Through a Hedge Backwards

Will special drawing rights supplant the dollar?

2009-05-19T08:16:00.000-07:00

Original article at http://www.voxeu.org/index.php?q=node/3538

Owen F. Humpage, 8 May 2009

China recently called for SDRs to replace the dollar as the international reserve currency and diminish the US economic supremacy. This column argues that because of the huge network benefits associated with using dollars, SDRs are not likely to supplant the dollar anytime soon as an international reserve unit, especially with the euro as a more viable competitor.

China wants a new international reserve currency, one that is “disconnected from economic conditions and sovereign interests of any single country.” It recommends resurrecting Special Drawing Rights (SDRs), a composite currency issued by the IMF, as a new international reserve unit.

While China claims that credit-based national reserve currencies are inherently risky, facilitate global imbalances, and foster the spread of financial crises, the key concern may be a bit more parochial. The country holds a huge official portfolio of dollar-denominated assets that could incur valuation losses if recent US actions to limit financial turmoil and stimulate the economy generated inflation and dollar depreciation (not unrelated to the problems France faced with its 1920s “sterling trap”).
Devil in the detail

* Adopting the SDR as a reserve asset is technically feasible, but it will not reduce the dollar’s role any time soon.
* People reap substantial economies from conducting cross-board commerce in dollars, and until the SDR matches these benefits – which is a long way off – central banks will still need dollars.

If anything, the euro is likely to challenge the dollar’s pre-eminence.

In the interim, countries that want to limit their exposure to credit-based reserve currencies, like the dollar, might simply allow their own currencies to appreciate.
Something old, something new

Complaints about the dollar and a fascination with SDRs are not new. The IMF created SDRs as an international reserve currency in the late 1960s to solve problems similar to China’s concerns that rose out of the Bretton Woods fixed-exchange-rate system. After World War II, the US dollar quickly emerged as the world’s key international currency, both as an official reserve unit and for financing international commerce.

Then, as today, countries accumulated reserves when they limited the appreciation of their currencies in the face of persistent balance-of-payments surpluses. Once acquired, official reserves then provided these countries with a buffer stock that they could draw down to mitigate the disruptive economic effects of unexpected balance-of-payments reversals.

Absent such reserves, these countries would either have to allow their currencies to depreciate or quickly tighten their monetary policies, but such abrupt adjustments might not be compatible with these countries’ current goals for inflation or real economic growth.
Dollar overhang and the closing gold window

By the early 1960s, many countries began to view their official dollar holdings as excessive. They worried that the US might be forced to devalue the dollar, saddling them with foreign-exchange losses. As the situation unfolded, some countries, led by France, sought to replace the dollar with a reserve currency unrelated to any single national currency, if not solely related to gold.

The IMF – then the guardian of the Bretton Woods parity grid – came up with the SDR. The IMF initially defined the SDR in terms of a fixed amount of gold, then equal to one dollar, and allocated 9.3 billion SDRs between 1970 and 1972 in proportion to member countries’ quotas in the IMF. On 15 August 1971, however, President Nixon closed the US gold window, refusing thereafter to convert dollars into US gold. By March 1973, the large developed countries had all allowed their currencies to float against the dollar, ending their need for any dollar reserves.

Despite the widespread acceptance of floating exchange rates, no country – including the US – has completely eschewed its portfolio of foreign-exchange reserves. Still, floating doomed the SDR. The IMF redefined the SDR as a weighted average of the US dollar, the British pound, the Japanese yen, and the currencies that eventually comprised the euro and made a second allocation of 21.4 billion SDRs between 1979 and 1981. Nevertheless, the SDR quickly devolved for the most part into a unit of account, primarily on the IMF’s books.
The dollar

The dollar remains reserve currency of choice. The IMF estimates that 64% of the world’s official foreign-exchange reserves are held in dollar-denominated assets. The euro, the second most widely held international reserve currency, lags well behind, followed by the British pound and Japanese yen.

These currencies’ official reserve rankings parallel their status in international commerce more generally. This correlation should be of no surprise. Why hold a currency that no one uses? According to a 2007 BIS survey, roughly 88% of daily foreign exchange trades involve dollars. Again, the euro is a distant second, with the British pound and Japanese yen trailing.

Network externalities from dollar usage

The world reaps substantial economies from using dollars.

* Many foreign-exchange transactions, even ones not directly involving US residents, are denominated and undertaken in dollars.
* International trade in fairly standardised commodities and in products that sell in highly competitive markets is typically conducted in US dollars. Invoicing in a single currency helps producers keep their prices in line with their competitors and simplifies price comparisons across the different producers. Naturally, these invoicing gains rise with the number of producers.

In contrast, international trade in heterogeneous manufactured goods, where price competition is not as crucial, tends to be denominated in the exporters’ currencies, but even in these cases importers – or their banks – will often acquire the exporters’ currencies by first trading their home currencies for US dollars and then trading dollars for the exporters’ currencies.
Size matters

The dollar has maintained this role over the years, despite substantial fluctuations in its exchange value, because the size, sophistication, and relative stability of the US economy generally render the costs of transacting in US dollars lower than the costs of transacting in currencies that do not equally share these characteristics. In large part, the widespread use of the dollar developed and continued because the US has been the largest, most broad-based exporter and importer in the world. With a lot of Americans trading globally, a lot of dollars will naturally change hands. Because traders must finance a large portion of their business in US dollars, they maintain accounts, seek loans, and undertake myriad other financial arrangements in dollars.

A strong and open US financial system helped facilitate the dollar’s international use. While a high degree of feedback naturally exists between the dollar’s expanding role in trade and the growth of an accommodating financial structure, US financial markets have always been innovative and relatively free of cumbersome regulations. Their breadth and depth enhances the liquidity of dollar-denominated assets. Moreover, as dollar trade expands and US financial markets grow, more and more foreign financial firms – even ones not located in the US – offer dollar-denominated products. All this makes holding dollars convenient and transacting in dollars relatively easy.

As the global network for dollars expands, the benefits of using the dollar in exchange rise. The process is self-reinforcing. Moreover, once the network benefits of a particular currency become substantial, people are prone to continue using it, even if viable competitor exists. The debate on the SDR’s possible challenge to the dollar echoes many of the points made in the dollar-vs-euro debate. The euro matches many of the dollar’s qualities, and its use continues to expand. Making the jump to a new international currency, even one as widely used as the euro, requires a substantial proportion of people to make the jump in close concert. Otherwise, the network benefits are lost. For that reason, the world is not likely to shift quickly away from dollars even if the SDRs become a new international-reserve option.
What’s a country to do?

Of course, if foreigners suspected that the costs of holding dollars in terms of lost purchasing power would soon exceed the network benefits of transacting in dollars, they might quickly migrate to an alternative international currency. At its core, China’s SDR plan may reflect a fear of US inflation. As Chinn and Frankel (2008) argue, the likely candidate is the euro, not the SDR.

In the meantime, countries – like China – that worry about their expanding dollar portfolios have another option – allow their currencies to appreciate.

Between mid-1995 and mid-2005, China pegged the renminbi to the dollar and bought dollars flowing into China through trade and investments. Had China not done so, the renminbi would have appreciated against the dollar, until the dollar inflow stopped. Between mid-2005 and mid-2008, China allowed the renminbi to appreciate against the dollar, but continued to limit the renminbi’s appreciation. Recently, the renminbi has remained little changed relative to the dollar. All this is fine; many countries manage their exchange rates, particularly to avoid appreciations, but accumulating a foreign-exchange exposure is a cost of doing so.
References

Bennett T. McCallum, “China, the US Dollar, and SDRs” presentation at the Shadow Open Market Committee, 24 April 2009, Washington, D. C., Cato Institute.

Linda Goldberg and Cedric Tille, “Vehicle Currency Use in International Trade,” Journal of International Economics forthcoming

Menzie Chinn and Jeffrey Frankel. “The Euro May Over the Next 15 Years Surpass the Dollar as Leading International Currency.” 2008,

Zhou Xiaochuan “Reform the International Monetary System” People’s Bank of China, March 3, 2009

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Paul Wilmott - number cruncher who foresaw financial crash

2009-05-01T01:17:00.000-07:00

Elena Moya, The Guardian, Friday 1 May 2009
http://www.guardian.co.uk/business/2009/may/01/paul-wilmott-interview

Photograph: Christian Sinibaldi

Paul Wilmott, one of the world's leading financial mathematicians, looks like a 30-something, although he is 49. Mathematics keeps him in shape, he says, relaxing in his jeans and trainers in his Bayswater flat.

Wilmott has made his name and fortune by applying mathematics to finance and now claims to run the biggest "quantitative analysis" website in the world. So-called "quants" combine maths and finance to produce many of the models that underlie the complex derivatives blamed for causing the credit crunch.

Wilmott had been warning for years that the models used by banks to value their assets were wrong. "Reality has vindicated me," he says. "I stood up in front of paying audiences and told them that they trusted the formulas too much and that they were also paid too much." A few people stormed out of his conferences, slamming the door, he adds.

The banking system crash has seen $1tn wiped off banks' assets worldwide after the complex formulas were proved wrong: the assets had been overpriced and the relationships between them were different from what was initially thought. If a sub-prime mortgage collapsed, millions of others followed suit.

"Following the formulas was like relying on your seatbelt to drive crazily: it's not going to save your life. People in risk management don't know a fraction of what they should; they're not sceptical, they haven't tested the data or used their imagination to find solutions."

Wilmott is also critical of the government's approach to the crisis. He claims its plan to insure more than £500bn of banks' toxic assets is based on a model and won't work as it only involves two banks (HBOS and RBS) leaving others outside the programme. Involving only a few banks won't kick-start the circular nature of inter-bank lending as all banks need to be involved.

"Governments know nothing of this subject, they spent two minutes thinking about it, without considering the consequences or getting [advice from] consultants," Wilmott says. "They're like rabbits caught in headlights. They are only talking to the bankers who got us into this mess, or lords or ladies who know nothing. They should be getting advice from people like me, who saw this coming."

According to Wilmott, the Financial Services Authority isn't much better. "They can't afford to pay the best people; we should send regulators to derivatives courses so they could ask questions to the banks."

Wilmott is angry about the amount of "idiots" who got the world into the present financial crisis. He was one of the thousands of protesters against the recent G20 summit. "Why weren't there more people there?" he wondered.

Wilmott is an evangelist for maths and its application to everyday life. His book on quantitative finance is used around the world by hordes of bankers who run the world's top trading desks.

Wilmott goes one step further than most of his peers, as he also tries to integrate into his analysis the financial world's biggest challenge to rationality: human behaviour.

"You can model electromagnetic waves: a mathematical model that shows molecules of air moving around a plane, making it fly," he says. "But in a financial model, you need more than numbers. The models in finance are not very good. In this field, it matters if you're not psychologically synchronised; people don't behave rationally. You can't rely on people following equations. It's half maths and half human."

Juggling

The son of an accountant and an entrepreneurial mother, both Paul and his brother became mathematicians. From an early age, at a grammar school in Birkenhead, Wilmott says he was always good at maths - and business.

As a child, he put together his vast collection of pets and organised a zoo that neighbours paid to visit. As an undergraduate at Oxford, he earned his pints from street performing with his juggling clubs. Ventures followed as the years went by, including a £170m hedge fund, which closed about four years ago after a fall-out between the partners.

Wilmott's two sons are also interested in maths; Zachary, 17, is preparing for his A levels in maths and Oscar, 19, is studying maths at Imperial College, London. His children may have followed his path because "I am an enthusiast, and they are intelligent," he says, adding that he didn't flood his sons with numbers from an early age.

"Mathematicians don't use numbers. Mathematics is about abstraction, all we use are symbols. If we keep educating in adding numbers, they won't go beyond a McDonald's desk." Calculus and algebra, which deal with concepts such as links between variables, are much more practical and important in life.

"Politicians say maths needs to be more practical, but you have to be more abstract. Mathematics makes your brain think in a very different way; a lot of people are afraid of it, but it's fun and intellectually satisfying."

Wilmott has focused on practical - and financial - rewards, since his days at Oxford, where he read maths and also got a PhD in fluid mechanics. At university, Wilmott designed a model that analysed the speed and efficiency of a double-razor shaving machine aimed at determining how far apart the blades should be, and which angle and speed would make the shaving most effective.

As the years went by, he also designed models on turbine plates for jet engine maker Rolls Royce, and other models for British Steel, British Telecom and for an explosives company that needed to calculate how to best blow up a mountain - "close to the edge of the mountain, but not too close," Wilmott remembers.

He travels the world lecturing bankers and regulators about quantitative finance and valuation methods. He also focuses on his teaching in 7City, a City-based professional training centre, and on his quants book, which he published in 1993 for the first time and keeps updating. His next challenge would be to develop a product that can make life more comfortable, and turn it into a business, he says.

Constants

"I'd never go and work for a bank, I am not an employee type. I don't respond well to orders. I am spoiled, I've done all my life what I wanted, my parents didn't stop me, so I've had an interesting life with lots of variety."

Business and maths are the two constants in his life - the professional one, at least. "Maths ruins your personal life," he concedes. "Some mathematicians have no connection with the real world and it's very hard to talk to them. But I am a fairly normal human being even if I am a mathematician. Others don't have any empathy, but I am in tears in half of the movies that I see."

He plugs into life by spending time with his American wife and his two children, skiing, or driving one of his three cars. Other mathematicians forget the real world, or see it in their own terms, Wilmott says. "I am talking the colours of the rainbow and they only see black and white."

Still, he admits applying maths to his personal life: while arguing with his wife, he sometimes uses the "reductio ad absurdum" principle to prove a point. In a delicate or tense conversation, bringing up extremes may not be the best way towards consensus, he acknowledges.

But the mathematical habit of challenging assumptions has always been a constant in his life, and he swears it always will be. "The natural thing for me is to think there is something wrong if everybody is agreeing."
CV: Paul Wilmott

Born 8 November 1959

Marital status Married to second wife. Two children

Education BA maths, PhD, applied maths, St Catherine's College, Oxford

Career

2002-present: Course director for certificate in quantitative finance

2002-2005: Partner in Caissa Capital Fund Management (NY and Bermuda)

1999: Academic director for Oxford University department for continuing education programmes in mathematical finance; founder of the diploma in mathematical finance

1997-1999: Group leader and founder of mathematical finance group at Oxford University

1996-present: Wilmott Associates. Clients include: Banco Santander; British Telecom; Citibank; IBM; Nationwide

Advisers Ditch 'Buy and Hold' For New Tactics

2009-04-30T22:26:00.000-07:00

From the Wall Street Journal
http://online.wsj.com/article/SB124096109870565775.html

The broad decline across financial markets in the past year has persuaded a small but growing number of financial advisers to abandon the traditional buy-and-hold strategy -- which emphasizes long-term investing in a mix of assets -- for a new approach geared to sidestep future market plunges and ease volatility.

Jeff Seymour, an adviser based in Cary, N.C., used to counsel clients to buy a diverse menu of stocks, bonds and commodities, and hold on for the long run. But early last year, he says, he recognized that "the macro-economic climate has changed.

"Today, Mr. Seymour keeps about 90% of his clients' money in such low-risk investments as short-term bonds, cash and gold. With some of the small amount that's left over, he uses leveraged exchange-traded funds to place magnified bets both on and against the Standard & Poor's 500-stock index."It's a complete rethink of how to do asset management," Mr. Seymour says.

Most of his clients are within a few percentage points of breaking even since the shift, he says, while his firm, Triangle Wealth Management LLC, has more than doubled in size.Buffeted by steep declines in stocks, many bonds, commodities and real estate, many advisers are questioning their faith in long-standing investment principles, such as controlling risk by building diverse portfolios. Some are adding increasingly exotic investments, including products that offer downside protection, to client portfolios. Others are trading more actively -- and say they plan to continue to do so until they see evidence of a new bull market.

To be sure, most advisers are staying the course. They point out that frequent trading leads to higher trading costs and tax bills, and that so-called alternative investments come with some serious downsides. Because the markets for many of these products are relatively undeveloped, for example, investors may face high fees, poor liquidity and a high degree of complexity.

Critics also contend that advisers who scale back on stocks are essentially trying to time the market, and are exposing their clients to another type of risk -- that of missing out on future rallies that could recoup recent losses."By abandoning time-proven prudent techniques, they run a serious risk of destroying their own credibility and their clients' portfolios," says Frank Armstrong, president and founder of Investor Solutions Inc., an independent financial advisory firm in Miami that still practices buy-and-hold investing.

The changes come at a time when financial advisers are coming under pressure from clients who are tired of paying fees only to watch their savings evaporate. Advisers have "a lot of cranky clients," says Mr. Armstrong. "They want to see something happen," he says.Certain advisers have long placed small tactical bets on sectors, countries or regions they expect to outperform the broad market.

Many have also placed a small portion of clients' portfolios into alternative investments, such as commodities and real-estate investment trusts.Offsetting RisksNow, some are adopting even less-conventional approaches in an attempt to more effectively offset the risks of investing in stocks -- and generate returns in a market they expect to remain depressed for some time. Some have ramped up their use of opportunistic trading to try to profit from short-term rallies and selloffs. Others are turning to "structured products," which are complex investments that often employ options to provide downside protection. Still others are using investments such as currencies or managed futures that they believe will rise when stocks fall."Asset allocations built on stocks and bonds are best suited to secular bull markets," says Louis Stanasolovich, founder of Legend Financial Advisors Inc. in Pittsburgh. "But the past nine years have proved that nontraditional thinking makes more sense in secular bear markets."

