one country’s voters from the natural effects that working less should entitle them to a lesser share of global goods and services, there are political intents behind the excessive liquidity.

Politicians are shying away from telling the truth to their voters and a vicious circle of self-indulgence and self-deceit is being buttressed by excessive liquidity.

Blaming incorrectly the equivalents of the Jews and Lombards of today, ie hedge funds and private equity investors, is the modern version of the French kings locking up the bankers in order to avoid taking the due blame and repaying the debts.

Long term it is a strategy which can ultimately lead only to decline.

Turning difficult issues which require courage, like global warming or global competition, into a religion of fear is the novel way by which politicians aim and unfortunately short-term succeed in keeping the masses, and often even the intelligentsia, in the dark and unable to confront policy-makers on the rightful field of rationality.

Rudi Bogni

The Left and Right defined the 20th century. What’s Next? Prospect (March 2007):

Left vs Right was and is purely a nominal distinction between two strands of the same totalitarian posture. The real problem of the 20th century was that the demographic and economic pressures that fractured the empires gave rise to national states with leaderships ill equipped to face the nihilist challenge. The vacuum was filled by totalitarian regimes, whose ideologies set fire to Europe and the world. Remember that Hitler was a failed architected, Staline had studied for the priesthood an Mussolini was a schoolteacher. The heirs of the 19th and 20th century nihilists are today’s faith-based terrorists. If today’s democracies fail to win against the new nihilists on the intellectual and communication level, they will have no chance to win in the security space and will create another dangerous vacuum, ready to be filled. Nation states have proven a disastrous political experiment in the 19th and 20th century; they may well prove catastrophic in the 21st century, due to nuclear proliferation. Nevertheless, I hope that the 21st century will see a substantial reduction of political infrastructures. If a conglomerate is bad or indifferent at most of what it does, shareholders force it back to its core competences. Everything else has got to go. Why should it be different for governments? This is neither left nor right; it is common sense. Large countries’ politicians love to deride small countries’ direct democracies. Why? Because they fear their example and their nimbleness. The political systems inherited from the 20th century, whether democratic or totalitarian, are neo-feudal, incompatible with a 21st century when electors vote every so many years, but consumers vote and bloggers blog 24/7.

The Stars and Gripes (12 July 2002):

Curing hatred of America is not easy. The European intelligentsia, because of the value its educational system places on knowledge for its own sake, tends to develop a highly critical sense and a healthy scepticism. US elites, despite being trained to think for themselves, tend to be less self-critical, perhaps too focused on getting rich. This creates a big communication gap. I concentrate on Europe versus America because if there is anybody who can help America to shed its self-satisfied myths and treat the rest of the world as equals with whom it is OK to disagree, it is us Europeans. US and European interests often converge, even when our hearts and minds do not meet.

What is certain is that half-educated people, with puerile, dogmatic, self-centred half-knowledge, are the salt of tyranny. The greatest tyrants of the century we have just survived, Hitler and Stalin, were half-educated men of hatred. Only knowledge accompanied by self-deprecating critical spirit can dispose of hatred, whether of America or of the rest of the world.

But I must admit - and this is why this book created a sense of emotional release - that until now I have never seriously confronted my close American friends with what I did not like about their country. I used the same polite diplomacy to avoid taking to task my Jewish and Arab friends over Palestine. This is wrong. Discourse is the stuff of civilised life; complacency is the crystallisation of ignorance and the begetter of lost lives.

Raised by the Yankee Game (3 May 2002)

When I hear the debate as to whether capitalism won over communism, triggering perhaps the end of history, I get very annoyed. Capitalism did not win a thing. Thatcher and Reagan may have pushed down communism’s crumbling walls, but the revolution was elsewhere. It was in places such as the City of London, beacons of freedom, where young men and women of any nationality could go to work every day reporting to a person of different background and culture, working for shareholders perhaps of a different country, free to choose their career, employer, lifestyle, perhaps even work attire. Free to speak their mind and to pay the price for it if necessary. But what a small price in comparison to that of living in an autocratic society such as the Soviet Union.

Brad Setser: Extraordinary Times

Brad Setser has a fascinating insight to offer in his newest post, Extraordinary Times:

In the last two weeks — if I am reading the Federal Reserves’ balance sheet data correctly — the Fed has:

Increased “other loans” to the financial system by around $230 billion (from $23.56b to $262.34b);

Increased its “other assets” by about $80b (from $98.67b to $183.89b);

Increased the securities it lends out to dealers by $60b (from $117.3b to $190.5b);

That works out to the provision of something like $370b of credit to the financial system in a two week period. And that is just what I saw on a cursory glance.

The most that the IMF ever lent out to cash strapped emerging economies in a year?

$30b, in the four quarters through September 1998 (i.e. the peak of the 97-98 crisis).

The most the IMF ever lend out over two years?

$40b, in the eight quarters through June 2003 (this covered crises in Argentina, Brazil, Uruguay and Turkey)

This is a very real crisis. The Fed’s balance tells a story of extraordinary stress. I never would have expected to see the Fed lent out these kinds of sums over such a short-period.

My response:

Excellent and timely, Brad. I’ve been speculating all week that the pressure being used on the Congress to pass the Paulson Plan is the threat of Fed illiquidity. As of two weeks ago, the Fed had lent out more than $600 billion of its $800 billion balance sheet Treasuries against crap MBS collateral.

The Paulson Plan would have allowed the banks to unwind the repos putting the Treasuries back in the Fed, get cash for the crap MBS, and get more Treasuries from the issues financing the $700+ billion funding of the Plan. As a bonus, the Paulson mark-to-maturity price becomes the implicit Level 3 price for capitalisation of all the firms and banks in the system, giving them some breathing room to stay in business. Everyone wins except the poor American taxpayer.

The Fed is very close to being illiquid. That is the fear factor we are seeing at work, and the reason no one will discuss why the bailout is needed - only emphasise the urgency.

Testimony of Marriner Eccles to the Committee on the Investigation of Economic Problems in 1933

Below are excerpts from the testimony of Marriner Eccles to the Senate Committee on the Investigation of Economic Problems in 1933. It is an historic document – laying out the future terms of the Federal Deposit Insurance Corporation, the management of money supply nationally through open market operations, the Bretton Woods Accord on currency stability, mortgage refinancing as monetary stimulus, and reforms of the Federal Reserve System to eradicate the excesses of untamed capitalism and financial dominance of Wall Street. He proposes higher income and inheritance taxes as essential to promote economic growth, curb inequality and forestall political instability. He encourages federal regulation of child labor, unemployment insurance, social security and other farsighted reforms. And he avows himself a capitalist throughout.