Last October, Mr. Stanasolovich revamped one of his portfolios that is aimed at delivering relatively consistent returns with low volatility. It currently consists mainly of government and agency bonds, hedge-fund-like mutual funds and a long-short commodities fund. It also holds "managed futures" funds, which seek to profit from gains and losses in commodities and financial futures, including a range of currencies, government securities and equity indexes. From Oct. 10, when Mr. Stanasolovich completed this makeover, through April 27, he says Legend's low-volatility portfolios are "essentially break even." The S&P's 500 is off about 3% over that period.Such unconventional approaches appear to be gaining sway. About 15% of the 500 advisers polled between December and March by consulting firms GDC Research LLC of Sherborn, Mass., and Practical Perspectives LLC of Boxford, Mass., say they have made significant changes in the way they manage retirement money over the past year. Among those who have made a change, 21% report increasing their use of opportunistic trading strategies. Eighteen percent say they have become more reliant on structured products and related investments, and 11% say they're incorporating other types of alternative investments.

Two prominent networks of financial advisers -- the National Association of Personal Financial Advisors and the Financial Planning Association -- are sponsoring panels at conferences this year on the subject of rethinking conventional approaches to investing and building client portfolios.'A Seismic Change'"There's a seismic change in the market," says Will Hepburn, president of the National Association of Active Investment Managers. "The people who were buy-and-hold-oriented lost a lot of money, and they don't want to do it again."Meanwhile, financial-services companies are rolling out products designed to lure gun-shy advisers.

Last July, Portfolio Management Consultants, the investment consulting arm of Envestnet Asset Management Inc., introduced seven portfolios that invest in ETFs based primarily on signals from quantitative models. Advisers -- who have invested over $200 million since the launch -- can select how much of their clients' portfolios to allocate to this tactical asset-allocation approach. Although many will put between 20% and 40% of client assets in them, some have shifted 100%, says Richard Hughes, group co-president.Helios LLC of Orlando, Fla., expects to start offering customized portfolios this summer that will enable independent advisers to use options strategies to get exposure to riskier asset classes, such as stocks, with limited downside. In exchange, they give up some potential appreciation.DWS Investments, the U.S. retail unit of Deutsche Bank AG's Asset Management division, says more financial advisers are using its so-called buffered notes, which offer limited principal protection.

"A lot of investing over the last 40 years has been done around traditional asset classes," says Chris Warren, head of structured products at DWS. "But over the last 18 months, the correlation among those asset classes has gone up a lot, so much of the benefits of portfolio diversification really aren't there."All these structured products add a layer of fees. Helios, for example, plans to charge a maximum fee of 0.95%.In October, Matthew Tuttle of Tuttle Wealth Management LLC in Stamford, Conn., gave up on buy-and-hold investing. He hired Murray Ruggiero Jr. -- who developed trading systems for managed-futures traders and funds -- to develop similar computer models for the ETFs and index funds he favors. Now, Mr. Tuttle decides what to buy and sell for his clients based on market trends."We trust the computer," he says.

He has been able to sidestep recent market slides while reducing the volatility of clients' portfolios, he says.Paying More in TaxesTo be sure, his clients will pay more in taxes. But Mr. Tuttle says no one is complaining. "Would you rather be tax-efficient and have losses?" he says.Other advisers are looking even further afield for alternative investments. Today, the average client of West Financial Consulting Inc. of Huntsville, Ala., holds about 20% in domestic and international stocks, down from 40% last year. Founder Larry West is currently using bond funds that make tactical bets. He is also recommending greater exposure to alternative investments, including managed-futures funds, bonds that back construction and expansion projects at churches, hedge-fund-like mutual funds, gas-drilling projects, and private partnerships that invest in real estate. He also holds positions in two private partnerships that invest in railroad cars.

There is some evidence that advisers who practice the traditional buy-and-hold philosophy are losing clients to managers trying new approaches. Jeff Porter of North Canton, Ohio, left his buy-and-hold-oriented planner last year and moved his account to Brenda Wenning of Newton, Mass. Ms. Wenning had been a financial adviser for years at a firm that practiced a buy-and-hold approach, but started actively managing clients' money -- in part by using leveraged ETFs -- when she opened her own practice in May 2008."I realized when I saw the market starting to change that the old buy-and-hold strategy just doesn't work," says Mr. Porter, whose account was already down 20% last year by the time he went to Ms. Wenning.

She immediately shifted his investments to cash -- a move he calculates saved him about $80,000. Since then, he says, Ms. Wenning has been slowly moving back into the markets. His old adviser hadn't bought or sold a single investment in his account last year."You're paying these people a fee to manage your money," Mr. Porter says. "They're really not earning their keep."Write to Anne Tergesen at anne.tergesen@wsj.com and Jane J. Kim at jane.kim@wsj.com

Laissez-Faire Capitalism Has Failed

2009-04-26T02:57:00.000-07:00

The financial crisis lays bare the weakness of the Anglo-Saxon model.

Nouriel Roubini, 02.19.09, 12:01 AM EST

http://www.forbes.com/2009/02/18/depression-financial-crisis-capitalism-opinions-columnists_recession_stimulus.html

It is now clear that this is the worst financial crisis since the Great Depression and the worst economic crisis in the last 60 years. While we are already in a severe and protracted U-shaped recession (the deluded hope of a short and shallow V-shaped contraction has evaporated), there is now a rising risk that this crisis will turn into an uglier, multiyear, L-shaped, Japanese-style stag-deflation (a deadly combination of stagnation, recession and deflation).

The latest data on third-quarter 2008 gross domestic product growth (at an annual rate) around the world are even worse than the first estimate for the U.S. (-3.8%). The figures were -6.0% for the euro zone, -8% for Germany, -12% for Japan, -16% for Singapore and -20% for Korea. The global economy is now literally in free fall as the contraction of consumption, capital spending, residential investment, production, employment, exports and imports is accelerating rather than decelerating.

To avoid this L-shaped near-depression, a strong, aggressive, coherent and credible combination of monetary easing (traditional and unorthodox), fiscal stimulus, proper cleanup of the financial system and reduction of the debt burden of insolvent private agents (households and nonfinancial companies) is necessary in the U.S. and other economies.

Unfortunately, the euro zone is well behind the U.S. in its policy efforts for several reasons. The first is that the European Central Bank is behind the curve in cutting policy rates and creating nontraditional facilities to deal with the liquidity and credit crunch. The second is that the fiscal stimulus is too modest, because those who can afford it (Germany) are lukewarm about it, and those who need it the most (Spain, Portugal, Greece, Italy) can least afford it, as they already have large budget deficits. The last reason is that there is a lack of cross-border burden sharing of the fiscal costs of bailing out financial institutions.

With its aggressive monetary easing and large fiscal stimulus putting it ahead, the U.S. has done more. Except for two elements, both key to avoiding a near-depression, which are still missing: a cleanup of the banking system that may require a proper triage between solvent and insolvent banks and the nationalization of many banks, even some of the largest ones; and a more aggressive, across-the-board reduction of the unsustainable debt burden of millions of insolvent households (i.e., a principal reduction of the face value of the mortgages, not just mortgage payments relief).

Moreover, in many countries, the banks may be too big to fail but also too big to save, as the fiscal/financial resources of the sovereign may not be large enough to rescue such large insolvencies in the financial system.

Traditionally, only emerging markets suffered--and still suffer--from such a problem. But now such sovereign risk, as measured by the sovereign spread, is also rising in many European economies whose banks may be larger than the ability of the sovereign to rescue them: Iceland, Greece, Spain, Italy, Belgium, Switzerland and, some suggest, even the U.K.

The process of socializing the private losses from this crisis has already moved many of the liabilities of the private sector onto the books of the sovereign. Among these liabilities are banks, other financial institutions and, soon possibly, households and some important nonfinancial corporate companies.

At some point a sovereign bank may crack, in which case the ability of governments to credibly commit to act as a backstop for the financial system, including deposit guarantees, could come unglued.

Thus the L-shaped, near-depression scenario is still quite possible (I assign it a 30% probability), unless appropriate and aggressive policy action is undertaken by the U.S. and other economies.

This severe economic and financial crisis is now also leading to a severe backlash against financial globalization, free trade and the free-market economic model.

To paraphrase Churchill, capitalist market economies open to trade and financial flows may be the worst economic regime--apart from the alternatives. However, while this crisis does not imply the end of market-economy capitalism, it has shown the failure of a particular model of capitalism. Namely, the laissez-faire, unregulated (or aggressively deregulated), Wild West model of free market capitalism with lack of prudential regulation, supervision of financial markets and proper provision of public goods by governments.

There is the failure of ideas--such as the "efficient market hypothesis," which deluded its believers about the absence of market failures such as asset bubbles; the "rational expectations" paradigm that clashes with the insights of behavioral economics and finance; and the "self-regulation of markets and institutions" that clashes with the classical agency problems in corporate governance--that are themselves exacerbated in financial companies by the greater degree of asymmetric information. For example, how can a chief executive or a board monitor the risk taking of thousands of separate profit and loss accounts? Then there are the distortions of compensation paid to bankers and traders.

This crisis also shows the failure of ideas such as the one that securitization will reduce systemic risk rather than actually increase it. That risk can be properly priced when the opacity and lack of transparency of financial firms and new instruments leads to unpriceable uncertainty rather than priceable risk.

It is clear that the Anglo-Saxon model of supervision and regulation of the financial system has failed. It relied on several factors: self-regulation that, in effect, meant no regulation; market discipline that does not exist when there is euphoria and irrational exuberance; and internal risk-management models that fail because, as a former chief executive of Citigroup (nyse: C - news - people ) put it, when the music is playing, you've got to stand up and dance.

Furthermore, the self-regulation approach created rating agencies that had massive conflicts of interest and a supervisory system dependent on principles rather than rules. In effect, this light-touch regulation became regulation of the softest touch.

Thus, all the pillars of the 2004 Basel II banking accord have already failed even before being implemented. Since the pendulum had swung too much in the direction of self-regulation and the principles-based approach, we now need more binding rules on liquidity, capital, leverage, transparency, compensation and so on.

But the design of the new system should be robust enough to counter three types of problems with rules. A tendency toward "regulatory arbitrage" should be kept in mind, as bankers can find creative ways to bypass rules faster than regulators can improve them. Then there is "jurisdictional arbitrage," as financial activity may move to more lax jurisdictions. And, finally, "regulatory capture," as regulators and supervisors are often captured--via revolving doors and other mechanisms--by the financial industry. So the new rules will have to be incentive-compatible, i.e., robust enough to overcome these regulatory failures.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.

Valuing banks through the looking glass

2009-04-24T08:04:00.000-07:00

Sometimes a blog posting has such delicious irony, as this one does from Professor Krugman, that it is worth repeating in full.

So the accounting rules say that a decline in the market value of a bank’s debt thanks to increased credit default swap spreads — that is, because investors think you’re more likely to fail — counts as a a profit. On the other hand, if your bank looks stronger, the spreads fall, and you book a loss.

FT Alphaville has the story. Citigroup reported

A net $2.5 billion positive CVA on derivative positions, excluding monolines, mainly due to the widening of Citi’s CDS spreads

while Morgan Stanley reported

Morgan Stanley would have been profitable this quarter if not for the dramatic improvement in our credit spreads - which is a significant positive development, but had a near-term negative impact on our revenues.
So Citigroup is profitable because investors think it’s failing, while Morgan Stanley is losing money because investors think it will survive. I am not making this up.

The only point I would make is that Lewis Carroll would have loved this story but might have favored it more for Alice Through the Looking Glass rather than Alice in Wonderland .

Fired Doctor of Derivatives Waits to Cry as Finance Jobs Vanish

2009-03-24T08:52:00.001-07:00

By Lisa Kassenaar and Stephanie Baker

http://www.bloomberg.com/apps/news?pid=20601109&sid=agdquPfpIk78

March 24 (Bloomberg) -- Raj and Nita Godhania are drinking Nescafe in their one-bedroom apartment in Princeton, New Jersey. Valentine cards are taped to otherwise bare walls, and a stack of blue Rubbermaid boxes towers over the TV. Their daughters, 12 and 7, have been helping pack.

Merrill Lynch fired Raj on Jan. 22 after he’d worked on the bank’s technology systems for 10 years. He got a promotion in 2006, sold his house in London, gave away the dog and moved his family to the U.S. Now, he’s scrambling to leave before his nine weeks of severance runs out and his L-1 work visa -- his right to be in the country -- is void because he’s out of a job.

Half a dozen calls to Merrill in three weeks -- some furious, some teary -- have yielded nothing, says Nita on a wintry February Friday. The New York-based firm so far has refused to pay the family’s $10,000 moving expense, buy four one-way plane tickets or help figure out how to let the children finish the school year, they say. Nita can’t work without a permit, and Raj, 45, has little time to find another company to sponsor him. The two British citizens don’t qualify for U.S. unemployment benefits.

“Merrill Lynch left us on the streets,” says Nita, 39, who now nurses a chronic headache. “I’m just so angry and scared. What the hell is going to happen to us?”

Quarter-Million Jobs

The shakeout in global banking has untethered more than a quarter of a million people, most of them in New York and London, who thought they were in secure, well-paying jobs. Some were investment bankers and traders who, with cheap credit and a gambler’s view of risk, raked in millions of dollars in annual bonuses over the past five years. Others, like Raj Godhania, greased the wheels at companies once seen as pillars of corporate strength, such as Citigroup Inc., UBS AG and Merrill Lynch & Co.

All are now displaced, forced to reflect on their fall and to find their way in a job market where the biggest U.S. and European banks may spill tens of thousands more workers before the carnage is over. By some measures, these folks are lucky: They’re well educated and have some money to fall back on. Still, bankers are struggling with a plunge in prestige -- and little sympathy -- after a decade-long orgy of ramping up leverage and flogging subprime debt that has left the world’s economy in tatters and taxpayers with the bill. In London in February, demonstrators hanged a mannequin dressed in a tie and bowler hat from Marble Arch.

“There’s a lot of finger-pointing going on now,” says Neil Servis, 40, the former head of Morgan Stanley’s collateralized-debt-obligation business in Europe, who lost his job in September. “Everyone is targeting bankers.”

Self-Worth

Public ire tends to be focused on the perks of those at the top, those who got the biggest bonuses. Managing directors who ran sales and trading divisions at major firms could have earned $10 million a year or more in boom times, says Regina Glocker, a partner at Exchange Place Partners, a New York executive-search firm. Mortgage traders or portfolio managers may have made $2 million. Still, legions in the middle ranks aren’t immune from criticism. Or angst.

“For most people, losing their job makes them question their self-worth or avoid neighbors, even if they didn’t cause the financial meltdown,” says Brendan Burchell, a University of Cambridge lecturer in Cambridge, England, who has studied the psychological consequences of unemployment. “These are people who used to enjoy telling everyone how busy they were and how important they were.”

No Callbacks

At job fairs in New York, bankers clutching leather folders filled with resumes wait in line for hours for five-minute interviews with potential employers or headhunters. Three Pink Slip parties at bars in Manhattan have lured more than 1,000 guests looking to connect with recruiters. Dealbreaker, a Wall Street blog, promotes the events with the tag line “If you’ve got misery, we’ve got company.”

Michael Migliaccio, a mortgage trader who worked for 11 years at RBS Greenwich Capital Markets Inc., a subsidiary of Edinburgh-based Royal Bank of Scotland Group Plc, was fired in December along with seven others on his trading desk, he says. He’s painting the inside of his house in Greenwich, Connecticut, saving the $3,000 his wife planned to spend on the job, and is worried about paying for his two teenagers’ college education.

Migliaccio, 44, has sent out his resume and attended a couple of networking sessions. No luck. “With so many people out of work, you don’t even get the callbacks,” he says. “It’s discouraging.”

Yet hardly surprising, given the balance-sheet blowups of the past two years. Financial institutions worldwide have racked up more than $1.2 trillion in losses and writedowns since mid- 2007, according to data compiled by Bloomberg. Lehman Brothers Holdings Inc. went bankrupt in September.

Bear, Merrill

Bear Stearns Cos. and Merrill Lynch were swallowed by commercial banks. And financial firms on both sides of the Atlantic, including Goldman Sachs Group Inc. and Lloyds Banking Group Plc, have received billions from their governments. The U.S. has plugged $173 billion into American International Group Inc., once the world’s largest insurance company, and propped up Citigroup three times. The U.K. government is now set to own 75 percent of RBS, Migliaccio’s former employer.

The system is convulsing, says Charles Geisst, author of “Wall Street: A History” and a finance professor at Manhattan College in New York. Most of the people who have been turned out of the banks are now, en masse, going to have to find something else to do.

“The jobs are not coming back,” he says. “This time, it’s permanent.”

Transaction Bubble

The jobs have disappeared because the “transaction bubble” has burst, Geisst says.

From 2003 to ‘07, banks hustled for short-term profit through transaction-based fee businesses, including packaging mortgages into debt securities and selling them to investors. The banks built up departments such as prime brokerage, which clears trades for hedge funds. They hired thousands of people to work in those units, from bankers to back-office programmers and accountants. In London alone, industry jobs ballooned by almost 50,000 to 353,000 in 2007 from ‘02, according to the Centre for Economic and Business Research.

The job cuts began as the markets turned in mid-2007. Merrill Lynch Chief Executive Officer Stanley O’Neal and Citigroup CEO Charles Prince were ousted following writedowns on mortgage-backed securities. Since then, financial firms worldwide have shed 282,000 jobs, about 5 percent of the total industry workforce, according to Bloomberg data.

Nobu’s Retreat

Bull-market hustle has vanished on both Wall Street and in the City of London. Steakhouses and shops selling sports cars and diamonds are nearly empty. In September, Sushi chef Nobu Matsuhisa shut down Ubon, his restaurant in London’s Canary Wharf, where glass skyscrapers house offices of the world’s biggest banks.

For Sunil Rally, who has been selling newspapers, gum and cigarettes at the corner of Wall and William streets in Lower Manhattan since 1991, sales are down 30 percent this year.

“Every day, business is less than the day before,” Rally says. He points across the street to where Mangia, a once bustling takeout panini and salad shop, cleared out a few days earlier. “It used to be busy,” he says. “But so many people are losing jobs.”

Growth Engine

The two cities gorged on revenue from rich bankers. Real estate values jumped to record highs. In London, 40 apartments overlooking Hyde Park had sold for an average price of 20 million pounds by early 2008, about $40 million at the time. Financial services accounted for 11 percent of U.K. income tax and 15 percent of corporation tax in the tax year ended on March 31, 2008, according to a report commissioned by London Mayor Boris Johnson. That’s a total of £42 billion -- more than the U.K.’s schools budget.

“Financial services has been the growth engine for the U.K. for a decade,” says Peter Hahn, a fellow at London’s Cass Business School and a former Citigroup banker. “The wealth from the City of London pumped up real estate prices throughout the country.”

Those days are over. On Wall Street, where the average pay at the five biggest New York-based securities firms in 2007 was $353,000, a 44 percent plunge in bonuses last year will cost New York State $1 billion in lost tax revenue, according to the Office of the State Comptroller. In the U.S., the share of gross domestic product coming from finance may tumble to about 5 percent from more than 8 percent in 2006, says Richard Florida, director of the Martin Prosperity Institute at the University of Toronto’s Rotman School of Management.

Recalibration

“The idea that so many people could move money around and make so many millions seemed economically unreasonable,” he says. “Moving those people on to other pursuits is going to be much better for our economy.”

Florida, author of “The Rise of the Creative Class,” says the expansion of financial services in the past decade soaked up talent from other industries.

“I see this as a recalibration,” he says. “Economic crises are a source of great innovation. It forces people to apply themselves to do more to add to productivity.”

There will still be bankers, of course. Well-connected dealmakers are jumping to so-called boutique firms such as Moelis & Co., the New York investment bank founded by former UBS executive Kenneth Moelis, and Quattro Partners LLP, the London investment adviser set up by former Lehman Brothers banker Michael Tory. The smaller firms are angling for new clients in part by offering advice on making money in distressed markets.

Malus Clause

Some financial workers who have been fired will be hired back when the economy rebounds. For them, and for those who still have jobs, compensation may never be so grand. Government- imposed taxes and salary caps and bank clawback provisions and deferred pay are the new rules of the game.

At New York-based Morgan Stanley, as much as two-thirds of pay is now in deferred stock and cash. Credit Suisse Group AG in Zurich is using about $5 billion of its most illiquid loans and bonds for bonuses to be paid out over five to eight years. Along with rival UBS, it’s forcing employees to allow the bank to try to take back cash bonuses if they leave the firm or are fired for cause. UBS calls this a malus clause-after the Latin word for bad.

Bankers used to feel like masters of their own destinies, hopping from one job to the next, hooked on their BlackBerries 24 hours a day. The buzz of navigating markets and billion- dollar deals was intoxicating.

“The trading room was exciting, and it was changing every day,” says Yan Assoun, 38, a Frenchman who headed European equity derivatives trading at Credit Suisse in London.

‘It’s Scary’

Now the glamour and perks are gone. In March, Morgan Stanley ordered London staff to start paying to use the firm’s gym and to front corporate expenses, including hotels and meals, out of their own pockets. Bankers and traders compensated in shares have also watched their net worths crumble.

“It’s scary,” says Assoun, who lost his job in December. Over several months, the bank slashed 20 percent of his 40- person team. “The entire industry is in shambles,” he says. “The pay structure from before is finished.”

Assoun, who has a Ph.D. in finance from the University of Paris Dauphine, worked at Deutsche Bank AG in London for six years before jumping to Credit Suisse in 2007. He’s looking for work at a hedge fund, brokerage or asset-management company, where he thinks the pay will be more predictable than at a bank, and he’s adjusting to his first break in 15 years.

“It’s a bit of a shock not to work,” says Assoun, who has a wife and two kids. “I haven’t cried yet. If I didn’t have a little financial security, I would feel worse. I can still feed my family.”

Who’s Next?

As fired bankers figure out what to do, those hanging on at beleaguered banks don’t feel so fortunate. They’ve lost so many colleagues that the work is more of a grind than ever, they say. And the payoff -- a lucrative career at a stable company -- has vanished. They’re beset with anxiety as everyone wonders who’s next.

Raj Godhania felt that stress for months in Merrill’s Hopewell, New Jersey, office. He began working late nights and weekends to keep up when his group was trimmed to three people from about nine, he says. The pressure rose when Bank of America Corp. took over Merrill on Jan. 1. “Every Monday, you’d see more empty cubicles,” he says.

‘Can’t Be Right’

On Jan. 22, in a scene played out at banks thousands of times, Godhania says he was called into a room with a department head and a woman from human resources. The boss read a couple of lines telling him his job was being eliminated and walked out. The human resources person then outlined the exit package. She gave him a form, he says, that would have granted him three more weeks of pay if he agreed not to sue Merrill or Bank of America and says he had 45 days to sign it. He never signed.

Godhania says he asked the woman from human resources about his work visa, which was dependent on his employment at Merrill. She didn’t know he had one, he recalls.

“I thought, ‘This can’t be right,’” he says. When he got home at about 11 a.m., he broke down, says Nita, his wife of 17 years. “His dream was to live and work here,” she says. “It was the first time I’ve seen him cry.”

William Halldin, a spokesman for Merrill Lynch, says the company doesn’t comment on individual cases. Bank of America expects to cut up to 35,000 jobs over three years as it combines with Merrill, he says.

‘Wasn’t Easy’

Axing workers is tough from the other side of the table, too. In banking, the cuts are so deep that many handing out the pink slips have lost their own jobs. When Servis, the former Morgan Stanley CDO executive, joined the firm from Deutsche Bank in London in September 2007, he was expecting to expand his structuring and syndication team of about 15. Instead, one of his first tasks was to eliminate jobs already targeted by management. After six months, his team had been cut in half.

“The credit markets collapsed just after I started,” he says. “It wasn’t easy. You spend hours trying to figure out how to reorganize.”

At least, Servis says, he believed his position was safe. Not so. In April 2008, Morgan Stanley further pared European structured finance, and in September, Servis lost his job. Now, even the managing director who told Servis his job was being eliminated is gone.

“It doesn’t look like I will ever be doing the same job again,” Servis says. He’s looking for a new position in the City and spending part of the week at Crowlands Heath Golf Club in Essex, just east of London, where he parlayed his Morgan Stanley earnings into an ownership stake.

Demanding Yield

Servis studied aeronautics at the University of Southampton and says he went into structured finance to use his math background. The money was good too.

“It was a bit of a gamble because in 1995 you didn’t know if the market would take off,” he says.

While many politicians and taxpayers have blamed banks that sold CDOs and other structured products for causing the financial crisis, Servis says customers were demanding higher returns.

“Investors were taking more risk than they should have,” he says. “You talked to a client about a product that yielded 8 percent, and they said they wanted a yield of 9, 10, 11 percent. I could tell them why that higher-yielding product was more risky, but investors were searching for yields.”

Now, as he helps sort out the golf club’s finances and pitches in by scrubbing down the kitchen, he finds himself on the other side of the banking world, trying to restructure the club’s £275,000 debt.

“I keep saying 275 million, forgetting it’s only in thousands,” he says.

No More Pilates

Janegail Orringer is also thinking smaller. She lost her job at New York-based hedge fund firm Halcyon Asset Management LLC on Dec. 18. A senior analyst of high-yield credit strategies, Orringer had worked at private equity firm Carlyle Group for nine years before moving to Halcyon in May 2007. She says she doesn’t expect demand for her skills to revive anytime soon and has taken on a couple of short-term consulting jobs.

She’s also rethinking her household budget.

That means fewer taxis and a cheaper hair salon. Orringer has dumped the $90, once-a-week Pilates class and a plan to renovate her 7-year-old daughter’s room in the Upper West Side apartment she shares with her husband, who teaches economics at the University of Pennsylvania’s Wharton School. The regular Sunday afternoon baby sitter is gone too. The full-time nanny stays. She’s also ordering cheaper cuts of meat from the butcher: No more veal chops.

Psychic Burden

It’s tough to live in New York City on much less than $400,000 a year, Orringer says, especially if a family has two kids in private school, where tuition can exceed $25,000 a year.

“I look around at my neighbors, and I wonder, ‘How do they make it?’” she says. “We have savings, although if I remain unemployed for several years, we’ll have to dramatically change our lifestyle.”

The psychic burden of losing a job may weigh most on Wall Street veterans. They’ve lived through the 1987 stock market crash and the dot-com bubble a decade later. This is worse, says Bill Greenwood, a former managing director at Carlyle.

“I have been telling colleagues that the business isn’t coming back for the rest of our careers,” Greenwood, 50, says, sipping Awake tea in a Starbucks coffee shop in Westport, Connecticut, not far from his home. “I can’t believe how people are in denial.”

New Plans

Greenwood jumped to Carlyle in 2006 from Merrill Lynch, where he had been a portfolio manager, to help build the private equity company’s first publicly listed investment fund. The unit completed an initial public offering in July 2007. By March 2008, the fund, a victim of the credit crunch, had faltered. He was let go a month later.

Now, Greenwood is still commuting the 50 miles (80 kilometers) to New York a few times a week for meetings with former colleagues and interviews, he says. He watches the markets and manages his own money at a desk in a friend’s office in Stamford, Connecticut.

He’s also trying to raise $10 million with three partners for a managed-futures business, Meridian Fund Management Services LLC. Managed-futures funds invest in commodity and financial futures and can bet against securities. Their performance has a low correlation with the stock market, and they’re regulated by the Commodity Futures Trading Commission. That, he says, could draw some investors who’ve been burned by opaque and illiquid investment products.

“I’m not doom and gloom,” Greenwood says. “You don’t get anywhere that way.”

Remembering Roots

Still, after almost a year without a regular job, he’s watching his cash. “The mantra has been, ‘Do you really need it right now?’” says Greenwood, who lives in a four-bedroom house at the end of a cul-de-sac in Fairfield, Connecticut, with his wife and four kids aged 13 to 19.

“I am one of nine children from a blue-collar community,” he says. His father worked for a family-owned industrial products business that’s now partly managed by one of Greenwood’s five brothers. “I’ve never lived high on the hog,” he says.

Others who earned millions of dollars over the years were more cavalier with their spending, Greenwood says.

“The whole concept that people were supposed to live on their salary and bank the bonus -- most people never did,” he says. “The huge house and vacations got them in trouble. It’s devastating to think about losing your house or figuring out how to support your family.”

‘Turn to Faith’

At St. Anthony of Padua, the Roman Catholic church in Fairfield where Greenwood is a congregant, Pastor John Baran is seeing some of that devastation.

“We are looking at the land of high margins here and a lot of expensive automobile payments and things like that,” he says. “People are all of a sudden struggling. Their vulnerability is really hitting them.”

The church is doing what it can, Baran says. It has quietly helped some members make mortgage payments. Attendance is up 20 percent since September.

“It’s like after 9-11,” he says. “Whenever people feel like the world is out of control, they turn to faith.”

Those best able to handle Wall Street’s big shrink may be the young men and women at the other end of the career path from Greenwood, the ones who filled junior positions on trading desks or in entry-level investment-banking programs. They’re more flexible, with no mortgages to pay and few bills except rent and restaurant tabs.

Spread Betting

William Hanbury, 25, set his sights on a career in finance after graduating from the University of Edinburgh, where he majored in economics. Now, after losing his equity derivatives sales job at Societe Generale SA in London, he’s started a business, Active Capital Management Ltd., that provides options- pricing software for spread betting.

Hanbury sees profit in the rush of unemployed traders in London who are placing short-term leveraged bets on the direction of stocks, currencies, commodities and indexes. So far, Hanbury has two clients and is hoping for more.

“I do still want to pursue a financial career,” he says. “But I don’t think there will be that many openings.”

Financial firms loaded up on young talent during the boom years, filling analyst and associate programs with college and business school graduates courted from prestigious universities. In New York, entry-level pay was about $65,000 a year and was often doubled by a bonus. In London, starting salaries were even higher -- £58,000 for London Business School MBAs plus a bonus.

Campus recruiting in the U.K. by banks this year will plunge about 28 percent, according to estimates from the London- based Association of Graduate Recruiters.

‘Relocating to Cincinnati’

In the U.S., students used to crush into auditoriums to hear Wall Street CEOs such as Goldman Sachs’s Lloyd Blankfein or JPMorgan Chase & Co.’s Jamie Dimon, says Claudia Tattanelli, chief executive of Philadelphia-based Universum, which polls undergraduate and MBA students on where they’d most like to work. Now, they just want to impress interviewers from accounting firm Ernst & Young LLP or packaged-goods producer Procter & Gamble Co.

“Students are actually now looking at relocating to Cincinnati,” Tattanelli says.

As for banking, the jig is up.

“It used to be the place to feel great about yourself and become a millionaire,” Tattanelli says. “Now, it’s not so sure you will make the money, even if the economy picks up. What’s an investment bank’s value proposition now? Work really long hours and not make so much money?”

Becoming Ari Gold

Banks and consulting firms so dominated campus job fairs at Princeton University in recent years that many students felt there were few other options, says Amit Chatwani, a 2004 graduate.

Chatwani ended up at a consulting company, and from an apartment in Manhattan’s Tribeca neighborhood, he started a blog called Leveraged Sell-Out that mocked his college pals’ long hours, obsession with Excel spreadsheets and attempts to land women by flashing their Goldman Sachs credentials.

“Now, there are just a ton of people laid off,” says Chatwani, 26, whose book “Damn It Feels Good to Be a Banker” came out last August, an ill-timed debut. Some of his friends are applying to business school. Others, inspired by the foul- mouthed Ari Gold on the HBO program Entourage, are talking about careers in Hollywood.

“They say, ‘Well, banking is over; I’m going to become an agent,’” he says.

Heading Home

Some young bankers in London and New York have happily ditched plans for a future in finance. Elizabeth Woodwick, 24, joined Lehman Brothers’ debt capital markets group in July 2006, after graduating from Williams College in Williamstown, Massachusetts.

She worked 15-hour days, she says, and after a year moved into an apartment with a spiffy new kitchen. That’s when she began baking to relax, throwing cookies or muffins in the oven before and after work. In June 2008, as markets wobbled, she quit Lehman and signed up for the French Culinary Institute’s program in classic pastry art.

“I liked the people, but it was so intense,” she says of her stint in banking, taking a break from a class assignment for which she was making a chocolate showpiece of the Berkshire Mountains. She calls Lehman’s demise just three months after she left “surreal.”

Now, she’s contemplating moving back to Minnesota, where she grew up, to work in a restaurant.

‘The Little Person’

The transition isn’t so simple for the Godhanias.

Nikita and Tinika, the girls, are being pulled from the school in New Jersey that took them a year to get used to. Their parents are withdrawing savings for airline tickets and to ship their possessions back to London, where they plan to rent an apartment and where Raj will join the ranks of those looking for work in the U.K.

Godhania has been following details of how 700 Merrill Lynch bankers were paid a total of $3.6 billion in bonuses before Bank of America took over the company.

“The other people, high up the ladder, have made it,” he says. “But me, the little person, cannot ask for even a small fraction of help. Why can’t they just apologize to us and pay to let us go back?”

It’s a question more unemployed financial services workers may be asking themselves. For most, though, there is no going back.

Rolling Stone's view of things - a coup d'etat

2009-03-22T04:33:00.001-07:00

URL: http://www.rollingstone.com/politics/story/26793903/the_big_takeover

Rollingstone.com

The Big Takeover

The global economic crisis isn't about money - it's about power. How Wall Street insiders are using the bailout to stage a revolution

MATT TAIBBI

Posted Mar 19, 2009 12:49 PM

It's over — we're officially, royally fucked. no empire can survive being rendered a permanent laughingstock, which is what happened as of a few weeks ago, when the buffoons who have been running things in this country finally went one step too far. It happened when Treasury Secretary Timothy Geithner was forced to admit that he was once again going to have to stuff billions of taxpayer dollars into a dying insurance giant called AIG, itself a profound symbol of our national decline — a corporation that got rich insuring the concrete and steel of American industry in the country's heyday, only to destroy itself chasing phantom fortunes at the Wall Street card tables, like a dissolute nobleman gambling away the family estate in the waning days of the British Empire.