Although he was a titan of industry - with banks, railroads and corporations spanning the American west - Eccles was born the son of an illiterate, bigamist, Mormon, Scottish immigrant. He was about as far as you could get from the Eastern elite ranks that ran US banking on Wall Street. But he sure understood money, economics and trade, and had the personal drive and charisma to carry his point with the president and with Congress.

Following his testimony, the Utah banker was invited by Franklin Roosevelt to come to Washington to spearhead legislation to enact his proposed reforms. Within two years he had drafted and enacted the Securities Act of 1933 and the Banking Act of 1933(a.k.a., The Glass-Steagall Act, which separated investment and commercial banking and established the FDIC) and the Banking Act of 1935 (which created the modern Board of Governors of the Federal Reserve System and Federal Open Market Committee). He served as Chairman of the Board of Governors of the Federal Reserve System from 1934 until 1951.

Read this and know that just one person, with vision and principles, can make a difference to the world in a time of crisis, establishing the basis for decades of prosperity and growth.

[page 8]

Before effective action can be taken to stop the devastating effects of the depression, it must be recognised that the breakdown of our present economic system is due to the failure of our political and financial leadership to intelligently deal with the money problem. In the real world there is no cause nor reason for the unemployment with its resultant dsestitution and suffering of fully one-third of our entire population. We have all and more of the material wealth which we had at the peak of our prosperity in the year 1929. Our people need and want everything which our abundant facilities and resources are able to provide for them. The problem of production has been solved, and we need no further capital accumulation for the present, which could only be utilised in further increasing our productive facilities or extending further foreign credits. We have a complete economic plant able to supply a superabundance of not only all the necessities of our people, but the comforts and luxuries as well. Our problem, then, becomes one purely of distribution. This can only be brought about by providing purchasing power sufficiently adequate to enable the people to obtain the consumption goods which we, as a nation, are able to produce. The economic system can serve no other purpose and expect to survive.

If our problem is then the result of the failure of our money system to properly function, which today is generally recognised, we then must turn to the consideration of the necessary corrective measures to be brought about in that field; otherwise, we can only expect to sink deeper in our dilemma and distress, with possible revolution, with social disintegration, with the world in ruins, the network of its financial obligations in shreds, with the very basis of law and order shattered. Under such a condition nothing but a primitive society is possible. Difficult and slow would then be the process of rebuilding and it could only then be brought about on a basis of a new political, economic and social system. Why risk such a catastrophe when it can be averted by aggressive measures in the right direction on the part of the Government?

* * *

[page 9]

We could do business on the basis of any dollar value as long as we have a reasonable balance between the value of all goods and services if it were not for the debt structure. The debt structure has obtained its present astronomical proportions due to an unbalanced distribution of wealth production as measured in buying power during our years of prosperity. Too much of the product of labor was diverted into capital goods, and as a result what seemed to be our prosperity was maintained on a basis of abnormal credit both at home and abroad. The time came when we seemed to reach a point of saturation in the credit structure where, generally speaking, additional credi was no longer available, with the result that debtors were forced to curtail their consumption in an effort to create a margin to apply on the reduction of debts. This naturally reduced the demand for goods of all kinds, bringing about what appeared to be overproduction, but what in reality was underconsumption measured in terms of the real world and not the money world. This naturally brought about a falling in prices and unemployment. Unemployment further decreased the consumption of goods, which further increased unemployment, thus bringing about a continuing decline in prices. Earnings began to disappear, requiring economies of all kinds – decreases in wages, salaries, and time of those employed.

[page 10]

The debt structure, in spite of the great amount of liquidation during the past three years, is rapidly becoming unsupportable, with the result that foreclosures, receiverships and bankruptcies are increasing in every field; delinquent taxes are mounting and forcing the closing of schools, thus breaking down our educational system, and moratoriums of all kinds are being resorted to – all this resulting in a steady and gradual breaking down of our entire credit structure, which can only bring additional distress, fear, rebellion, and chaos.

* * *

As an example of Government control and operation of the economic system look to the period of the war, at which time, under Government direction, we were able to produce enough and support not only our entire civilian population on a standard of living far higher than at present, but an immense army of our most productive workers engaged in the business of war, parasites on the economic system, consuming and destroying vast quantities produced by our civilian population; we also provided allies with an endless stream of war materials and consumption goods of all kinds. It seemed as though we were enriched by the waste and destruction of war. Certainly we were not impoverished, because we did not consume and waste except that which we produced. As a matter of fact we consumed and wasted less than we produced as evidenced by the additions to our plant and facilities during the war and the goods which we furnished to our allies. The debt incurred by the Government during the war represents the profit which accrued to certain portions of our population through the operation of our economic system. No Government debt would have been necessary and no great price inflation would have resulted if we had drawn back into the Federal Treasury through taxation all of the profits and savings accumulated during the war.

* * *

[page 11]

How was it that during the period of the prosperity after the war we were able in spite of what is termed our extravagance – which was not extravagance at all; we saved too much and consumed too little – how was it we were able to balance a $4,000,000,000 annual Budget, to pay off ten billion of the Government debt, to make four major reductions in our income tax rates (otherwise all of the Government debt would have been paid), to extend $10,000,000,000 credit to foreign countries represented by our surplus production which we shipped abroad, and add approximately $100,000,000,000 by capital accumulation to our national wealth, represented by plants, equipment, buildings, and construction of all kinds? In the light of this record, is it consistent for our political and financial leadership to demand at this time a balanced Budget by the inauguration of a general sales tax, further reducing the buying power of our people? Is it necessary to conserve Government credit to the point of providing a starvation existence for millions of our people in a land of superabundance? Is the universal demand for Government economy consistent at this time? Is the present lack of confidence due to an unbalanced Budget?

What the public and the business men of this country are interested in is a revival of employment and purchasing power. This would automatically restore confidence and increase profits to a point where the Budget would automatically be balanced in just the same manner as the individual, corporation, State, and city budget would be balanced.

[page 12]

During the past three years there has been such tremendous liquidation and scaling down of debts that extraordinary measures have had to be taken to prevent a general collapse of the credit structure. If such a policy is continued what assurance is there that the influences radiating from a marking down of the claims of creditors will not result in a further decline of prices? In other words, after we have reduced all debts through a basis of scaling down 25 per cent to 50 per cent, what reason have we to expect that prices will not have a further decline by like amount? And then again, the practical difficulties of bringing about such a adjustment on a broad scale seem to be insurmountable.