The latest bailout came as AIG admitted to having just posted the largest quarterly loss in American corporate history — some $61.7 billion. In the final three months of last year, the company lost more than $27 million every hour. That's $465,000 a minute, a yearly income for a median American household every six seconds, roughly $7,750 a second. And all this happened at the end of eight straight years that America devoted to frantically chasing the shadow of a terrorist threat to no avail, eight years spent stopping every citizen at every airport to search every purse, bag, crotch and briefcase for juice boxes and explosive tubes of toothpaste. Yet in the end, our government had no mechanism for searching the balance sheets of companies that held life-or-death power over our society and was unable to spot holes in the national economy the size of Libya (whose entire GDP last year was smaller than AIG's 2008 losses).

So it's time to admit it: We're fools, protagonists in a kind of gruesome comedy about the marriage of greed and stupidity. And the worst part about it is that we're still in denial — we still think this is some kind of unfortunate accident, not something that was created by the group of psychopaths on Wall Street whom we allowed to gang-rape the American Dream. When Geithner announced the new $30 billion bailout, the party line was that poor AIG was just a victim of a lot of shitty luck — bad year for business, you know, what with the financial crisis and all. Edward Liddy, the company's CEO, actually compared it to catching a cold: "The marketplace is a pretty crummy place to be right now," he said. "When the world catches pneumonia, we get it too." In a pathetic attempt at name-dropping, he even whined that AIG was being "consumed by the same issues that are driving house prices down and 401K statements down and Warren Buffet's investment portfolio down."

Liddy made AIG sound like an orphan begging in a soup line, hungry and sick from being left out in someone else's financial weather. He conveniently forgot to mention that AIG had spent more than a decade systematically scheming to evade U.S. and international regulators, or that one of the causes of its "pneumonia" was making colossal, world-sinking $500 billion bets with money it didn't have, in a toxic and completely unregulated derivatives market.

Nor did anyone mention that when AIG finally got up from its seat at the Wall Street casino, broke and busted in the afterdawn light, it owed money all over town — and that a huge chunk of your taxpayer dollars in this particular bailout scam will be going to pay off the other high rollers at its table. Or that this was a casino unique among all casinos, one where middle-class taxpayers cover the bets of billionaires.

People are pissed off about this financial crisis, and about this bailout, but they're not pissed off enough. The reality is that the worldwide economic meltdown and the bailout that followed were together a kind of revolution, a coup d'état. They cemented and formalized a political trend that has been snowballing for decades: the gradual takeover of the government by a small class of connected insiders, who used money to control elections, buy influence and systematically weaken financial regulations.

The crisis was the coup de grâce: Given virtually free rein over the economy, these same insiders first wrecked the financial world, then cunningly granted themselves nearly unlimited emergency powers to clean up their own mess. And so the gambling-addict leaders of companies like AIG end up not penniless and in jail, but with an Alien-style death grip on the Treasury and the Federal Reserve — "our partners in the government," as Liddy put it with a shockingly casual matter-of-factness after the most recent bailout.

The mistake most people make in looking at the financial crisis is thinking of it in terms of money, a habit that might lead you to look at the unfolding mess as a huge bonus-killing downer for the Wall Street class. But if you look at it in purely Machiavellian terms, what you see is a colossal power grab that threatens to turn the federal government into a kind of giant Enron — a huge, impenetrable black box filled with self-dealing insiders whose scheme is the securing of individual profits at the expense of an ocean of unwitting involuntary shareholders, previously known as taxpayers.

I. PATIENT ZERO

The best way to understand the financial crisis is to understand the meltdown at AIG. AIG is what happens when short, bald managers of otherwise boring financial bureaucracies start seeing Brad Pitt in the mirror. This is a company that built a giant fortune across more than a century by betting on safety-conscious policyholders — people who wear seat belts and build houses on high ground — and then blew it all in a year or two by turning their entire balance sheet over to a guy who acted like making huge bets with other people's money would make his dick bigger.

That guy — the Patient Zero of the global economic meltdown — was one Joseph Cassano, the head of a tiny, 400-person unit within the company called AIG Financial Products, or AIGFP. Cassano, a pudgy, balding Brooklyn College grad with beady eyes and way too much forehead, cut his teeth in the Eighties working for Mike Milken, the granddaddy of modern Wall Street debt alchemists. Milken, who pioneered the creative use of junk bonds, relied on messianic genius and a whole array of insider schemes to evade detection while wreaking financial disaster. Cassano, by contrast, was just a greedy little turd with a knack for selective accounting who ran his scam right out in the open, thanks to Washington's deregulation of the Wall Street casino. "It's all about the regulatory environment," says a government source involved with the AIG bailout. "These guys look for holes in the system, for ways they can do trades without government interference. Whatever is unregulated, all the action is going to pile into that."

The mess Cassano created had its roots in an investment boom fueled in part by a relatively new type of financial instrument called a collateralized-debt obligation. A CDO is like a box full of diced-up assets. They can be anything: mortgages, corporate loans, aircraft loans, credit-card loans, even other CDOs. So as X mortgage holder pays his bill, and Y corporate debtor pays his bill, and Z credit-card debtor pays his bill, money flows into the box.

The key idea behind a CDO is that there will always be at least some money in the box, regardless of how dicey the individual assets inside it are. No matter how you look at a single unemployed ex-con trying to pay the note on a six-bedroom house, he looks like a bad investment. But dump his loan in a box with a smorgasbord of auto loans, credit-card debt, corporate bonds and other crap, and you can be reasonably sure that somebody is going to pay up. Say $100 is supposed to come into the box every month. Even in an apocalypse, when $90 in payments might default, you'll still get $10. What the inventors of the CDO did is divide up the box into groups of investors and put that $10 into its own level, or "tranche." They then convinced ratings agencies like Moody's and S&P to give that top tranche the highest AAA rating — meaning it has close to zero credit risk.

Suddenly, thanks to this financial seal of approval, banks had a way to turn their shittiest mortgages and other financial waste into investment-grade paper and sell them to institutional investors like pensions and insurance companies, which were forced by regulators to keep their portfolios as safe as possible. Because CDOs offered higher rates of return than truly safe products like Treasury bills, it was a win-win: Banks made a fortune selling CDOs, and big investors made much more holding them.

The problem was, none of this was based on reality. "The banks knew they were selling crap," says a London-based trader from one of the bailed-out companies. To get AAA ratings, the CDOs relied not on their actual underlying assets but on crazy mathematical formulas that the banks cooked up to make the investments look safer than they really were. "They had some back room somewhere where a bunch of Indian guys who'd been doing nothing but math for God knows how many years would come up with some kind of model saying that this or that combination of debtors would only default once every 10,000 years," says one young trader who sold CDOs for a major investment bank. "It was nuts."

Now that even the crappiest mortgages could be sold to conservative investors, the CDOs spurred a massive explosion of irresponsible and predatory lending. In fact, there was such a crush to underwrite CDOs that it became hard to find enough subprime mortgages — read: enough unemployed meth dealers willing to buy million-dollar homes for no money down — to fill them all. As banks and investors of all kinds took on more and more in CDOs and similar instruments, they needed some way to hedge their massive bets — some kind of insurance policy, in case the housing bubble burst and all that debt went south at the same time. This was particularly true for investment banks, many of which got stuck holding or "warehousing" CDOs when they wrote more than they could sell. And that's were Joe Cassano came in.

Known for his boldness and arrogance, Cassano took over as chief of AIGFP in 2001. He was the favorite of Maurice "Hank" Greenberg, the head of AIG, who admired the younger man's hard-driving ways, even if neither he nor his successors fully understood exactly what it was that Cassano did. According to a source familiar with AIG's internal operations, Cassano basically told senior management, "You know insurance, I know investments, so you do what you do, and I'll do what I do — leave me alone." Given a free hand within the company, Cassano set out from his offices in London to sell a lucrative form of "insurance" to all those investors holding lots of CDOs. His tool of choice was another new financial instrument known as a credit-default swap, or CDS.

The CDS was popularized by J.P. Morgan, in particular by a group of young, creative bankers who would later become known as the "Morgan Mafia," as many of them would go on to assume influential positions in the finance world. In 1994, in between booze and games of tennis at a resort in Boca Raton, Florida, the Morgan gang plotted a way to help boost the bank's returns. One of their goals was to find a way to lend more money, while working around regulations that required them to keep a set amount of cash in reserve to back those loans. What they came up with was an early version of the credit-default swap.

In its simplest form, a CDS is just a bet on an outcome. Say Bank A writes a million-dollar mortgage to the Pope for a town house in the West Village. Bank A wants to hedge its mortgage risk in case the Pope can't make his monthly payments, so it buys CDS protection from Bank B, wherein it agrees to pay Bank B a premium of $1,000 a month for five years. In return, Bank B agrees to pay Bank A the full million-dollar value of the Pope's mortgage if he defaults. In theory, Bank A is covered if the Pope goes on a meth binge and loses his job.

When Morgan presented their plans for credit swaps to regulators in the late Nineties, they argued that if they bought CDS protection for enough of the investments in their portfolio, they had effectively moved the risk off their books. Therefore, they argued, they should be allowed to lend more, without keeping more cash in reserve. A whole host of regulators — from the Federal Reserve to the Office of the Comptroller of the Currency — accepted the argument, and Morgan was allowed to put more money on the street.

What Cassano did was to transform the credit swaps that Morgan popularized into the world's largest bet on the housing boom. In theory, at least, there's nothing wrong with buying a CDS to insure your investments. Investors paid a premium to AIGFP, and in return the company promised to pick up the tab if the mortgage-backed CDOs went bust. But as Cassano went on a selling spree, the deals he made differed from traditional insurance in several significant ways. First, the party selling CDS protection didn't have to post any money upfront. When a $100 corporate bond is sold, for example, someone has to show 100 actual dollars. But when you sell a $100 CDS guarantee, you don't have to show a dime. So Cassano could sell investment banks billions in guarantees without having any single asset to back it up.

Secondly, Cassano was selling so-called "naked" CDS deals. In a "naked" CDS, neither party actually holds the underlying loan. In other words, Bank B not only sells CDS protection to Bank A for its mortgage on the Pope — it turns around and sells protection to Bank C for the very same mortgage. This could go on ad nauseam: You could have Banks D through Z also betting on Bank A's mortgage. Unlike traditional insurance, Cassano was offering investors an opportunity to bet that someone else's house would burn down, or take out a term life policy on the guy with AIDS down the street. It was no different from gambling, the Wall Street version of a bunch of frat brothers betting on Jay Feely to make a field goal. Cassano was taking book for every bank that bet short on the housing market, but he didn't have the cash to pay off if the kick went wide.

In a span of only seven years, Cassano sold some $500 billion worth of CDS protection, with at least $64 billion of that tied to the subprime mortgage market. AIG didn't have even a fraction of that amount of cash on hand to cover its bets, but neither did it expect it would ever need any reserves. So long as defaults on the underlying securities remained a highly unlikely proposition, AIG was essentially collecting huge and steadily climbing premiums by selling insurance for the disaster it thought would never come.

Initially, at least, the revenues were enormous: AIGFP's returns went from $737 million in 1999 to $3.2 billion in 2005. Over the past seven years, the subsidiary's 400 employees were paid a total of $3.5 billion; Cassano himself pocketed at least $280 million in compensation. Everyone made their money — and then it all went to shit.

II. THE REGULATORS

Cassano's outrageous gamble wouldn't have been possible had he not had the good fortune to take over AIGFP just as Sen. Phil Gramm — a grinning, laissez-faire ideologue from Texas — had finished engineering the most dramatic deregulation of the financial industry since Emperor Hien Tsung invented paper money in 806 A.D. For years, Washington had kept a watchful eye on the nation's banks. Ever since the Great Depression, commercial banks — those that kept money on deposit for individuals and businesses — had not been allowed to double as investment banks, which raise money by issuing and selling securities. The Glass-Steagall Act, passed during the Depression, also prevented banks of any kind from getting into the insurance business.

But in the late Nineties, a few years before Cassano took over AIGFP, all that changed. The Democrats, tired of getting slaughtered in the fundraising arena by Republicans, decided to throw off their old reliance on unions and interest groups and become more "business-friendly." Wall Street responded by flooding Washington with money, buying allies in both parties. In the 10-year period beginning in 1998, financial companies spent $1.7 billion on federal campaign contributions and another $3.4 billion on lobbyists. They quickly got what they paid for. In 1999, Gramm co-sponsored a bill that repealed key aspects of the Glass-Steagall Act, smoothing the way for the creation of financial megafirms like Citigroup. The move did away with the built-in protections afforded by smaller banks. In the old days, a local banker knew the people whose loans were on his balance sheet: He wasn't going to give a million-dollar mortgage to a homeless meth addict, since he would have to keep that loan on his books. But a giant merged bank might write that loan and then sell it off to some fool in China, and who cared?

The very next year, Gramm compounded the problem by writing a sweeping new law called the Commodity Futures Modernization Act that made it impossible to regulate credit swaps as either gambling or securities. Commercial banks — which, thanks to Gramm, were now competing directly with investment banks for customers — were driven to buy credit swaps to loosen capital in search of higher yields. "By ruling that credit-default swaps were not gaming and not a security, the way was cleared for the growth of the market," said Eric Dinallo, head of the New York State Insurance Department.

The blanket exemption meant that Joe Cassano could now sell as many CDS contracts as he wanted, building up as huge a position as he wanted, without anyone in government saying a word. "You have to remember, investment banks aren't in the business of making huge directional bets," says the government source involved in the AIG bailout. When investment banks write CDS deals, they hedge them. But insurance companies don't have to hedge. And that's what AIG did. "They just bet massively long on the housing market," says the source. "Billions and billions."

In the biggest joke of all, Cassano's wheeling and dealing was regulated by the Office of Thrift Supervision, an agency that would prove to be defiantly uninterested in keeping watch over his operations. How a behemoth like AIG came to be regulated by the little-known and relatively small OTS is yet another triumph of the deregulatory instinct. Under another law passed in 1999, certain kinds of holding companies could choose the OTS as their regulator, provided they owned one or more thrifts (better known as savings-and-loans). Because the OTS was viewed as more compliant than the Fed or the Securities and Exchange Commission, companies rushed to reclassify themselves as thrifts. In 1999, AIG purchased a thrift in Delaware and managed to get approval for OTS regulation of its entire operation.

Making matters even more hilarious, AIGFP — a London-based subsidiary of an American insurance company — ought to have been regulated by one of Europe's more stringent regulators, like Britain's Financial Services Authority. But the OTS managed to convince the Europeans that it had the muscle to regulate these giant companies. By 2007, the EU had conferred legitimacy to OTS supervision of three mammoth firms — GE, AIG and Ameriprise.

That same year, as the subprime crisis was exploding, the Government Accountability Office criticized the OTS, noting a "disparity between the size of the agency and the diverse firms it oversees." Among other things, the GAO report noted that the entire OTS had only one insurance specialist on staff — and this despite the fact that it was the primary regulator for the world's largest insurer!

"There's this notion that the regulators couldn't do anything to stop AIG," says a government official who was present during the bailout. "That's bullshit. What you have to understand is that these regulators have ultimate power. They can send you a letter and say, 'You don't exist anymore,' and that's basically that. They don't even really need due process. The OTS could have said, 'We're going to pull your charter; we're going to pull your license; we're going to sue you.' And getting sued by your primary regulator is the kiss of death."

When AIG finally blew up, the OTS regulator ostensibly in charge of overseeing the insurance giant — a guy named C.K. Lee — basically admitted that he had blown it. His mistake, Lee said, was that he believed all those credit swaps in Cassano's portfolio were "fairly benign products." Why? Because the company told him so. "The judgment the company was making was that there was no big credit risk," he explained. (Lee now works as Midwest region director of the OTS; the agency declined to make him available for an interview.)

In early March, after the latest bailout of AIG, Treasury Secretary Timothy Geithner took what seemed to be a thinly veiled shot at the OTS, calling AIG a "huge, complex global insurance company attached to a very complicated investment bank/hedge fund that was allowed to build up without any adult supervision." But even without that "adult supervision," AIG might have been OK had it not been for a complete lack of internal controls. For six months before its meltdown, according to insiders, the company had been searching for a full-time chief financial officer and a chief risk-assessment officer, but never got around to hiring either. That meant that the 18th-largest company in the world had no one checking to make sure its balance sheet was safe and no one keeping track of how much cash and assets the firm had on hand. The situation was so bad that when outside consultants were called in a few weeks before the bailout, senior executives were unable to answer even the most basic questions about their company — like, for instance, how much exposure the firm had to the residential-mortgage market.

III. THE CRASH

Ironically, when reality finally caught up to Cassano, it wasn't because the housing market crapped but because of AIG itself. Before 2005, the company's debt was rated triple-A, meaning he didn't need to post much cash to sell CDS protection: The solid creditworthiness of AIG's name was guarantee enough. But the company's crummy accounting practices eventually caused its credit rating to be downgraded, triggering clauses in the CDS contracts that forced Cassano to post substantially more collateral to back his deals.

By the fall of 2007, it was evident that AIGFP's portfolio had turned poisonous, but like every good Wall Street huckster, Cassano schemed to keep his insane, Earth-swallowing gamble hidden from public view. That August, balls bulging, he announced to investors on a conference call that "it is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions." As he spoke, his CDS portfolio was racking up $352 million in losses. When the growing credit crunch prompted senior AIG executives to re-examine its liabilities, a company accountant named Joseph St. Denis became "gravely concerned" about the CDS deals and their potential for mass destruction. Cassano responded by personally forcing the poor sap out of the firm, telling him he was "deliberately excluded" from the financial review for fear that he might "pollute the process."