The time element required would indefinitely prolong the depression; such a policy would necessitate the further liquidation of banks, insurance companies, and all credit institutions, for if the obligations of public bodies, corporations, and individuals were appreciably reduced the assets of such institutions would diminish correspondingly, forcing their liquidation on a large scale. Nothing would so hinder any possibility of recovery. Bank and insurance failures destroy confidence and spread disaster and fear throughout the economic world. The present volume of money would diminish with increased hoarding and decreased credit and velocity, making for further deflation and requiring increased Government support without beneficial results until we would be forced from the gold standard in spite of our 40 per cent of the world’s gold, and, at that point, an undesirable and possibly an uncontrolled inflation with all its attendant evils would likely result, and thus the very action designed to preserve the gold standard and re-establish confidence would destroy both.

[page 13]

We have nearly one and a half billion currency more in circulation at the present time than we had at the peak of 1929, and under our present money system we are able to increase this by several billion more without resorting to any of the three inflationary measures popularly advocated. There is sufficient money available in our present system to adequately adjust our present price structure. Our price structure depends more upon the velocity of money than it does upon its volume.

* * *

In 1929 the high level of prices was supported by a corresponding velocity of credit. The last Federal Reserve Bulletin gives an illuminating picture of this relationship as shown by figures of all member banks. From 1923 to 1925 the turnover of deposits fluctuated from 26 to 32 times per year. From the autumn of 1925 to 1929 the turnover rose to 45 times per year. In 1930, with deposits still increasing, the turnover declined at the year end to 26 times. During the last quarter of 1932 the turnover dropped to 16 times per year. Note that from the high price level of 1929 to the low level of the present this turnover has declined from 45 to 16, or 64 per cent.

[page 14]

I repeat there is plenty of money today to bring about a restoration of prices, but the chief trouble is that it is in the wrong place; it is concentrated in the larger financial centers of the country, the creditor sections, leaving a great portion of the back country, or the debtor sections, drained dry and making it appear that there is a great shortage of money and that it is, therefore, necessary for the Government to print more. This maldistribution of our money supply is the result of the relationship between debtor and creditor sections – just the same as the realtion between this as a creditor nation and another nation as a debtor nation – and the development of our industries into vast systems concentrated in the larger centers. During the period of the depression the creditor sections have acted on our system like a great suction pump, drawing a large portion of the available income and deposits in payment of interest, debts, insurance and dividends as well as in the transfer of balances by the larger corporations normally carried throughout the country.

[page 15]

The maladjustment referred to must be corrected before there can be the necessary velocity of money. I see no way of correcting this situation except through Government action.

[page 21]

Mr Eccles: Of course, the way I look at this matter is that we have the power to produce, just as in the period of prosperity after the war demonstrated when we had a standard of living for a period from 1921 to 1929 which, of course, was far in excess of what it is now. Yet in spite of that standard of living we saved too much a I have previously tried to show.

Senator Gore: You have got Foster in the back of your head?

Mr Eccles: I only wish there were more who had. We saved too much in this regard, that we added too much to our capital equipment. Creating overproduction in one case and underconsumption in the other because of an uneconomic distribution of wealth production. . . . Of course, we are losing $2,000,000,000 per month in unemployment. I can conceive of no greater waste than the waste of reducing our national income about half of what it was. I can not conceive of any waste as great as that. Labor, after all, is our only source of wealth.

[page 22]

There could be no waste in post offices or in roads or in schools. You would have something to show for it. With war all you have left is the expense of taking care of maimed and crippled and sick veterans. That is what is left from war. And it is all wastage.

Senator Gore: You have touched the point. The real cause of the existing trouble was the war, with destruction of over 300 billion dollars of wealth in four years. We are paying the price now. The boys paid the price in blood on the field. We are paying the economic price today. And you may just as well pass a resolution to raise the dead that fell in France as to try to pass laws to avert the inevitable consequences of that war.

Mr Eccles: It is true we are suffering the consequences of the war, but there is no reason why we should be suffering from the consequences of the war if it had not been for the international or the interallied debt that resulted from it. WE are suffering from a debt structure. We are not suffering from the waste, because after all, we know today that we have the power and the facilities to produce certainly all that the people of this country need and want.

* * *

We now see, after nearly four years of depression, that private capital will not go into public works or self-liquidating projects except through government and that if we leave our “rugged individual” to follow his own interest under these conditions he does precisely the wrong thing. Each corporation for its own protection discharges men, reduces pay rolls, curtails its orders for raw materials, postpones construction of new plants and pays off bank loans, adding to the surplus of unusable funds. Every single thing it does to reduce the flow of money makes the situation worse for business as a whole.

[page 24]

I am talking about private credit. If it is credit we need why do not say 200 of our great corporations controlling 40 per cent of our industrial output that are in such shape that they do not need credit – they have great amounts of surplus funds – if it is credit that is needed why do they not put men to work? For the very reason that there is not a demand for goods, that we have destroyed the ability to buy at the source through the operation of our capitalistic system, which has brought about such a maldistribution of wealth production that it has gravitated and gravitated into the hands of – well, comparatively few. Maybe several millions of people. We have still got the unemployment and have got no buying power as a result.

[page 25 – proposal of bank deposit insurance and failed bank resolution]

[page 27 – laying out the basis for what was later to be the FDIC]

However, there is always this danger about that class of thing [Government guarantee of bank deposits]. It encourages bad practices and bad management. It may put a premium on them, which of course we do not want to do, and if it is done there must be rules and regulations for the proper conduct of banks requiring eligibility, and if they fail to meet the eligibility they would be suspended after so much notice, and the fund would be drawn upon to take care of any loss.

[page 31]

Farm mortgages at present are possibly the most undesirable and frozen of all loans, and frozen loans are preventing, to some extent, the necessary expansion of credit. The plan I have proposed [to refinance existing farm mortgages at new lower rates] will very effectively and immediately make liquid billions of dollars of assets for which there is no market today, while at the same time it will bring about a reduction of at least one-third of the average annual payments on the farm debt now required to be made by farm mortgage debtors without requiring any financing or loss by the Federal Government, thus bringing about the necessary relief in the farm mortgage field. This plan has the advantage, as a result of the Government guarantee of the Federal land bank bonds, of diverting surplus funds carried in the great creditor sections into the indirect financing of farm mortgages where it is impossible even at a high rate of interest, which farmers can not pay, to attract those funds directly.

* * *

No program designed to bring this country out of the depression can be considered apart from the relations of this country to the rest of the world unless a policy of complete isolation is adopted and an embargo put on gold exports and our domestic economy adjusted to meet such a condition.

Our international problems are far more difficult and will be slower to work out because of our inability to control the action of other nations. These problems can be met only through international conferences over a period of time. The most important of these problems and the one which must be settled before any progress can be made in the meeting of our domestic or other foreign problems is the problem of interallied debts.

There is a great demand on the part of the public and most of the press of this country that these debts be paid. It seems to me that our political leaders have lacked the courage to face this problem in a realistic manner. This has greatly contributed to prolonging the depression. The public, generally speaking, is not fully informed as to the impossibility of our foreign debtors complying with these demands, which cn only be complied with at the expense of our own people.

[page 32]

It is elementary that debts between nations can ultimately be paid only in goods, gold, or services, or a combination of the three. We already have over 40 per cent of the gold supply of the world – that is not true; it is between 35 and 40 per cent – and as a result most of the former gold standard countries have been forced to leave that standard and currency inflation has been the result. This has greatly reduced the cost of producing foreign goods in terms of our dollar and has made it almost impossible for foreign countries to buy American goods because of the high price of our dollar measured in the depreciated value of their money. This naturally has resulted in debtors trying to meet their obligations by producing and selling more than they buy, thus enabling them to have a favourable balance of trade necessary to meet their obligations to us. If this country is to receive payment of foreign debts, it must buy and consume more than it produces, thus creating a trade balance favourable to our debtors.

* * *

We must choose either between accepting sufficient foreign goods to pay the foreign debts owing to this country, or cancel the debts. This is not a moral problem, but a mathematical one.

[page 33 – the outline of what later became the Bretton Woods Accord]

Cancellation, or a settlement of the debts on a basis which would practically amount to cancellation, in exchange for stabilisation of the currency of the debtors, together with certain trade concessions and an agreement to reduce armaments would be a small price for this country to pay as compared with the great benefits which the entire world, including ourselves, would derive therefrom. Without a stabilisation of foreign currencies it will be difficult, if not impossible, in my opinion, to substantially raise the price level in this country as long as we stay on a gold basis. Our debtors will default and we will likely be forced to abandon gold and depreciate our currency in relation to that of other countries in order to raise our price level in this country and to meet foreign competition unless we are instrumental in inducing foreign countries to stabilise their currencies on a gold basis, or gold and silver basis if action is taken internationally to remonetise silver.

[page 33]

Senator Shortridge: Then I take it you would have the tariffs reduced?

Mr Eccles: No. Debts cancelled. Then I think with the prosperity that you would get in this country you can collect more than that in income and inheritance taxes when you stop this loss of $2,000,000,000 a month through unemployment. You start the process of wealth, and even a capitalist is far better off. I am a capitalist.

* * *

The program which I have proposed is largely of an emergency nature designed to bring rapid economic recovery. However, when recovery is restored, I believe that in order to avoid future disastrous depressions and sustain a balanced prosperity, it will be necessary during the next few years for the Government to assume a greater control and regulation of our entire economic system. There must be a more equitable distribution of wealth production in order to keep purchasing power in a more even balance with production.

If this is to be accomplished there should be a unification of our banking system under the supervision of the Federal Reserve Bank in order to more effectively control our entire money and credit system; a high income and inheritance tax is essential in order to control capital accumulations (this diversion of taxes should be left solely to the central government – the real property and sales tax left to the States); there should be national child labor, minimum wage, unemployment insurance and old age pension laws (such laws left up to the States only create confusion and can not meet the situation nationally unless similar and uniform laws are passed by all States at the same time, which is improbable); all new capital issues offered to the public and all foreign financing should receive the approval of an agency of the Federal Government; this control should also extend to all means of transportation and communication so as to ensure their operation in the public interest. A national planning board, similar to the industries board during the war, is necessary to the proper coordination of public and private activities of the economic world.

Such measures as I have proposed may frighten those of our people who possess wealth. However, they should feel reassured in reflecting upon the following quotation from one of our leading economists:

It is utterly impossible, as this country has demonstrated again and again, for the rich to save as much as they have been trying to save, and save anything that is worth saving. They can save idle factories and useless railroad coaches; they can save empty office buildings and closed banks; they can save paper evidences of foreign loans; but as a class they can not save anything that is worth saving, above and beyond the amount that is made profitable by the increase of consumer buying. It is for the interests of the well to do – to protect them from the results of their own folly – that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit. This is not “soaking the rich”; it is saving the rich. Incidentally, it is the only way to assure them the serenity and security which they do not have at the present moment.

[page 35]
I feel that one of two things is inevitable: That either we have got to take a chance on meeting this unemployment problem and this low-price problem or we are going to get a collapse of our credit structure, which means a collapse of our capitalistic system, and we will then start over. And I therefore would like to see us attempt to regulate and operate our economy which today requires more action from the top due to our entire interdependency than it did in our earlier days.

The quote I have bolded is my favorite part of this testimony, though it is not Eccles' own words. I would be grateful for anyone who can track down a proper citation for the quote. Eccles thought it was either Stuart Chase or William Trufant Foster.

If you've made it this far, you might also enjoy: Fisher's Debt Deflation Theory of Great Depressions and a possible revision

Did Buffett Just Give Us A Coded Warning?

Warren Buffett, new stakeholder in the megalithic survivor-biased Goldman Sachs, has referred to recent upheavals in the financial markets as "an economic Pearl Harbour". He is a very smart man who knows his history, having lived it and seen it up close. He will know better than most that Pearl Harbour is now understood in well informed circles to not only have been foreseen by FDR, but provoked by FDR in an orchestrated campaign to engineer a war with Japan dating from a plan adopted in 1940.

As yoyomo reminds us in an earlier thread, the book Day of Deceit: The Truth About FDR and Pearl Harbour provides dispositive documentary evidence.

Historians have long debated whether President Roosevelt had advance knowledge of Japan's December 7, 1941, attack on Pearl Harbor. Using documents pried loose through the Freedom of Information Act during 17 years of research, Stinnett provides overwhelming evidence that FDR and his top advisers knew that Japanese warships were heading toward Hawaii. The heart of his argument is even more inflammatory: Stinnett argues that FDR, who desired to sway public opinion in support of U.S. entry into WWII, instigated a policy intended to provoke a Japanese attack. The plan was outlined in a U.S. Naval Intelligence secret strategy memo of October 1940; Roosevelt immediately began implementing its eight steps (which included deploying U.S. warships in Japanese territorial waters and imposing a total embargo intended to strangle Japan's economy), all of which, according to Stinnett, climaxed in the Japanese attack.

Warren Buffet knows better than most just how dirty and mean this Bush administration plays. The politically motivated prosecutions of AIG after he endorsed Kerry in 2004 will have left scars, and his advising Obama puts him at huge risk if Rove succeeds with another GOP victory.

He is in the insurance business, isn't he? So think of his acquisition of a huge stake in Goldman Sachs and his endorsement of the Paulson Plan as insurance. Meanwhile, he may just be patriot enough to have provided a coded clue as to what he really believes you can expect.

Marcy Kaptur (D-OH): "Real reform now or nothing!"

Must see.



She rips Wall Street a new one.