The following February, when AIG posted $11.5 billion in annual losses, it announced the resignation of Cassano as head of AIGFP, saying an auditor had found a "material weakness" in the CDS portfolio. But amazingly, the company not only allowed Cassano to keep $34 million in bonuses, it kept him on as a consultant for $1 million a month. In fact, Cassano remained on the payroll and kept collecting his monthly million through the end of September 2008, even after taxpayers had been forced to hand AIG $85 billion to patch up his fuck-ups. When asked in October why the company still retained Cassano at his $1 million-a-month rate despite his role in the probable downfall of Western civilization, CEO Martin Sullivan told Congress with a straight face that AIG wanted to "retain the 20-year knowledge that Mr. Cassano had." (Cassano, who is apparently hiding out in his lavish town house near Harrods in London, could not be reached for comment.)

What sank AIG in the end was another credit downgrade. Cassano had written so many CDS deals that when the company was facing another downgrade to its credit rating last September, from AA to A, it needed to post billions in collateral — not only more cash than it had on its balance sheet but more cash than it could raise even if it sold off every single one of its liquid assets. Even so, management dithered for days, not believing the company was in serious trouble. AIG was a dried-up prune, sapped of any real value, and its top executives didn't even know it.

On the weekend of September 13th, AIG's senior leaders were summoned to the offices of the New York Federal Reserve. Regulators from Dinallo's insurance office were there, as was Geithner, then chief of the New York Fed. Treasury Secretary Hank Paulson, who spent most of the weekend preoccupied with the collapse of Lehman Brothers, came in and out. Also present, for reasons that would emerge later, was Lloyd Blankfein, CEO of Goldman Sachs. The only relevant government office that wasn't represented was the regulator that should have been there all along: the OTS.

"We sat down with Paulson, Geithner and Dinallo," says a person present at the negotiations. "I didn't see the OTS even once."

On September 14th, according to another person present, Treasury officials presented Blankfein and other bankers in attendance with an absurd proposal: "They basically asked them to spend a day and check to see if they could raise the money privately." The laughably short time span to complete the mammoth task made the answer a foregone conclusion. At the end of the day, the bankers came back and told the government officials, gee, we checked, but we can't raise that much. And the bailout was on.

A short time later, it came out that AIG was planning to pay some $90 million in deferred compensation to former executives, and to accelerate the payout of $277 million in bonuses to others — a move the company insisted was necessary to "retain key employees." When Congress balked, AIG canceled the $90 million in payments.

Then, in January 2009, the company did it again. After all those years letting Cassano run wild, and after already getting caught paying out insane bonuses while on the public till, AIG decided to pay out another $450 million in bonuses. And to whom? To the 400 or so employees in Cassano's old unit, AIGFP, which is due to go out of business shortly! Yes, that's right, an average of $1.1 million in taxpayer-backed money apiece, to the very people who spent the past decade or so punching a hole in the fabric of the universe!

"We, uh, needed to keep these highly expert people in their seats," AIG spokeswoman Christina Pretto says to me in early February.

"But didn't these 'highly expert people' basically destroy your company?" I ask.

Pretto protests, says this isn't fair. The employees at AIGFP have already taken pay cuts, she says. Not retaining them would dilute the value of the company even further, make it harder to wrap up the unit's operations in an orderly fashion.

The bonuses are a nice comic touch highlighting one of the more outrageous tangents of the bailout age, namely the fact that, even with the planet in flames, some members of the Wall Street class can't even get used to the tragedy of having to fly coach. "These people need their trips to Baja, their spa treatments, their hand jobs," says an official involved in the AIG bailout, a serious look on his face, apparently not even half-kidding. "They don't function well without them."

IV. THE POWER GRAB

So that's the first step in wall street's power grab: making up things like credit-default swaps and collateralized-debt obligations, financial products so complex and inscrutable that ordinary American dumb people — to say nothing of federal regulators and even the CEOs of major corporations like AIG — are too intimidated to even try to understand them. That, combined with wise political investments, enabled the nation's top bankers to effectively scrap any meaningful oversight of the financial industry. In 1997 and 1998, the years leading up to the passage of Phil Gramm's fateful act that gutted Glass-Steagall, the banking, brokerage and insurance industries spent $350 million on political contributions and lobbying. Gramm alone — then the chairman of the Senate Banking Committee — collected $2.6 million in only five years. The law passed 90-8 in the Senate, with the support of 38 Democrats, including some names that might surprise you: Joe Biden, John Kerry, Tom Daschle, Dick Durbin, even John Edwards.

The act helped create the too-big-to-fail financial behemoths like Citigroup, AIG and Bank of America — and in turn helped those companies slowly crush their smaller competitors, leaving the major Wall Street firms with even more money and power to lobby for further deregulatory measures. "We're moving to an oligopolistic situation," Kenneth Guenther, a top executive with the Independent Community Bankers of America, lamented after the Gramm measure was passed.

The situation worsened in 2004, in an extraordinary move toward deregulation that never even got to a vote. At the time, the European Union was threatening to more strictly regulate the foreign operations of America's big investment banks if the U.S. didn't strengthen its own oversight. So the top five investment banks got together on April 28th of that year and — with the helpful assistance of then-Goldman Sachs chief and future Treasury Secretary Hank Paulson — made a pitch to George Bush's SEC chief at the time, William Donaldson, himself a former investment banker. The banks generously volunteered to submit to new rules restricting them from engaging in excessively risky activity. In exchange, they asked to be released from any lending restrictions. The discussion about the new rules lasted just 55 minutes, and there was not a single representative of a major media outlet there to record the fateful decision.

Donaldson OK'd the proposal, and the new rules were enough to get the EU to drop its threat to regulate the five firms. The only catch was, neither Donaldson nor his successor, Christopher Cox, actually did any regulating of the banks. They named a commission of seven people to oversee the five companies, whose combined assets came to total more than $4 trillion. But in the last year and a half of Cox's tenure, the group had no director and did not complete a single inspection. Great deal for the banks, which originally complained about being regulated by both Europe and the SEC, and ended up being regulated by no one.

Once the capital requirements were gone, those top five banks went hog-wild, jumping ass-first into the then-raging housing bubble. One of those was Bear Stearns, which used its freedom to drown itself in bad mortgage loans. In the short period between the 2004 change and Bear's collapse, the firm's debt-to-equity ratio soared from 12-1 to an insane 33-1. Another culprit was Goldman Sachs, which also had the good fortune, around then, to see its CEO, a bald-headed Frankensteinian goon named Hank Paulson (who received an estimated $200 million tax deferral by joining the government), ascend to Treasury secretary.

Freed from all capital restraints, sitting pretty with its man running the Treasury, Goldman jumped into the housing craze just like everyone else on Wall Street. Although it famously scored an $11 billion coup in 2007 when one of its trading units smartly shorted the housing market, the move didn't tell the whole story. In truth, Goldman still had a huge exposure come that fateful summer of 2008 — to none other than Joe Cassano.

Goldman Sachs, it turns out, was Cassano's biggest customer, with $20 billion of exposure in Cassano's CDS book. Which might explain why Goldman chief Lloyd Blankfein was in the room with ex-Goldmanite Hank Paulson that weekend of September 13th, when the federal government was supposedly bailing out AIG.

When asked why Blankfein was there, one of the government officials who was in the meeting shrugs. "One might say that it's because Goldman had so much exposure to AIGFP's portfolio," he says. "You'll never prove that, but one might suppose."

Market analyst Eric Salzman is more blunt. "If AIG went down," he says, "there was a good chance Goldman would not be able to collect." The AIG bailout, in effect, was Goldman bailing out Goldman.

Eventually, Paulson went a step further, elevating another ex-Goldmanite named Edward Liddy to run AIG — a company whose bailout money would be coming, in part, from the newly created TARP program, administered by another Goldman banker named Neel Kashkari.

V. REPO MEN

There are plenty of people who have noticed, in recent years, that when they lost their homes to foreclosure or were forced into bankruptcy because of crippling credit-card debt, no one in the government was there to rescue them. But when Goldman Sachs — a company whose average employee still made more than $350,000 last year, even in the midst of a depression — was suddenly faced with the possibility of losing money on the unregulated insurance deals it bought for its insane housing bets, the government was there in an instant to patch the hole. That's the essence of the bailout: rich bankers bailing out rich bankers, using the taxpayers' credit card.

The people who have spent their lives cloistered in this Wall Street community aren't much for sharing information with the great unwashed. Because all of this shit is complicated, because most of us mortals don't know what the hell LIBOR is or how a REIT works or how to use the word "zero coupon bond" in a sentence without sounding stupid — well, then, the people who do speak this idiotic language cannot under any circumstances be bothered to explain it to us and instead spend a lot of time rolling their eyes and asking us to trust them.

That roll of the eyes is a key part of the psychology of Paulsonism. The state is now being asked not just to call off its regulators or give tax breaks or funnel a few contracts to connected companies; it is intervening directly in the economy, for the sole purpose of preserving the influence of the megafirms. In essence, Paulson used the bailout to transform the government into a giant bureaucracy of entitled assholedom, one that would socialize "toxic" risks but keep both the profits and the management of the bailed-out firms in private hands. Moreover, this whole process would be done in secret, away from the prying eyes of NASCAR dads, broke-ass liberals who read translations of French novels, subprime mortgage holders and other such financial losers.

Some aspects of the bailout were secretive to the point of absurdity. In fact, if you look closely at just a few lines in the Federal Reserve's weekly public disclosures, you can literally see the moment where a big chunk of your money disappeared for good. The H4 report (called "Factors Affecting Reserve Balances") summarizes the activities of the Fed each week. You can find it online, and it's pretty much the only thing the Fed ever tells the world about what it does. For the week ending February 18th, the number under the heading "Repurchase Agreements" on the table is zero. It's a significant number.

Why? In the pre-crisis days, the Fed used to manage the money supply by periodically buying and selling securities on the open market through so-called Repurchase Agreements, or Repos. The Fed would typically dump $25 billion or so in cash onto the market every week, buying up Treasury bills, U.S. securities and even mortgage-backed securities from institutions like Goldman Sachs and J.P. Morgan, who would then "repurchase" them in a short period of time, usually one to seven days. This was the Fed's primary mechanism for controlling interest rates: Buying up securities gives banks more money to lend, which makes interest rates go down. Selling the securities back to the banks reduces the money available for lending, which makes interest rates go up.

If you look at the weekly H4 reports going back to the summer of 2007, you start to notice something alarming. At the start of the credit crunch, around August of that year, you see the Fed buying a few more Repos than usual — $33 billion or so. By November, as private-bank reserves were dwindling to alarmingly low levels, the Fed started injecting even more cash than usual into the economy: $48 billion. By late December, the number was up to $58 billion; by the following March, around the time of the Bear Stearns rescue, the Repo number had jumped to $77 billion. In the week of May 1st, 2008, the number was $115 billion — "out of control now," according to one congressional aide. For the rest of 2008, the numbers remained similarly in the stratosphere, the Fed pumping as much as $125 billion of these short-term loans into the economy — until suddenly, at the start of this year, the number drops to nothing. Zero.

The reason the number has dropped to nothing is that the Fed had simply stopped using relatively transparent devices like repurchase agreements to pump its money into the hands of private companies. By early 2009, a whole series of new government operations had been invented to inject cash into the economy, most all of them completely secretive and with names you've never heard of. There is the Term Auction Facility, the Term Securities Lending Facility, the Primary Dealer Credit Facility, the Commercial Paper Funding Facility and a monster called the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (boasting the chat-room horror-show acronym ABCPMMMFLF). For good measure, there's also something called a Money Market Investor Funding Facility, plus three facilities called Maiden Lane I, II and III to aid bailout recipients like Bear Stearns and AIG.

While the rest of America, and most of Congress, have been bugging out about the $700 billion bailout program called TARP, all of these newly created organisms in the Federal Reserve zoo have quietly been pumping not billions but trillions of dollars into the hands of private companies (at least $3 trillion so far in loans, with as much as $5.7 trillion more in guarantees of private investments). Although this technically isn't taxpayer money, it still affects taxpayers directly, because the activities of the Fed impact the economy as a whole. And this new, secretive activity by the Fed completely eclipses the TARP program in terms of its influence on the economy.

No one knows who's getting that money or exactly how much of it is disappearing through these new holes in the hull of America's credit rating. Moreover, no one can really be sure if these new institutions are even temporary at all — or whether they are being set up as permanent, state-aided crutches to Wall Street, designed to systematically suck bad investments off the ledgers of irresponsible lenders.

"They're supposed to be temporary," says Paul-Martin Foss, an aide to Rep. Ron Paul. "But we keep getting notices every six months or so that they're being renewed. They just sort of quietly announce it."

None other than disgraced senator Ted Stevens was the poor sap who made the unpleasant discovery that if Congress didn't like the Fed handing trillions of dollars to banks without any oversight, Congress could apparently go fuck itself — or so said the law. When Stevens asked the GAO about what authority Congress has to monitor the Fed, he got back a letter citing an obscure statute that nobody had ever heard of before: the Accounting and Auditing Act of 1950. The relevant section, 31 USC 714(b), dictated that congressional audits of the Federal Reserve may not include "deliberations, decisions and actions on monetary policy matters." The exemption, as Foss notes, "basically includes everything." According to the law, in other words, the Fed simply cannot be audited by Congress. Or by anyone else, for that matter.

VI. WINNERS AND LOSERS

Stevens isn't the only person in Congress to be given the finger by the Fed. In January, when Rep. Alan Grayson of Florida asked Federal Reserve vice chairman Donald Kohn where all the money went — only $1.2 trillion had vanished by then — Kohn gave Grayson a classic eye roll, saying he would be "very hesitant" to name names because it might discourage banks from taking the money.

"Has that ever happened?" Grayson asked. "Have people ever said, 'We will not take your $100 billion because people will find out about it?'"

"Well, we said we would not publish the names of the borrowers, so we have no test of that," Kohn answered, visibly annoyed with Grayson's meddling.

Grayson pressed on, demanding to know on what terms the Fed was lending the money. Presumably it was buying assets and making loans, but no one knew how it was pricing those assets — in other words, no one knew what kind of deal it was striking on behalf of taxpayers. So when Grayson asked if the purchased assets were "marked to market" — a methodology that assigns a concrete value to assets, based on the market rate on the day they are traded — Kohn answered, mysteriously, "The ones that have market values are marked to market." The implication was that the Fed was purchasing derivatives like credit swaps or other instruments that were basically impossible to value objectively — paying real money for God knows what.

"Well, how much of them don't have market values?" asked Grayson. "How much of them are worthless?"

"None are worthless," Kohn snapped.

"Then why don't you mark them to market?" Grayson demanded.

"Well," Kohn sighed, "we are marking the ones to market that have market values."

In essence, the Fed was telling Congress to lay off and let the experts handle things. "It's like buying a car in a used-car lot without opening the hood, and saying, 'I think it's fine,'" says Dan Fuss, an analyst with the investment firm Loomis Sayles. "The salesman says, 'Don't worry about it. Trust me.' It'll probably get us out of the lot, but how much farther? None of us knows."

When one considers the comparatively extensive system of congressional checks and balances that goes into the spending of every dollar in the budget via the normal appropriations process, what's happening in the Fed amounts to something truly revolutionary — a kind of shadow government with a budget many times the size of the normal federal outlay, administered dictatorially by one man, Fed chairman Ben Bernanke. "We spend hours and hours and hours arguing over $10 million amendments on the floor of the Senate, but there has been no discussion about who has been receiving this $3 trillion," says Sen. Bernie Sanders. "It is beyond comprehension."

Count Sanders among those who don't buy the argument that Wall Street firms shouldn't have to face being outed as recipients of public funds, that making this information public might cause investors to panic and dump their holdings in these firms. "I guess if we made that public, they'd go on strike or something," he muses.

And the Fed isn't the only arm of the bailout that has closed ranks. The Treasury, too, has maintained incredible secrecy surrounding its implementation even of the TARP program, which was mandated by Congress. To this date, no one knows exactly what criteria the Treasury Department used to determine which banks received bailout funds and which didn't — particularly the first $350 billion given out under Bush appointee Hank Paulson.

The situation with the first TARP payments grew so absurd that when the Congressional Oversight Panel, charged with monitoring the bailout money, sent a query to Paulson asking how he decided whom to give money to, Treasury responded — and this isn't a joke — by directing the panel to a copy of the TARP application form on its website. Elizabeth Warren, the chair of the Congressional Oversight Panel, was struck nearly speechless by the response.

"Do you believe that?" she says incredulously. "That's not what we had in mind."

Another member of Congress, who asked not to be named, offers his own theory about the TARP process. "I think basically if you knew Hank Paulson, you got the money," he says.

This cozy arrangement created yet another opportunity for big banks to devour market share at the expense of smaller regional lenders. While all the bigwigs at Citi and Goldman and Bank of America who had Paulson on speed-dial got bailed out right away — remember that TARP was originally passed because money had to be lent right now, that day, that minute, to stave off emergency — many small banks are still waiting for help. Five months into the TARP program, some not only haven't received any funds, they haven't even gotten a call back about their applications.

"There's definitely a feeling among community bankers that no one up there cares much if they make it or not," says Tanya Wheeless, president of the Arizona Bankers Association.