Quotable: On Bank Balance Sheets

"The problem with financial institution balance sheets is that on the left hand side nothing is right and on the right hand side nothing is left."

Rep McDermott (D-WA): Paulson "able to catch a pass he threw to himself"

Rep McDermott gets it:

Mr Speaker,

The people in Washington State are very troubled by the fact that King George has been disposed of by King Henry.

We picked up Newsweek magazine today and we have a new King... King Henry?

We're supposed to give him 700 billion dollars of our money. He doesn't want any review. He wants to be able to do whatever he wants with it. He doesn't want any Congressional oversight. And worst of all, the new king is just like the old king: He doesn't want any sacrifice.

He says, "Oh we can't threaten the salares of the investment bankers who drove us into a ditch. We can't get anyone to pay for this."

This is the third time we've done it with this bunch. First the war, that didn't get paid for. Then the tax cuts, that didn't get paid for, and now King Henry takes over to distribute 700 billion dollars. He's going to be there for four months. And in four months he will make deals and then he'll go out and he'll be able to catch a pass he threw to himself.

"Non-Reviewable" - Sometimes there really ARE conspiracies

The text of the proposed emergency markets legislation is now available. Just as expected, it will contain a provision to provide immunity from any review by any court or executive agency. Either get with the collaborationists or get with the insurgents. There is no other choice. The USA doesn’t exist as we once knew it.

The relevant text from the legislation:

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Good luck, everyone. We’re in uncharted waters now. There is no rule of law if this passes - there are no markets. We’ve all been had, and the worst is yet to come.

The Unitary Federal Reserve - Crisis Choreography

Along with much of the world, I have watched with increasing disquiet as the United States of America morphed under President Bush into a lawless soft dictatorship more like the USSR than the USA.  Under his theory of the "unitary executive" the laws that Congress enacted were disapplied by signing statements and secret legal opinions.  The protections of the Constitution were eroded and marginalized by police powers and warrantless surveillance.  International treaties governing the protection of sovereignty, rules of war and the universal rights of man were distorted by unilateral interpretation and willfully hidden misconduct.  Court rulings and judicial review were avoided, and where forced, were ignored or overridden or negated by executive pardon.  Transparency and audit became a joke with refusals to cooperate with tribunals or to comply with supeonas or produce evidence.  This lawlessness has not made the world or the United States or its allies safer in the age of terrorism as it has degraded and confused what we might have hoped to defend.

Just as we here in the rest of the world hoped we might breathe easy with the end of the Bush administration in sight, and several creditable candidates for president coming forward, the lawless unitary executive has expanded to embrace the Treasury and the Federal Reserve, debasing and contaminating the financial markets globally with its spread to our own central banks and market authorities and destabilizing our banks and investment markets.  Once again in the name of crisis and expediency the laws are ignored, decisions are taken in secret, extra-judicial reapportionment of property and contract is mandated by executive fiat, and legislative review and judicial intervention are impossible. Over the past year every financial crisis has been met with lawless and Enron-esque innovation by the Federal Reserve and Treasury, and this week was arguably more extreme.

After this week's secret and unaccountable and extra-legal moves by the US financial authorities, I will not be holding any assets in the United States.  I do not understand the rules.  I doubt any rules will be applied fairly to all the players.  I cannot be sure who the umpire works for, or what principles the umpire thinks they should uphold.  I will not play the game.*

Let's look at a timeline of some of the decisions I would class as extra-legal or Enron-esque:

The (Selectively Leaked) Discount Rate Cut (August 2008)

Super SIV (October 2007)

Term Auction Facility (December 2007)

Bear Stearns/JP Morgan bailout and subsidy (March 2008)

Primary Dealer Credit Facility (March 2008)

Reverse MBS Swaps (April 2008)

Equity investment and collateral (September 2008)

Administrative Repeal of 23A (September 2008)

AIG nationalisation (September 2008)

Expansion of the Fed Balance Sheet through unprecedented Treasury refinance without appropriation by Congress (September 2008)

Central bank dollar liquidity draws (September 2008)

Resolution Trust Company/Super SIV Redux (next)

And that's just the list of actions we know about.  Much may have been orchestrated and influenced behind the scenes in  credit markets and traded equities and commodities.

At no stage have any of these significant enhancements to the prerogatives of the Federal Reserve, these derogations of explicit statutory limits, these stark departures from past authority and conduct, been the subject of democratic legislative proposal or review, or even public consultation and comment.  In the name of exigency, they have all been sprung as fait accompli on a shocked financial community, and since been treated as unquestionable and unreviewable.  Every initiative introduced as a temporary measure has become a permanent fixture.

The unitary executive of the Bush presidency eroded and disregarded the civil rights of Americans and others.  The unitary Federal Reserve disregards the property and contract rights of Americans and others.  Arguably the actions of the Federal Reserve over the past year represent the largest state confiscation of wealth in the history of man, dispossessing currency investors, equity investors, bond investors and taxpayers of literally trillions of dollars of current and future wealth by executive fiat.

The hypocrisy of the Bush administration criticizing Chavez while defending Paulson and Bernanke should be the stuff of late night stand up comedy.

And the answer to the crisis so created, according to those in authority in Washington and Wall Street, is to give more concentrated power with less review and less oversight to the Federal Reserve.  The reforms now being discussed in Washington are aimed at (1) gutting the SEC so that it can no longer challenge the Fed's primacy in investment bank and financial conglomerate prudential supervision, oversight of clearing and settlement systems, market integrity and stability and introducing “principles based” regulation so that no one well connected need ever worry about prosecution or conviction ever again; (2) gutting the FDIC so that it can no longer challenge the Fed's determination of capital adequacy or prudential supervision at insured banks or restrain cross-affiliate financing or excessively risky activity within bank holding company groups; (3) gutting the CFTC so that the Fed has primacy to oversee risk management in all OTC and exchange-traded derivatives clearing and margin; and (4) providing explicit powers to the Federal Reserve to promote "market stability" by means which shall be secret, unreviewable, and above challenge in the courts; and (5) making the Federal Reserve the prime global regulator for review of the regulatory and prudential supervision arrangements everywhere else in the world through mandated “harmonization” of global standards as a quid pro quo for foreign market recognition and access.

Stalin couldn’t have drafted a better plan for central control of the global economy after wreaking such havoc and devastation.

Up until this week I thought the gold bugs a bit mad.  I couldn't see the sense of holding something that couldn't be spent but could be seized (as gold was seized in the 1940s).  I still think they are a bit mad, but I am actively looking for any alternative to currency and market investments as a medium of exchange and store of value.  Given the very public concerns now being expressed in China and Russia, I am keeping company I would have once thought very surprising indeed.