Which, of course, is exactly the opposite of what should be happening, since small, regional banks are far less guilty of the kinds of predatory lending that sank the economy. "They're not giving out subprime loans or easy credit," says Wheeless. "At the community level, it's much more bread-and-butter banking."

Nonetheless, the lion's share of the bailout money has gone to the larger, so-called "systemically important" banks. "It's like Treasury is picking winners and losers," says one state banking official who asked not to be identified.

This itself is a hugely important political development. In essence, the bailout accelerated the decline of regional community lenders by boosting the political power of their giant national competitors.

Which, when you think about it, is insane: What had brought us to the brink of collapse in the first place was this relentless instinct for building ever-larger megacompanies, passing deregulatory measures to gradually feed all the little fish in the sea to an ever-shrinking pool of Bigger Fish. To fix this problem, the government should have slowly liquidated these monster, too-big-to-fail firms and broken them down to smaller, more manageable companies. Instead, federal regulators closed ranks and used an almost completely secret bailout process to double down on the same faulty, merger-happy thinking that got us here in the first place, creating a constellation of megafirms under government control that are even bigger, more unwieldy and more crammed to the gills with systemic risk.

In essence, Paulson and his cronies turned the federal government into one gigantic, half-opaque holding company, one whose balance sheet includes the world's most appallingly large and risky hedge fund, a controlling stake in a dying insurance giant, huge investments in a group of teetering megabanks, and shares here and there in various auto-finance companies, student loans, and other failing businesses. Like AIG, this new federal holding company is a firm that has no mechanism for auditing itself and is run by leaders who have very little grasp of the daily operations of its disparate subsidiary operations.

In other words, it's AIG's rip-roaringly shitty business model writ almost inconceivably massive — to echo Geithner, a huge, complex global company attached to a very complicated investment bank/hedge fund that's been allowed to build up without adult supervision. How much of what kinds of crap is actually on our balance sheet, and what did we pay for it? When exactly will the rent come due, when will the money run out? Does anyone know what the hell is going on? And on the linear spectrum of capitalism to socialism, where exactly are we now? Is there a dictionary word that even describes what we are now? It would be funny, if it weren't such a nightmare.

VII. YOU DON'T GET IT

The real question from here is whether the Obama administration is going to move to bring the financial system back to a place where sanity is restored and the general public can have a say in things or whether the new financial bureaucracy will remain obscure, secretive and hopelessly complex. It might not bode well that Geithner, Obama's Treasury secretary, is one of the architects of the Paulson bailouts; as chief of the New York Fed, he helped orchestrate the Goldman-friendly AIG bailout and the secretive Maiden Lane facilities used to funnel funds to the dying company. Neither did it look good when Geithner — himself a protégé of notorious Goldman alum John Thain, the Merrill Lynch chief who paid out billions in bonuses after the state spent billions bailing out his firm — picked a former Goldman lobbyist named Mark Patterson to be his top aide.

In fact, most of Geithner's early moves reek strongly of Paulsonism. He has continually talked about partnering with private investors to create a so-called "bad bank" that would systemically relieve private lenders of bad assets — the kind of massive, opaque, quasi-private bureaucratic nightmare that Paulson specialized in. Geithner even refloated a Paulson proposal to use TALF, one of the Fed's new facilities, to essentially lend cheap money to hedge funds to invest in troubled banks while practically guaranteeing them enormous profits.

God knows exactly what this does for the taxpayer, but hedge-fund managers sure love the idea. "This is exactly what the financial system needs," said Andrew Feldstein, CEO of Blue Mountain Capital and one of the Morgan Mafia. Strangely, there aren't many people who don't run hedge funds who have expressed anything like that kind of enthusiasm for Geithner's ideas.

As complex as all the finances are, the politics aren't hard to follow. By creating an urgent crisis that can only be solved by those fluent in a language too complex for ordinary people to understand, the Wall Street crowd has turned the vast majority of Americans into non-participants in their own political future. There is a reason it used to be a crime in the Confederate states to teach a slave to read: Literacy is power. In the age of the CDS and CDO, most of us are financial illiterates. By making an already too-complex economy even more complex, Wall Street has used the crisis to effect a historic, revolutionary change in our political system — transforming a democracy into a two-tiered state, one with plugged-in financial bureaucrats above and clueless customers below.

The most galling thing about this financial crisis is that so many Wall Street types think they actually deserve not only their huge bonuses and lavish lifestyles but the awesome political power their own mistakes have left them in possession of. When challenged, they talk about how hard they work, the 90-hour weeks, the stress, the failed marriages, the hemorrhoids and gallstones they all get before they hit 40.

"But wait a minute," you say to them. "No one ever asked you to stay up all night eight days a week trying to get filthy rich shorting what's left of the American auto industry or selling $600 billion in toxic, irredeemable mortgages to ex-strippers on work release and Taco Bell clerks. Actually, come to think of it, why are we even giving taxpayer money to you people? Why are we not throwing your ass in jail instead?"

But before you even finish saying that, they're rolling their eyes, because You Don't Get It. These people were never about anything except turning money into money, in order to get more money; valueswise they're on par with crack addicts, or obsessive sexual deviants who burgle homes to steal panties. Yet these are the people in whose hands our entire political future now rests.

Good luck with that, America. And enjoy tax season.

[From Issue 1075 — April 2, 2009]

Elite Circling the Wagons

2009-03-21T11:22:00.001-07:00

Off With the Bankers

By SIMON JOHNSON and JAMES KWAK

http://www.nytimes.com/2009/03/20/opinion/20johnson.html?_r=2&ref=opinion

A.I.G. can hardly claim that its generous bonuses attract the best and the brightest. So instead, it defends the payments by arguing they’re needed to retain employees who are crucial for winding down transactions that are “difficult to understand and manage.” In other words, only the people who stuck the knife into the American International Group can neatly extract it for a decent burial.

There is no reason to believe this.

Similar arguments made during the 1997 Asian financial crisis, when currencies and stock markets collapsed in much of Southeast Asia, turned out to be a smokescreen to protect the executives who were partly responsible for the mess. Recovery from that crisis required Indonesia, South Korea and Thailand to close or consolidate banks. In all three countries, bankers protested, claiming that their connections with borrowers were critical to recovery.

In South Korea, cozy relationships between banks and the large conglomerates called chaebols were a major reason for the crisis. But after the crisis hit, Korean bankers and companies insisted that the complexity of chaebols like Samsung and LG — with their many separate but interwoven businesses — meant that outsiders would not be able to distinguish good loans from bad.

In Thailand, some argued that the preponderance of family-owned businesses — and the lack of clarity about precisely which family members were really in charge — meant that only bankers already working in big institutions like Bangkok Bank and Siam Commercial Bank could determine which borrowers were creditworthy.

The leaders of Thailand and South Korea did not listen to such arguments, and thank goodness. Some of the leading Thai banks were taken over by the government. After the crisis, a civil servant in charge of one such bank noted that its bad loans were much bigger than had been indicated before the takeover, largely because of an internal coverup. Only when outsiders took over did the public discover the full scope of the losses.

The South Korean government also demanded that the banks and the chaebols make a clean break. This generated a great deal of political noise — particularly when foreign managers were brought in, as when the Carlyle Group bought a stake in KorAm Bank in 2000 and Lone Star Funds purchased the Korea Exchange Bank in 2003.

But these reforms made all the difference. Banks became healthy and resumed lending within a few years after the crisis broke. The chaebols that survived are stronger than they were before the crisis. They are now withstanding the severe pressure of the global recession because they were forced to become better regulated, and more separate from banks.

Indonesia did not respond to the crisis so wisely, and the costs were severe. In 1997, Bambang Trihatmodjo, a son of President Suharto, had to close his troubled bank, Bank Andromeda, but proceeded to continue essentially the same operation under a different bank’s name. The new bank was only a small player in the overall economy, and the ruling elite seemed to think that no one would care. But Indonesia lost the support of the United States when it reneged on promises to replace failed bankers with more competent and honest ones.

The lesson of all this is that when insiders have broken a financial institution, the most direct remedy is to kick them out. Traders are hardly in short supply, and you don’t need to rely on the ones who made the toxic trades in the first place. Companies must always plan around the potential departure of even their star traders, or they are certain to fail. A.I.G. does not need to keep all of its traders, especially since it takes far fewer people to unwind a portfolio than to build it up.

If A.I.G. wants to argue that complex transactions, hedging positions and counterparty relationships require employees who are intimately familiar with those trades, it should at least provide evidence that the arguments for doing so are sounder than the ones made in Indonesia in 1997, when leading bank-owning conglomerates claimed that only they understood their financing arrangements, which certainly were complex. Or the Russian bankers in 1998 who were convinced that only they and their friends could possibly close the deals that they had taken on. We heard variants of the same idea in Poland in 1990, Ukraine in 1994 (and in the Ukrainian crises subsequently), and Argentina in 2002.

Any grain of truth in these arguments must be weighed against the costs of allowing discredited insiders to manage institutions after they have blown them up. Even if the conclusion is that a few experts need to be retained, offering guaranteed bonuses to virtually the entire operation is hardly the way to achieve the desired results. We should not let people think that the best way to guarantee job security is to lose lots of money in a really complicated way.

The argument that A.I.G.’s traders are the people that we must depend on to save the United States economy is as weak and self-serving as it was in Thailand, Korea or Indonesia. A.I.G. is essentially advocating survival of the weakest. Thankfully, the American people are not buying it.

Simon Johnson is a professor at the M.I.T. Sloan School of Management and a former chief economist at the International Monetary Fund. James Kwak is a student at Yale Law School.

AIG and Credit Default Swaps

2009-03-17T08:04:00.000-07:00

Behind Insurer’s Crisis, Blind Eye to a Web of Risk

http://www.nytimes.com/2008/09/28/business/28melt.html

By GRETCHEN MORGENSON

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

— Joseph J. Cassano, a former A.I.G. executive, August 2007

Two weeks ago, the nation’s most powerful regulators and bankers huddled in the Lower Manhattan fortress that is the Federal Reserve Bank of New York, desperately trying to stave off disaster.

As the group, led by Treasury Secretary Henry M. Paulson Jr., pondered the collapse of one of America’s oldest investment banks, Lehman Brothers, a more dangerous threat emerged: American International Group, the world’s largest insurer, was teetering. A.I.G. needed billions of dollars to right itself and had suddenly begged for help.

One of the Wall Street chief executives participating in the meeting was Lloyd C. Blankfein of Goldman Sachs, Mr. Paulson’s former firm. Mr. Blankfein had particular reason for concern.

Although it was not widely known, Goldman, a Wall Street stalwart that had seemed immune to its rivals’ woes, was A.I.G.’s largest trading partner, according to six people close to the insurer who requested anonymity because of confidentiality agreements. A collapse of the insurer threatened to leave a hole of as much as $20 billion in Goldman’s side, several of these people said.

Days later, federal officials, who had let Lehman die and initially balked at tossing a lifeline to A.I.G., ended up bailing out the insurer for $85 billion.

Their message was simple: Lehman was expendable. But if A.I.G. unspooled, so could some of the mightiest enterprises in the world.

A Goldman spokesman said in an interview that the firm was never imperiled by A.I.G.’s troubles and that Mr. Blankfein participated in the Fed discussions to safeguard the entire financial system, not his firm’s own interests.

Yet an exploration of A.I.G.’s demise and its relationships with firms like Goldman offers important insights into the mystifying, virally connected — and astonishingly fragile — financial world that began to implode in recent weeks.

Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.

Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.

In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.

“It is beyond shocking that this small operation could blow up the holding company,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn. “They found a quick way to make a fast buck on derivatives based on A.I.G.’s solid credit rating and strong balance sheet. But it all got out of control.”

The London Office

The insurance giant’s London unit was known as A.I.G. Financial Products, or A.I.G.F.P. It was run with almost complete autonomy, and with an iron hand, by Joseph J. Cassano, according to current and former A.I.G. employees.

A onetime executive with Drexel Burnham Lambert — the investment bank made famous in the 1980s by the junk bond king Michael R. Milken, who later pleaded guilty to six felony charges — Mr. Cassano helped start the London unit in 1987.

The unit became profitable enough that analysts considered Mr. Cassano a dark horse candidate to succeed Maurice R. Greenberg, the longtime chief executive who shaped A.I.G. in his own image until he was ousted amid an accounting scandal three years ago.

But last February, Mr. Cassano resigned after the London unit began bleeding money and auditors raised questions about how the unit valued its holdings. By Sept. 15, the unit’s troubles forced a major downgrade in A.I.G.’s debt rating, requiring the company to post roughly $15 billion in additional collateral — which then prompted the federal rescue.

Mr. Cassano, 53, lives in a handsome, three-story town house in the Knightsbridge neighborhood of London, just around the corner from Harrods department store on a quiet square with a private garden.

He did not respond to interview requests left at his home and with his lawyer. An A.I.G. spokesman also declined to comment.

At A.I.G., Mr. Cassano found himself ensconced in a behemoth that had a long and storied history of deftly juggling risks. It insured people and properties against natural disasters and death, offered sophisticated asset management services and did so reliably and with bravado on many continents. Even now, its insurance subsidiaries are financially strong.

When Mr. Cassano first waded into the derivatives market, his biggest business was selling so-called plain vanilla products like interest rate swaps. Such swaps allow participants to bet on the direction of interest rates and, in theory, insulate themselves from unforeseen financial events.

Ten years ago, a “watershed” moment changed the profile of the derivatives that Mr. Cassano traded, according to a transcript of comments he made at an industry event last year. Derivatives specialists from J. P. Morgan, a leading bank that had many dealings with Mr. Cassano’s unit, came calling with a novel idea.

Morgan proposed the following: A.I.G. should try writing insurance on packages of debt known as “collateralized debt obligations.” C.D.O.’s. were pools of loans sliced into tranches and sold to investors based on the credit quality of the underlying securities.

The proposal meant that the London unit was essentially agreeing to provide insurance to financial institutions holding C.D.O.’s and other debts in case they defaulted — in much the same way some homeowners are required to buy mortgage insurance to protect lenders in case the borrowers cannot pay back their loans.

Under the terms of the insurance derivatives that the London unit underwrote, customers paid a premium to insure their debt for a period of time, usually four or five years, according to the company. Many European banks, for instance, paid A.I.G. to insure bonds that they held in their portfolios.

Because the underlying debt securities — mostly corporate issues and a smattering of mortgage securities — carried blue-chip ratings, A.I.G. Financial Products was happy to book income in exchange for providing insurance. After all, Mr. Cassano and his colleagues apparently assumed, they would never have to pay any claims.

Since A.I.G. itself was a highly rated company, it did not have to post collateral on the insurance it wrote, analysts said. That made the contracts all the more profitable.

These insurance products were known as “credit default swaps,” or C.D.S.’s in Wall Street argot, and the London unit used them to turn itself into a cash register.

The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999.

Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.

Mr. Cassano and his colleagues minted tidy fortunes during these high-cotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.

In fact, compensation expenses took a large percentage of the unit’s revenue. In lean years it was 33 percent; in fatter ones 46 percent. Over all, A.I.G. Financial Products paid its employees $3.56 billion during the last seven years.

The London unit’s reach was also vast. While clients and counterparties remain closely guarded secrets in the derivatives trade, Mr. Cassano talked publicly about how proud he was of his customer list.

At the 2007 conference he noted that his company worked with a “global swath” of top-notch entities that included “banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.”

Of course, as this intricate skein expanded over the years, it meant that the participants were linked to one another by contracts that existed for the most part inside the financial world’s version of a black box.

Goldman Sachs was a member of A.I.G.’s derivatives club, according to people familiar with the operation. It was a customer of A.I.G.’s credit insurance and also acted as an intermediary for trades between A.I.G. and its other clients.

Few knew of Goldman’s exposure to A.I.G. When the insurer’s flameout became public, David A. Viniar, Goldman’s chief financial officer, assured analysts on Sept. 16 that his firm’s exposure was “immaterial,” a view that the company reiterated in an interview.

Later that same day, the government announced its two-year, $85 billion loan to A.I.G., offering it a chance to sell its assets in an orderly fashion and theoretically repay taxpayers for their trouble. The plan saved the insurer’s trading partners but decimated its shareholders.

Lucas van Praag, a Goldman spokesman, declined to detail how badly hurt his firm might have been had A.I.G. collapsed two weeks ago. He disputed the calculation that Goldman had $20 billion worth of risk tied to A.I.G., saying the figure failed to account for collateral and hedges that Goldman deployed to reduce its risk.

Regarding Mr. Blankfein’s presence at the Fed during talks about an A.I.G. bailout, he said: “I think it would be a mistake to read into it that he was there because of our own interests. We were engaged because of the implications to the entire system.”

Mr. van Praag declined to comment on what communications, if any, took place between Mr. Blankfein and the Treasury secretary, Mr. Paulson, during the bailout discussions.

A Treasury spokeswoman declined to comment about the A.I.G. rescue and Goldman’s role. The government recently allowed Goldman to change its regulatory status to help bolster its finances amid the market turmoil.

An Executive’s Optimism

Regardless of Goldman’s exposure, by last year, A.I.G. Financial Products’ portfolio of credit default swaps stood at roughly $500 billion. It was generating as much as $250 million a year in income on insurance premiums, Mr. Cassano told investors.

Because it was not an insurance company, A.I.G. Financial Products did not have to report to state insurance regulators. But for the last four years, the London-based unit’s operations, whose trades were routed through Banque A.I.G., a French institution, were reviewed routinely by an American regulator, the Office of Thrift Supervision.

A handful of the agency’s officials were always on the scene at an A.I.G. Financial Products branch office in Connecticut, but it is unclear whether they raised any red flags. Their reports are not made public and a spokeswoman would not provide details.

For his part, Mr. Cassano apparently was not worried that his unit had taken on more than it could handle. In an August 2007 conference call with analysts, he described the credit default swaps as almost a sure thing.

“It is hard to get this message across, but these are very much handpicked,” he assured those on the phone.

Just a few months later, however, the credit crisis deepened. A.I.G. Financial Products began to choke on losses — though they were only on paper.

In the quarter that ended Sept. 30, 2007, A.I.G. recognized a $352 million unrealized loss on the credit default swap portfolio.

Because the London unit was set up as a bank and not an insurer, and because of the way its derivatives contracts were written, it had to put up collateral to its trading partners when the value of the underlying securities they had insured declined. Any obligations that the unit could not pay had to be met by its corporate parent.

So began A.I.G.’s downward spiral as it, its clients, its trading partners and other companies were swept into the drowning pool set in motion by the housing downturn.

Mortgage foreclosures set off questions about the quality of debts across the entire credit spectrum. When the value of other debts sagged, calls for collateral on the securities issued by the credit default swaps sideswiped A.I.G. Financial Products and its legendary, sprawling parent.

Yet throughout much of 2007, the unit maintained that its risk assessments were reliable and its portfolios conservative. Last fall, however, the methods that A.I.G. used to value its derivatives portfolio began to come under fire from trading partners.

In February, A.I.G.’s auditors identified problems in the firm’s swaps accounting. Then, three months ago, regulators and federal prosecutors said they were investigating the insurer’s accounting.

This was not the first time A.I.G. Financial Products had run afoul of authorities. In 2004, without admitting or denying accusations that it helped clients improperly burnish their financial statements, A.I.G. paid $126 million and entered into a deferred prosecution agreement to settle federal civil and criminal investigations.

The settlement was a black mark on A.I.G.’s reputation and, according to analysts, distressed Mr. Greenberg, who still ran the company at the time. Still, as Mr. Cassano later told investors, the case caused A.I.G. to improve its risk management and establish a committee to maintain quality control.

“That’s a committee that I sit on, along with many of the senior managers at A.I.G., and we look at a whole variety of transactions that come in to make sure that they are maintaining the quality that we need to,” Mr. Cassano told them. “And so I think the things that have been put in at our level and the things that have been put in at the parent level will ensure that there won’t be any of those kinds of mistakes again.”

At the end of A.I.G.’s most recent quarter, the London unit’s losses reached $25 billion.

As those losses mounted, and A.I.G.’s once formidable stock price plunged, it became harder for the insurer to survive — imperiling other companies that did business with it and leading it to stun the Federal Reserve gathering two weeks ago with a plea for help.

Mr. Greenberg, who has seen the value of his personal A.I.G. holdings decline by more than $5 billion this year, dumped five million shares late last week. A lawyer for Mr. Greenberg did not return a phone call seeking comment.

For his part, Mr. Cassano has departed from a company that is a far cry from what it was a year ago when he spoke confidently at the analyst conference.

“We’re sitting on a great balance sheet, a strong investment portfolio and a global trading platform where we can take advantage of the market in any variety of places,” he said then. “The question for us is, where in the capital markets can we gain the best opportunity, the best execution for the business acumen that sits in our shop?”

This article has been revised to reflect the following correction:

Correction: September 30, 2008
Because of an editing error, an article on Sunday about the financial problems of American International Group referred incorrectly to the timing and participants at meetings at the New York Federal Reserve between Saturday, Sept. 13, and Monday, Sept. 15. Although there were indeed meetings that weekend, there was also a separate meeting on Monday to discuss financial aid for A.I.G. Lloyd C. Blankfein, the chief executive of Goldman Sachs, was the only Wall Street chief executive who attended the Monday meeting, not the only chief executive who attended weekend meetings. Also, Henry M. Paulson Jr., the Treasury secretary, did not lead or attend the Monday meeting. (Both Mr. Blankfein and Mr. Paulson did attend the weekend meetings.)

Shadow Finance

2009-03-15T04:04:00.001-07:00

Peruvian guru holds key to crisis

Renowned economist Hernando de Soto tells Neasa MacErlean how to end the credit crunch

Neasa MacErlean
The Observer, Sunday 15 March 2009

The Bank of England can go in for quantitative easing and cut interest rates all it likes, but such a monetary approach will do very little to ease the current crisis. This is the view of Hernando de Soto, the Peruvian economist whose work with the poor has pushed him into the frame for a Nobel prize.

"Your authorities have a very clear idea what to do with money," he says from his office in Lima. "But I am not so sure they know how to handle credit." Since the current problems are really about credit, in his view we are largely barking up the wrong tree. Figures are produced to support this. As far as he can establish, there is about $13 trillion of actual notes and coins in the world; about $170tn of traditional credit such as bonds and equity; and upwards of $600tn (but maybe as much as $1 quadrillion) of derivatives. Since he believes that the current difficulties are caused mainly by the derivatives market, he does not believe they will be resolved by opening or closing monetary valves.

Now 67 and head of the Institute for Liberty and Democracy think-tank in Peru, he was born in the country but his parents moved to Switzerland when he was a child and it was 38 years before he returned to live in Peru. So he is unusual in coming from both the first and third worlds. Former President Bill Clinton called him "the world's greatest living economist", and other admirers include George W Bush, Vladimir Putin and Hamid Karzai. Last December the UN adopted a report it had commissioned from de Soto and Madeleine Albright, former US secretary of state, through a body they had chaired together, the Commission on Legal Empowerment of the Poor. In May they will meet UN secretary general Ban Ki-moon. If all goes as expected, de Soto will be helping to run projects in 40 African nations within five years, implementing blueprints he has developed to start creating prosperity.

As a specialist on the economies of poor states, de Soto did not expect to see the UK and US suddenly meeting some of his definitions of poverty, but says: "All of a sudden you have become a banana republic." What had made capitalism so strong for centuries in parts of Europe and North America was how capital - from physical property to shares - was clearly registered and recorded. What dramatically undermined capitalism since about 2000 was the growth of unregistered assets - derivatives. Now that those have turned toxic, as the loans attached to them have been defaulted on or have come to be regarded as worthless or significantly devalued, we do not even know how big the problem is. We do not know where it is either - mainly because the banks have been reluctant to reveal the truth.

Many of the derivatives that have caused the crisis are bearer bonds, and there is no worldwide register of them. De Soto is used to living in a country which is about 60 per cent a hidden - or shadow - economy; the black market accounts for most trade and most people have no title to their home. His work is about empowering people by recording their entitlement to certain assets (most obviously their homes), thereby, enabling them to borrow, trade, receive letters and conduct other basic commercial transactions through those assets.

The UK and the US have become shadow economies - albeit by a different route - through the toxic asset crisis. Both have now started detoxification programmes, but in a rather wobbly fashion. The Royal Bank of Scotland and Lloyds have signed up to the government's asset protection scheme and other banks have until the end of this month to follow suit. It is only when all banks with significant problems sign up, make honest declarations and the toxic assets are taken off the books that they will start lending normally to each other and businesses once more, says de Soto.

"You will end up there," he says. "But it's very frustrating to see this from the outside. The whole source of the debacle is the US and the UK. And it is tough to watch you not getting to the centre of the issue. There is an intellectual lag. But this is a problem that can't be dealt with in terms of traditional monetary policy."

Detoxification is a process we have more experience of than we realise. When East and West Germany reunited in 1990, the East German currency had to be detoxified and de Soto believes that the work of the 300 or so experts involved in that programme would provide useful insights now.

But once detoxification happens, results could be seen quickly: "This [the detoxification process] is something that could be done in two or three months. It will be a painful exercise but, once you have found a way to take the detoxification out of the system, you are going to be able to free up credit."

The work he plans to do in Africa will be similar to the work he thinks the US and UK must do now - pulling trade and assets out of the shadow economy, setting up registers and focusing on transparency. But de Soto never expected that he would be giving the same advice to London and Washington as he would be giving to Africa.

Over the Hedge

2009-03-14T03:51:00.001-07:00

The five hotshots who took Fortress Investment Group public were worth billions at first. Today they look like arrogant showboats, and their story helps explain why hedge funds are imploding by the thousands—and why there’s still a truckload of money to be made.

by Bethany McLean April 2009

Fortress founders Randal Nardone, Wesley Edens, and Robert Kauffman, who, along with the two other principals, became paper billionaires in the company’s 2007 I.P.O. Photo illustrations by Darrow.

It used to be that to become a billionaire, rather than a mere millionaire, you had to inherit money, or build an empire that would last for a long, long time. But in the era that has just ended, you could become a billionaire just by managing other people’s money. You didn’t have to do so for very long—and, maybe, you didn’t even have to do so very well.

On February 9, 2007, a company called Fortress Investment Group began trading on the New York Stock Exchange. Fortress, which both runs hedge funds and makes private-equity investments, was part of the seemingly miraculous wave of money begetting more money, in which people who managed others’ fortunes made even greater fortunes for themselves. Those who thought they’d found a way to get in on the miracle snapped up Fortress’s shares. The stock had been priced at $18.50 the day before and promptly shot up to $35 when trading began in the morning. By the end of the day the five principals of Fortress—all youngish men who were present on that winter morning to ring the bell at the N.Y.S.E.—were worth a combined $10.7 billion.

Video: Bethany McLean on hedge funds and the financial crisis. Photograph by Gasper Tringale.

The five Fortress guys hadn’t spent years toiling in obscurity to build their business. Fortress was founded as a private partnership only a decade ago by Wesley Edens, now 47, Randal Nardone, 51, and Robert Kauffman, 45. Edens, the C.E.O., is a cerebral, intense, very private wunderkind who made his reputation at Lehman Brothers—and a fortune for his firm—buying assets from the Resolution Trust Corporation. He made partner at Lehman when he was barely past 30. In 1993, he left “abruptly,” as the press described it, due to “philosophical differences with management.” He joined a prestigious money-management firm called BlackRock, split to spend a short year at the Swiss bank UBS, and then set up his own shop—Fortress.

In 2002, Edens, Nardone, and Kauffman were joined by Peter Briger Jr., 44, and Michael “Novo” Novogratz, 43. Both are Princetonians who became Goldman Sachs partners. Of Briger, someone who knows him says, “He could take a pile of napkins and figure out how to make money.” He is seen as a scrappy, tough trader type who knows how to play hardball in the often brutal world of distressed debt. His high-profile deals have included loans to both fallen New York real-estate mogul Harry Macklowe and Donald Trump’s struggling Chicago hotel project. As for Novogratz, a former college wrestler and army helicopter pilot, he’s the kind of guy who makes other guys “starry-eyed,” as a friend puts it. This is due to his great charm and his embrace of a lifestyle that more than one person calls “lunatic”—they mean it as a compliment—due to his love of partying. Indeed, sources say that, while Goldman Sachs wanted Novo’s considerable skills, the firm was nervous about his lifestyle issues, and the two parted ways.

Making money seemed to be simple for Fortress. And no wonder. While the five principals are seen by their colleagues as extremely smart—“these are not B-team guys,” says one—in recent years it was hard to lose, and Fortress, like its peers, charged rich fees. For instance, its hedge funds, which were run by Novogratz and Briger, cost investors a management fee of between 1 and 3 percent of the total assets under management, as well as “incentive fees”—20 to 25 percent of any profits. At Fortress, such fees for all of its businesses totaled over $1 billion in 2007, more than double than in 2005.

Peter Briger Jr. and Michael “Novo” Novogratz, who joined Fortress in 2002. Both are Princetonians and former Goldman Sachs partners.

While the $10.7 billion the five principals made with the I.P.O. was only paper wealth, that didn’t really matter, because they’d already made fortunes from the business before they sold it to the public. They did so in three ways. First, they borrowed money, used $250 million of it to pay themselves a dividend, and used part of the I.P.O. proceeds to pay back the loan. Second, they sold a 15 percent stake to the Japanese bank Nomura for $888 million right before the I.P.O. Last, from 2005 until the date of the I.P.O., they distributed to themselves hundreds of millions from the accumulated fees that investors had paid. In other words, each man got an average of $400 million in cash even before the I.P.O. But the Fortress men are big believers in their own prowess. They say they took all that money—and more—and put it into the funds and investments they managed. And they still own 77 percent of the company’s stock. “We have invested more than we have taken out,” says Edens, in a rare interview. “We have bet on ourselves more than anyone else has.”

To go with their bravado, they lived a normal lifestyle—that is, “normal” by the rarefied standards of those who made their fortunes in finance. Edens has had an apartment on Manhattan’s Central Park West since his Lehman days, owns land in Montana, and bought an $18 million house on Martha’s Vineyard from J. Crew C.E.O. Mickey Drexler. Kauffman, who runs Fortress’s European business, bought into Michael Waltrip’s nascar team, valued recently at $86 million. Novogratz purchased Robert de Niro’s Tribeca duplex for $12.25 million—and then bought the apartment underneath to make a triplex. Briger built a 12,000-square-foot home in East Hampton in 2007 to add to his residence in Manhattan. A helicopter that is partially owned by Fortress, purchased before the company went public, sometimes shuttles Novogratz and Briger to and from the firm’s Manhattan offices. (The men say they reimburse Fortress for the expense.)

There are few better measures of the end of the era of easy money than the chart of Fortress’s stock, which went almost straight down after the I.P.O. On Wednesday, December 3, 2008, it plummeted 25 percent, to $1.87—a 95 percent drop from its opening-day high—after Fortress told investors that they would not be allowed to withdraw the $3.5 billion they had invested in Fortress’s Drawbridge Global Macro fund, which is run by Novogratz. By the end of October, the fund was 26 percent below its high-water mark; Briger’s fund had also suffered double-digit losses. The redemption requests, combined with the investment losses, would have brought down Novogratz’s fund, which had $8 billion in assets on September 30, to just $3.65 billion. The firm also canceled its dividend for the last two quarters of 2008. Bad jokes about “cracks in the Fortress” and “pulling up the Drawbridge” are now making the rounds on the Street.

Truth be told, in the hedge-fund universe, about the only thing that makes Fortress unusual is its publicly traded stock. The entire industry is reeling as investors pull billions from funds that have lost billions. (While private equity has its own severe problems—maybe more severe—investors don’t expect to get their money back for years, thereby delaying the day of reckoning.) According to the Chicago-based firm Hedge Fund Research, 2008 was by far the worst year for hedge funds since it began tracking the industry, in 1990. The average fund fell 18 percent—and for many top names, the numbers are even worse. The flagship hedge fund run by Steve Mandel of Lone Pine Capital, one of the most respected managers, was down 32 percent last year. “So many ‘smart’ guys had their heads handed to them,” comments one knowledgeable observer. Or as famous hedge-fund manager George Soros told Congress in testimony last fall, “Many hedge-fund managers forgot the cardinal rule of hedge-fund investing, which is to protect investor capital during down markets.”

Today, the burning question for most hedge-fund managers isn’t whether their industry will contract but, rather, by how much. Soros told Congress that the amount of money hedge funds manage would shrink by 50 to 75 percent.

The industry’s problem isn’t just bad performance. Regulators in both the U.S. and the U.K. made headlines by charging that short-selling by hedge funds—in which a manager bets that a stock will decline in value—helped cause the market’s crash. There’s also outright fraud, for which the poster boy is Bernie Madoff. While his operation wasn’t actually a hedge fund, the scandal has infused another dose of what-are-they-actually-doing-with-my-money fear into investors. Add to that Arthur Nadel, the Florida hedge-fund manager who allegedly bilked investors out of $300 million before fleeing. (The not-so-reassuring headline in Forbes: poof! another fund manager disappears.) While fraud may not be exactly the norm, the underlying paranoia is this: Are hedge funds just a legal scam, in which investors pay through the nose for something that isn’t what it’s cracked up to be?

There are many managers who argue that the industry’s problems are at least in part of its own making. Says Leon Cooperman, who founded the $3 billion hedge fund Omega Advisors in 1991, after a 25-year career at Goldman Sachs, “Hedge funds have shot themselves in the foot. They have not treated investors correctly.” Atop his list of sins: refusing to allow investors to take their money out, which is known in the industry as “gating” investors. Cooperman is not alone. Says Brooke Parish, senior managing director at the $9 billion hedge fund York Capital Management, “Someone worked hard for that money, and it’s someone else’s money. You give their money back when you promised it. I’m upset with the hubris, the lack of humility, the arrogance. It gives this industry a black eye, and it will take a long period of time to work through.”

Another manager tells me a story about Morgan Stanley’s annual hedge-fund conference at the Breakers, in Palm Beach, which was held the last week of January. In years past, every hedge-fund manager wanted a plum spot on a panel, so they could present themselves to prospective investors. This year, Morgan had to beg its clients to participate. Managers were reluctant not because they didn’t want—or need—the money, but because “no one wanted to be subject to a Q&A from strangers about why we all suck so bad,” as this manager put it. And those who worried were right to do so. “It was open warfare,” he says. He adds that the attitude from wealthy families was “Who are these bourgeois pigs who ripped us off?”

Another manager describes the mood at the Breakers as “pure, unbridled anger.” A source says one foreign investor at the conference declared, “These hedge-fund managers are like the Somali pirates!”—and he wasn’t kidding.