For now the ECB, Bank of England and others are content to cooperate with the Fed, but as the chaos deepens and it becomes clear that the losses are to be allocated principally outside the US borders to those foolish enough to hold assets the Fed’s policies degrade and debase, they will begin to question and to look to each other for common interest and alignment.

The loss of 1200 lives on the Lusitania was deliberately allowed to justify US entry into World War I.  The attacks on Pearl Harbour were known in the White House three days before the bombs fell, but were ignored to justify entry into World War II.  Tonkin Gulf was a fraud.  WTC hijackers were financed by US allies and WTC 7 was . . . whatever.  Saddam’s weapons of mass destruction were fabricated in the forgery shop of Ahmad Chalabi’s Iraqi National Congress.  You get the idea.

Not all catastrophic events were willful or anticipated, but all were used to force through an agenda that was pre-agreed by a powerful elite that stood to profit from a preferred course of policies that could only be pursued in the undemocratic atmosphere of crisis.  Crisis prevents objective determination of the public interest.  Crisis undermines both markets and democracy.

I no longer believe that every financial collapse is unanticipated or without behind the scenes orchestration of effects.  I no longer trust the authorities to act fairly, honestly, in the public interest.

In the past year and just this past week, trillions of dollars of wealth have been allocated or misallocated, preserved, appropriated or destroyed by central bank fiat.  If we really have nations of laws and not men, capitalist markets and not command economies, then it’s essential we peek behind the curtain to ask by whom and why and hold them accountable.

Lawlessness has not enhanced our security as citizens, and lawlessness will not enhance our security as investors or depositors either. Banks and markets require regulation in the public interest, and determination of the public interest requires transparency, accountability and the rule of law.

_____________________________

* For those cynics out there, let me remind you I gave up trading in January this year. I had a small amount of cash in a US dollar account. That account is now closed.

Hat tip to Joe Mason, for expressing similar views here on RGE Finance and Banking yesterday: Crisis Policy is Redrawing the Boundaries of our Financial System - and not necessarily in productive ways

And, as ever, thanks to the courageous Professor Roubini for providing a forum for views challenging the orthodoxy.

"Deficit Attention Disorder"

I must admit to being delighted that the EU finance ministers have found unity on one point: dismissal of Tim Geithner as officious, ignorant and unaccountable. He is an example, right up there with George W. Bush, of the privileged American elite who "fail upwards" throughout a career.

Europe's nations may have an escalating debt crisis, but they have been addressing it sensibly and cautiously by trying to rein in further debt through reductions in government spending.

The perfect example from the meeting logistics: EU finance ministers shared a bus to the meeting, while Tim Geithner insisted on a private car.

Geithner seems to abhor austerity and sacrifice, preferring any strategy which keeps debt growing to fund the investment banking, security, prisons and war industries on which the American economy now depends for so much of its GDP. (2 percent of Americans are in prison, while 1 percent work for the Department of Defense.)

He encouraged a ten-fold increase in leverage of the EFSF to create a massive new debt overhang. Madness. The cure for a refinancing crisis is not more leverage to be later refinanced.

Europe has its problems, but one thing I know is that the default setting for Europe is cooperation where the default setting for America is conflict. If Tim Geithner's objective in coming to Poland was to stimulate consensus among European finance ministers, then he can go home happy. He succeeded. They are unified in finding him and his policies discredited. They will work together from that consensus to find a more workable solution for Europe than could ever be conceived in Washington, precisely because they will work together in recognition of mutuality of interest.

UPDATE: As this is being linked elsewhere, I'll add a suggestion about what I would advise the eurozone finance ministers. I would advise them to have every EU state with off balance sheet, hidden liabilities on derivatives - whether undertaken for window dressing to gain admission to the eurozone or any other purpose - to default on any further margin or resettlement payments. The Hammersmith and Fulham defaults of the late 1980s proved a wonderful discipline on the investment banks, schooling them in the limits of preying on local governments. It might be time for another lesson at the national level.

Each of the defaulted derivatives contracts could be referred to an EU committee to determine whether the contract had any legitimate rationale beyond disguising the financial condition or otherwise deceiving the public or other EU governments. If there was no legitimate rationale which served the public interest, then the contract would be declared unenforceable.

This wouldn't address decades of deficit spending, but it would provide a popular demonstration of resolve to shaft Wall Street rather than the taxpayer, at least in the first instance. The politicians should then have enough breathing room to reach a more resilient agreement on fiscal policy and funding going forward.

I appreciate that questioning the validity and enforceability of derivatives contracts might be "extra-legal" in the sense that it would be contrary to accepted legal norms. But since virtually every intervention and liquidity programme innovated by a central bank since 2007 has been without legal or statutory basis, despite the huge redistributions of national wealth, I hardly consider that a sticking point.

Denninger warns of US political failure

Every now and then I have enjoyed reading Karl Denninger's Market Ticker on current events. His most recent video, which he warns may be his last, warns that the line crossed by the Treasury and Federal Reserve in creating new money to bail out Wall Street will - if unchallenged - lead to the political failure of the United States and its constitutional government as a representative democracy. He makes some very good points.

Unlike most people, I knew in 2002 and early 2003 that the United States was determined to attack and occupy Iraq because I have a long memory for bank failures. I knew that Ahmad Chalabi was the same forger, embezzler and fraudster who had looted Bank Petra of $300 million before fleeing Jordan, almost causing the collapse of the Jordanian economy. Since all the intelligence fabricated for the war emanated from Chalabi's Iraqi National Congress, I knew the whole thing was being orchestrated by authorities.

I get the same queasy feeling today about events on Wall Street, and like Denninger, I wonder what the plan really is for the nation as more and more lines are crossed with extra-legal executive authority. I did not expect in 2002 and 2003 that war for oil in Iraq would lead to black sites, renditions, torture, Blackwater deployed in New Orleans, and other proximate results of a lawlessness and unaccountability that remained unchallenged and unchecked. I do not know what to expect of the USA in the years to come. That worries me deeply.

Ring Fences, Rustlers and a global bank insolvency

In this week which has seen so much speculation on the fate of Lehman Brothers, it seems only sensible to review how an international insolvency of a major bank works and what it might mean for international creditors. The insolvency treatment of international banks has remained one of the stubbornly difficult areas of law to harmonise and huge uncertainty and complexity remains. For excellent background, see Cross-border bank insolvency by Rosa Maria Lastra of Queen Mary, University of London.

Although markets are global, and Lehman Brothers operations span the globe, all insolvency is local. The basic premise is that each jurisdiction buries its own dead and keeps whatever treasure or garbage it finds with the corpse. Local creditors get to recover their claims out of the locally available assets. If, and only if, there are any assets left over will international creditors be invited to make a claim for the rest. Europe has managed to harmonise cross-border insolvency for banks under directives and local law to embody principles of universality and unity within the EU, but that only works equitably if enough assets are in the EU when the bank fails, and local insolvency law still applies in all its divergent complexity.

Claims against a bank are deemed located wherever the contract creating the claim is undertaken. If it is under US law then the claimant must look to the liquidator in the United States and assets under his control for recovery. If the claim is in Hong Kong, then the claimant looks to the Hong Kong receiver and assets.

The key to having a happy insolvency, if such a thing exists, lies in ensuring that when a globalised bank goes bust, all the best assets are inside your borders and subject to seizure by your liquidators on behalf of your creditors. Everyone else outside your borders is on their own. As the US dollar is the reserve currency of banking and US Treasuries, Agencies and other assets are the highest preferred asset class, the US is almost always in a good position in an international bank failure.

The principle of using local assets for local recovery is known as the “ring fence” – the idea being that insolvency drops an invisible “ring fence” around any valuable assets at the borders to meet claims arising within the borders. No country is more assiduous in weaving the ring fence than the United States of America. It is a very successful strategy for US creditors. US creditors of failed international banks tend to recover disproportionately relative to creditors anywhere else. The ring fence contains all these choicest assets for US creditors, and all the international creditors are forced to pick among the dross of foreign assets to eke out a recovery, only receiving any residual US assets remaining after US creditors get 100 percent recovery.

Lehman has been deeply troubled and subject to speculation since the early spring. That was just about the time that we started to see a marked sell off in foreign markets where Lehman has long been a major player. Recently, along with intensification of that sell off, we have seen a strengthening of the US dollar and US asset markets.

If one were cynical, and one believed that Lehman was going to be allowed to fail pour encouragement les autres one might wonder if Lehman was quietly bidden – or even explicitly ordered – to sell off its foreign holdings and repatriate the proceeds to asset classes within the US ring fence. This would ensure that US creditors of Lehman received a satisfactory recovery at the expense of foreign creditors. It would also contribute to a nice pre-election illusion of a “flight to quality” as US dollar and assets strengthened on the direction of flow.

If one were really cynical, one might even think that a wily bank supervisor might arrange to ensure 100 percent recovery for its creditors with a bit of creative misappropriation thrown in the mix. Broker dealers normally hold securities and other assets in nominee name on behalf of their investor clients. Under modern market regulation, these nominee assets are supposed to be held separately from a firm’s own assets so that they can be protected in an insolvency and restored to the clients with minimal loss and inconvenience. Liberalisations and financial innovations have undermined the segregation principle by promoting much more intensive use of client assets for leverage (prime brokerage and margin lending) and alternative income streams (securities lending). As a result, it is often very difficult to discern in a failed broker who has the better claim to assets which were held to a client account but reused for finance and/or trading purposes. The main source of evidence is the books of the failed broker.

On the wholesale side, margin and collateralisation in connection with derivatives and securities finance arrangements mean that creditors under these arrangements should have good delivery and secure legal claims to assets provided under market standard agreements. As a result, preferred wholesale creditors could have been streamed the choicest assets under arrangements that will look above suspicion on review as being consistent with market best practice.

If Lehman were to go into insolvency, I will be interested to discover whether US creditors achieve a much higher proportion of recovery than their global peers in other locations where Lehman did business. If so, it will likely be because of the US ring fence and the months of repatriation of assets and funds back into the confines of the ring fence before the failure was finally orchestrated. It will also be because the choicest assets were preferentially delivered to preferred US creditors under market standard margin and collateral arrangements.

Unfortunately, the pace of an international insolvency means that any retrospective evaluation will be so far down the road that I will likely be almost alone in looking backwards to see what the final distribution effects are and what they mean for equitable principles of international banking practice.

Weaning the banks off the Old Lady's teat

There is a warm sense of security that comes from suckling liquidity from the teat of the central bank rather than foraging for capital and earnings in a harsh world full of threats and predators. Nonetheless, there comes a time when a good mother pushes away her importunate young and forces them to fend for themselves subject to her stern guidance and supervision.

Central banks have been suckling their broods of commercial banks since the credit crunch first exploded on the scene in August 2007. Now there are signs that the Bank of England and European Central Bank, at least, are keen to push their broods toward self-sufficiency, even at the risk that not all survive independently.

The Old Lady of Threadneedle Street has announced that she really, really means it when she says that the Special Liquidity Scheme introduced to enable banks to draw her gilts against mortgage-backed collateral will be closed down 20th October. The SLS was opened as a “one-off operation with a finite life” and was never intended to do more than bridge the liquidity gap created by the collapse of the mortgage-back securities market while banks adjusted their business models to changed market conditions.

The banks, led by UBS, are throwing temper tantrums, stamping their little feet, screaming in the financial press, but so far the Old Lady is holding firm. Mervyn King said last month:

"The SLS was introduced as a measure to deal with a legacy problem of liquidity of the stock of assets which banks owned last year when the crisis hit. So that window will close in October. The longer-term issue of tightening of credit conditions is much wider. That is to do with the health of the capital position of the banking system, and it's very important not to confuse the two".

Mr King’s determination to husband what remains of the Old Lady’s resources may have something to do with profligate abuse of them when opened to her brood. What started out as a scheme to extend up to £50 billion (a bit less than $100 million) in liquidity to shore up the UK credit markets during a surprise credit dislocation may have been drawn for as much as £200 billion in total as crunch turned to constriction. The Bank will only publish the true scale in October after the SLS closes. The SLS has been hungrily drained by banks keen to swap whatever unmarketable dross remained on their books for good central bank gilts.

The abuse has been made plain in numbers reported by the BIS.

Banks issued a record £45bn in mortgage-backed bonds in the three months to the end of June - more even than at the very height of the housing boom in 2006 - according to figures from the Bank for International Settlements. . . . . The Quarterly Review added: "Most of the UK issuance followed the Bank of England's announcement in April 2008 of a Special Liquidity Scheme (SLS) that enables UK banks to swap illiquid assets such as mortgage-backed securities against UK Treasury bills."

This record mortgage-backed issuance comes at a time when new mortgage lending in the UK has contracted very sharply, down 71 percent year on year for the month of July. That indicates a cynical abuse of the Old Lady’s generosity. Rather than be left with dry dugs dangling to her waist, the Old Lady would prefer to wean the banks while she retains ample bosom and sufficient other assets to shore up her public stature.

Over at the European Central Bank, a rule change this week will increase haircuts (discounts to stated market value) for collateral provided under that liquidity scheme from next February. The ECB has made available over EUR 367 billion (a bit less than $700 billion) under very liberal terms.

According the Financial Times:

The changes, which take effect from February 1, include increases in the average “haircuts” applied to asset-backed securities. A haircut is the amount deducted from the market value of a product when judging its value as collateral. In future, a blanket 12 per cent haircut will apply, replacing a previous sliding scale of between 2 per cent and 18 per cent. There will be penalties for asset-backed securities valued using models and for unsecured bank bonds.

Restrictions already in place on banks using assets they themselves had formed were extended to stop banks using assets from issues to which they had offered currency hedges or liquidity support above a certain level.

Analysts at Barclays Capital said the extra haircuts would mean banks might have to post an additional €25bn-€45bn of securities for collateral purposes. “That could cost €375m to €450m annually to banks ... Not in­significant, but probably bearable,” said Laurent Fransolet, analyst at Barcap.

The normally politic Yves Mersch made explicit reference in his remarks to "dangers of gaming the system".

Nonetheless, with house purchases falling to new lows and credit getting progressively tighter, the Labour government and the Council of Mortgage Lenders are wild to have another source of cheap liquidity if the Old Lady denies them. A new scheme for taxpayer-subsidised mortgage finance is in the offing. It is clearly bad public policy to have the government subsidise further borrowing for the housing sector after such a destructive bubble, but the scale of vested interest and the unpopularity of the Labour incumbents as the house prices fall make a new scheme a certainty all the same.

Rather like a mother who loves her young no matter how ill-bred, destructive and abusive they are to their peers or the community, the Old Lady of Threadneedle Street is unlikely to mind very much if British banks prosper by depredations on the politicians, taxpayers, market counterparties, corporate treasurers, hedge funds and others so long as they are out of the house. Having proved they have no sense of gratitude or duty to the Old Lady that preserved them in time of need, the others who will become their new targets can expect even less consideration.

Liquidity, Bank Capital and Market Reform

A friend forwarded some thoughts on liquidity that are worth sharing here, as liquidity is central to the utility of assets as bank capital and to stabilising markets under stress. My friend's points are in bold, with my commentary below.

Central bankers and securities regulators lost sight of liquidity over the past decade or two in permitting reforms which compromised the health of the financial system. Thanks to the Greenspan and Bernanke puts, and to surplus recycling by Asian economies, many took liquidity - like oxygen - for granted. Like oxygen, you only realise how critical liquidity is when its absence becomes noticeable.

Now that bank regulators have rediscovered liquidity as an essential attribute of healthy banks and healthy markets, it is important to reinforce some key qualities.

Liquidity means you can generate cash from a physical asset or paper claim.

If you can't exchange the asset for a major currency to meet a sudden funding need, then the asset shouldn't be permitted as regulatory capital. Basel II and Basel III have generated hundreds of pages around credit scoring and asset type while ignoring the fact that most of what banks are attributing as capital cannot be turned into cash on demand.

Liquidity can be gained by sale or repo of an asset, preferably in a transparent market. Where no market exists or the market has become illiquid, then liquidity must be gained through a central bank.

Virtually all RMBS markets failed under stress in 2008 and 2009, with failures spreading to other asset classes as investors grew wary of dealer spreads and perceived shallow dealer commitment levels. As the scope of funding problems grew, illiquidity spread to sovereign debt for troubled countries such as Greece and Portugal. Few OTC asset markets have recovered sufficient liquidity for dealing in size.

When the public markets will not price an asset in size without a large spread, then the central banks become the market makers of last resort. Without central bank repo of illiquid RMBS and sovereign debt, virtually every major bank in the OECD would have failed.

Because they now have the role of market maker of last resort, central banks should become much more active in ensuring that any asset permitted to be classed as capital by a bank can be liquidated on demand in a public market. Rather than leaving market structure to the investment banks and their tame securities regulators, the central banks should be driving forward reforms to ensure that capital assets are issued in fungible series, in size, and traded in transparent exchange markets with committed market makers.

This will require a major policy reversal on exchange regulation. Securities regulators have been under pressure for several decades to liberalise OTC markets, permit fragmentation to off-exchange trading systems, and turn a blind eye to issuance of securities in small, idiosyncratic offerings that will never liquidly trade except back through the offering investment banks. The quality assurance and market conduct functions of exchanges have been eroded following demutualisation, and exchanges now are run for profit of their highly concentrated owners rather than in the public interest.

Markets are at the heart of successful civilisations. Markets require quality norms, information publication, and price transparency to operate effectively. Regulators and investors allowed credit ratings to substitute for exchange listing rules and reporting requirements during the liquidity boom. Ratings were gamed by the banks until they were meaningless. We should now be forcing assets back onto exchanges and force the exchanges to regulate quality and information norms in the public interest. If this requires re-mutualising the exchanges, or public ownership of exchanges, then that should be on the agenda. Letting the exchanges be run by the thugs who gamed the markets and the rating agencies isn't healthy.

Liquidity means that proceeds of sale will be paid as funds to your account in a currency you can use widely to meet obligations.

If you can only sell your asset into a market denominated in a currency which itself is not liquid and not legal tender for meeting your obligations, then you haven't got liquidity vested in the asset. A lot of investors in emerging markets are probably going to find that liquidity in those markets is a lot less than they might think, despite advances in exchange trading of emerging market assets, and the currencies might be less liquid too in a falling market. If they require funding in their home currency, they risk taking a big hit on sale and FX spreads when they realise the asset under stress.

Liquidity is measured by size, speed and spread - not by price levels.

Whatever the market price, a market isn't liquid if those holding assets in size cannot deal in size. A market is not liquid if those holding assets cannot sell at the time the sell decision is made, but must wait to identify or attract sufficient buyers. A market is not liquid if the spread between the bid and ask is so wide that buyers will be deterred from the market by the risk of never recovering the spread in appreciation or returns. The way that markets have levitated on minimal volumes in 2010 and 2011 is no indication that the markets are liquid. As we've seen in August, even mild selling can have a massive effect on prices in an illiquid market.

Short sales are an attribute of liquid markets. If a market can't be shorted, then the market will fail as prices fall.

Short sellers will come in to buy assets in a falling market to realise a profit. They provide liquidity when everyone else is too scared to deal.

Securities markets regulators and central bankers need to think through liquidity as an attribute of market structure in the public interest. Idiosyncratic, illiquid, ill-transparent deals and instruments which have dominated market growth for the past two decades are behind the weakness of bank capital and market recovery. The regulatory incentives should be toward standardisation of securities terms and offering documents, much larger issues of securities and series of bonds, and fungibility of asset types within a class. Exchange trading should be encouraged, fragmentation discouraged. Exchanges should provide rigorous listing rules, timely reporting of market relevant information, full price transparency and two-way quote obligations on market makers. If we got that right, then much of the misrepresentation, mispricing, inefficiency and fraud of the past would become impossible in future.