The Compensation Scheme

Contrast the Breakers with a scene from just a few years ago, when Goldman Sachs held its annual conference, this one aimed at so-called emerging managers—those who were supposed to be the industry’s new rock stars—in Miami, Florida. Over cocktails at the pool, there was chatter by those who had never run hedge funds of raising billions for their start-ups. After all, Eric Mindich, who made partner at Goldman Sachs at 27 before quitting that plum perch to start a hedge fund called Eton Park, had begun with $3.5 billion. The air at the conference, says one attendee, was a mixture of “money lust, arrogance, and am-I-going-to-get-mine anxiety.” (This year, Goldman Sachs canceled its conference.)

Citadel founder Kenneth Griffin’s net worth was estimated at $3 billion in 2007. His firm’s two main funds lost about 55 percent in 2008.

While hedge funds all manage money, they do so in very different ways. Some may invest solely in stocks, while others make bets on the direction of currencies around the globe. Many don’t actually “hedge” at all. What unites them is the way that managers are paid. Like Fortress, all hedge funds charge investors a certain percentage of assets under management, plus a cut of the net profits. The standard is “2 and 20,” or 2 percent of assets annually plus 20 percent of any profits. (As recently as five years ago, the standard was 1 and 20.) Some charge much more. Citadel, a well-known Chicago-based hedge fund, used to charge not 2 percent but whatever its expenses were, which could be as high as 8 or 9 percent of assets, plus 20 percent of profits. (Even after these fees, however, investors got an annualized return of 22 percent from 1998 through the end of 2007.)

For investors, it was supposed to make sense to pay so much more than the 1 percent of assets that a mutual fund might charge, because hedge funds were supposed to offer something that a mutual fund couldn’t. The macho hedge-fund men scorned the mutual-fund boys, who measured themselves by the wimpy “relative return”—how their numbers stacked up against the S&P 500. In contrast, hedge funds, including Fortress, aimed for “absolute return”—positive numbers no matter what the S&P 500 did. The idea was that a hedge fund limited your “exposure to market risks,” as Fortress puts it in financial filings. The setup was supposed to make so much sense that another industry—“fund of funds”—sprang up. Funds of funds sold investors a collection of hedge funds, and charged another layer of fees—usually 1 and 10—on top of the manager’s fees.

Some hedge-fund managers defend the loss of 18 percent of investors’ money as trouncing the S&P 500, which lost 37 percent in 2008. True, but that wasn’t supposed to be the goal. Cooperman calls hedge-fund compensation an “asymmetric fee structure”: “If I make a lot, you pay me. If I lose a lot, I don’t give anything back.”

“Do the math,” says another veteran Wall Streeter. What he means is this: Assume you give a manager $100 million and he doubles it. The manager gets $20 million. The next year, he’s down 50 percent. Your $100 million is now $90 million, but the manager has $20 million.

Unfortunately, in flush times few did that particular math, and so, for wealthy investors, endowments, and pension funds, hedge funds became the new luxury must-have. And for smart youngsters—or those who thought they were smart—coming out of Harvard Business School, or with a few years on Wall Street, well, how else could you get rich so quickly? “The shocking thing was how easy it was to get in from 2002 to 2006,” says one longtime manager. “All you had to do was raise your hand and say I’ll take 2 and 20. That was the barrier to entry. It boggled my mind.”

In mid-2008, there were some 10,000 hedge funds, according to Hedge Fund Research—more than five times the number of companies listed on the New York Stock Exchange, and up from just 3,000 funds a decade earlier. Assets mushroomed from around $400 billion to about $2 trillion. Everyone wanted to be the next Eric Mindich—or the next Kenneth Griffin, who started trading when he was a sophomore at Harvard, and after graduation founded Citadel with $1 million of backing from a wealthy investor. At its peak, Citadel had some $20 billion in assets; Griffin’s estimated net worth of $3 billion made him 117th on the 2007 Forbes Four Hundred.

Such wealth didn’t make Griffin unique—on the contrary. By 2006 you needed to make at least $50 million to make Trader Monthly’s list of the top 100 traders, ranked by pay, on the Street. You needed $1 billion in annual earnings to crack the top five—and the top five were all hedge-fund managers. That year, the magazine—which suspended operations this February—gave up capping the number of hedge-fund managers who could make the list, because, the editors wrote, “we could no longer ignore the ever-widening chasm between hedge fund traders and the rest of the pack.” By the following year, the bottom-of-the-list haul had risen to $75 million. “The size of paychecks as they relate to performance got out of control, particularly in the last few years,” says Brad Balter, who runs a hedge-fund advisory firm called Balter Capital Management. “The numbers in many cases were staggering, and this is particularly frustrating in cases where performance ceased to matter.” As Balter points out, if a fund with billions under management took the standard 2 percent fee on those dollars, managers could earn fortunes regardless of their returns.

One requisite toy of the newly rich hedge-fund managers was expensive art. Steven Cohen, who runs the multi-billion-dollar fund SAC Capital, became the trendsetter when he paid $8 million in 2004 for British artist Damien Hirst’s shark in formaldehyde. He also owns two de Koonings that he bought from DreamWorks co-founder David Geffen for $63 million and $137.5 million, respectively, as well as works by Picasso, Warhol, Pollock, and Munch.

The other was expensive offices. In New York, the place to be was “the Plaza District”—the area stretching from Park Avenue to Sixth Avenue, just south of Central Park. A view of the park was coveted: “The park means power,” says Ben Friedland, a senior vice president at the real-estate company CB Richard Ellis, who does most of his business with financial-services firms. And the higher the floor the better. Evan Margolin, a managing director at Studley, another real-estate firm, which helps tenants with their commercial-real-estate requirements, says that over the last four or five years rents increased between 50 and 100 percent or even more in the Plaza District, depending on the building. At the peak, the most coveted space rented for more than $200 per square foot. (By this measure, Fortress was relatively conservative. Its offices on the 46th floor of 1345 Avenue of the Americas, four blocks from the park, cost some $8.4 million in rent in 2007, but the building is considered more corporate than high hedge-fund style.) After the crash of last fall, however, the Manhattan rent increases of the last few years have been all but erased, says Friedland.

Bankers once lined up to pitch hedge funds on selling shares to the public. One successful manager says he had no fewer than nine investment banks urging him to do an I.P.O. Cooperman, for his part, says he gave some advice for those funds that did go public: “I said to all of them, within five years you will buy yourself back at 20 cents on the dollar.” Indeed, while the few other funds that followed in Fortress’s footsteps have fared a tiny bit better, they certainly haven’t fared well. Both the Blackstone Group, a private-equity firm, and the hedge fund Och-Ziff Capital Management have seen their stocks fall more than 80 percent from their highs.

For old-timers, it was all a shock. “When I started a hedge fund, people asked me what I did. I said, ‘I run a hedge fund,’ and they said, ‘What’s that?’ This included people on Wall Street,” says one manager, who started his now multi-billion-dollar fund over a decade ago. “We got to a period in the late 1990s where if someone said to me, ‘Do you work at a hedge fund?’ I would have said, ‘Not as you know it. We hedge.’”

Jamie Dinan, C.E.O. of York Capital Management, says that, when he started, most of his friends thought he was nuts. If you graduated from Harvard Business School, as he did, you worked as a banker, not as a low-class trader. Initially, he operated out of a windowless office and figured that if things went well he might one day net some $200,000 annually from his management and performance fees. “I never dreamed this,” he says.

The Secret Sauce

It all begs a fairly simple question, which is: How could there have been as many great investors as there were hedge funds being started?

The short answer is there weren’t.

In the later years of the hedge-fund explosion, there weren’t any serious tests of a manager’s prowess, because it was so easy to make money. In addition, David Kabiller, a principal at AQR Capital Management—a roughly $20 billion hedge fund founded by Goldman Sachs alums Kabiller, Cliff Asness, John Liew, and Robert Krail—points out that there isn’t any way to measure most hedge funds. While any investor in a mutual fund can glance at the S&P 500 to get a yardstick of how well his fund manager is doing, a hedge fund with a more esoteric strategy is harder to measure. “If there aren’t any benchmarks, then you can’t be discovered,” says Kabiller.

As money flooded in, even those managers who did something unique soon found billions of dollars copying them. That reduced the available returns. In response, some managers began to hunt off the beaten paths and buy more exotic stuff—stakes in private Chinese companies, or securities based on mortgages, for instance—that wasn’t as “liquid” (meaning it couldn’t be sold as easily) as a stock.

And there was a secret sauce that washed away all sins: debt. The cost of borrowing money was so insanely low that a hedge-fund manager could make a trade that would earn only a sliver of a return, and then juice that return by using a truckload of borrowed money. As the money rolled in, many young managers thought they were geniuses. Or as Keith McCullough, who sold a hedge fund he founded and then started a research site for investors called Research Edge, says, “Some of them actually thought it was due to their intelligence, and not just the cycle.”

While some funds resisted the siren call of debt, Fortress, for the most part, wasn’t one of them. Its financial filings note that “the funds we manage may operate with a substantial degree of leverage.… This leverage creates the potential for higher returns, but also increases the volatility.”

As another hedge-fund manager tells me, Warren Buffett brilliantly predicted that there would be a day of reckoning: “You only learn who has been swimming naked when the tide goes out.”

A Series of Unfortunate Events

Fortress’s stock, which had sunk to $10 by August 2008, should have been a sign that the tide was going out. But few hedge-fund managers were adroit enough to head for shore.

“You know the children’s books ‘A Series of Unfortunate Events’?” Jamie Dinan asks me. “Horrible, horrible things happen in those books. That’s how I feel about last fall.”

Another manager tells me that his fund was down 2 percent at the end of August. By October, he was down 26 percent. “We have great confidence in our analytical ability, and when the world is panicking, we stand up,” he says. “In retrospect, I should have panicked.”

As the investment banks that provided the debt began to fight for their own survival, those hedge funds that depended on it were faced with margin calls. But even funds that weren’t debt-laden were hit with problems from the banking panic. To reduce their risk, many funds began to sell their positions and move to cash. For example, the stock holdings of Atticus Capital, whose co-chairman is Nathaniel Rothschild, fell from $8.1 billion at the end of June to just $510 million by the end of September. In addition, just as you wouldn’t want your money at a bank that goes under, hedge funds didn’t want to be trapped at a firm that went under, so they moved their money to banks they thought were safer. In order to do so, they had to sell their long positions and get out of the short positions, driving down the price of the former and driving up the price of the latter—thereby exacerbating the selling pressure.

In a way, hedge funds were eating one another alive. As managers sold their positions, some discovered, as one manager puts it, that “all our names were owned by the same guys. We had become the market. When I ran for the exits, all the buyers who should have been there were doing the same.” During the third quarter, a Goldman Sachs index which tracks stocks that are heavily owned by hedge funds lost 19 percent, more than twice the decline of the S&P 500, while another Goldman Sachs index that tracks stocks which hedge funds were likely to sell short actually gained 2.4 percent, according to a Cambridge Associates LLC report. “Hedge funds were shooting at each other,” says one manager, meaning that some funds would make bets against stocks that were heavily owned by other managers.

And then there was the September 2008 bankruptcy of Lehman Brothers. Not only did that roil the market further—it caused a particular problem for hedge funds. Because the U.S. actually has fairly strict rules about the amount of debt you can use, many funds had set up offshore accounts—sometimes with Lehman London—where the rules were far laxer. What they failed to understand was that bankruptcy rules are also different in London, and that they wouldn’t be able to get their money out. One manager estimates that roughly half of the hedge funds in existence had at least some exposure to Lehman London.

At the same time, hedge funds found themselves becoming a scapegoat for the problems in the market. “We are the whipping boys,” says one executive. The C.E.O.’s of investment banks including Bear Stearns, Lehman, and Morgan Stanley blamed short-selling by hedge funds for the declines in their stock—no matter that these banks had previously made a lot of money from the industry, and that Morgan Stanley’s C.E.O., John Mack, had once worked as the chairman of a hedge fund—Pequot Capital. On September 18, New York attorney general Andrew Cuomo announced an investigation into whether traders illegally spread rumors to drive down the stock prices of financial firms, and likened the activity to “looters after a hurricane.” On September 19, the S.E.C. temporarily banned short-selling in a list of almost 1,000 finance-related stocks. A few days later, the agency ordered more than two dozen hedge funds to turn over records as part of an investigation into whether traders were spreading rumors to manipulate share prices downward.

Although Cuomo was careful to single out illegal short-selling, some managers took it as a criticism of the industry. So one manager was surprised to get a call from Cuomo’s office, shortly after the announcement, inviting him to lunch at the Core Club (a Manhattan venue opened three years ago for “leaders” willing to part with a $50,000 initiation fee). The suggested campaign donation: $1,000. When he arrived, he battled for elevator space with other hedge-fund managers. “It was the hedge-fund community of New York,” he recalls. Cuomo told the assembled managers that, if he were an investor, he would have sold housing-related stocks short as well. He also told them that they needed a Washington lobbyist because the industry lacked a voice. (One manager who was at the event emphasizes that Cuomo had targeted only illegal short-selling, and was right to launch an investigation into that.)

By mid-October, rumors that Citadel—which also depended on debt—was in trouble began to sweep through the market. On October 24, more than 1,000 listeners crowded onto a conference call in which Citadel said that its two largest funds were down 35 percent due to the “unprecedented de-leveraging that took place around the world,” as C.F.O. Gerald Beeson described it. Citadel finished the year with its two main funds down over 50 percent (although smaller funds were up more than 40 percent), and it told investors it would suspend redemptions in them until the end of March, at which time it would re-evaluate market conditions. (Citadel did reimburse investors for most of the fees they paid in 2008.) Other big-name funds, including Thomas Steyer’s Farallon and Paul Tudor Jones’s BVI Global, also limited redemptions. Even Über-trader Steve Cohen’s SAC Capital put a chunk of investors’ money in a “side pocket,” meaning that they can’t take it out, although SAC did say it would try to get people their money in 2009.

SAC Capital founder and chief Steven Cohen, whose fabulous art collecton includes works by Picasso and Pollock.

Managers who employ gates defend the practice on the grounds that it’s within their legal rights, and that selling their positions to meet redemption requests would be unfair to those investors who wanted to stay. But the widespread impression among investors is that managers broke a social contract and are doing it to save their own skins. And there may be another reason for the gates. Fortress’s documents, for instance, disclose that “our funds have various agreements that create debt or debt-like obligations … with a material number of counterparties. Such agreements in many instances contain covenants or ‘triggers’ that require our funds to maintain specified amounts of assets under management.” (The firm says it renegotiated those deals, and has already returned 70 percent of investors’ money. The rest of it will be paid out over the next 18 months.)

Other hedge-fund managers who do not employ gating are outraged, in part because the practice has hurt them. “It is the stupidest thing I have ever seen my industry do,” says Jim Chanos, who runs a well-known hedge-fund firm called Kynikos Associates, which specializes in short-selling. “It’s given rise to the worst fears—that hedge funds are a roach motel.” He also says that, while his fund was up more than 50 percent last year, he has gotten redemption requests for 20 percent of his assets—not because investors want to cash out, but because they can’t get money anywhere else. “I am an A.T.M. machine,” he says, in a comment that was repeated to me by many other managers.

Others in the industry also say that preventing investors from taking their money out is nothing short of an admission that the assets in the fund can’t be sold as they are currently valued. One manager tells me that he has a debt security that he is valuing at 50 cents on the dollar. He knows another fund that is marking the identical security at 90 cents on the dollar.

This means that the headline number for the industry—down 18 percent—may not be an accurate read. (In fairness, this is probably not an issue for hedge funds that deal mostly in actively traded securities.) One manager laughs when I ask him if 18 percent is really the right number. “It’s way worse,” he says. “Way worse.”

Whether they’re down 18 percent or more, many managers are subject to so-called high-water marks, according to which they agree to waive performance fees until they have made back investors’ money. This can make it hard for a fund to stay in business, because there’s no money coming in to pay employees. As Fortress’s filings note, some of its funds “face particular retention issues with respect to investment professionals whose compensation is tied, often in large part, to performance thresholds.”

You might ask where these people are going to go. “There is a purge on Wall Street,” says York Capital’s Parish. “The new dream job is a salary, health care, and Jamie Dinan buys you lunch every day.”

“Five years ago, if you’d gone to start a fund, people would have fought over you,” says another manager. “Now they won’t return your phone call.”

Nor is it clear when the purge will be over. In the coming year, private-equity firms will ask investors to pony up more capital, which will force more redemptions from hedge funds. People may also try to redeem in order to pay their taxes. “No silver lining in any of this cloud,” says a hedge-fund trader. “The first quarter of 2009 is going to be another eyepopper for the industry.”

As another manager says to me dryly, “The new $500 million is $50 million.”

It isn’t clear what the future holds for Fortress. In my admittedly 100 percent unscientific survey of the industry, I found that redemption requests are usually unrelated to the size of a fund’s losses, and may have more to do with how investors feel about a particular manager, or about their need for cash.

While there are complaints that the Fortress principals are arrogant, there are clearly a lot of people who are willing to trust them with their hard-earned cash. Even during the meltdown of 2008, the firm raised a net $6.2 billion in new capital for its funds, a figure that includes $3 billion Briger raised during the tumultuous month of November.

Some of those familiar with Fortress say that while in the good times the people who worked there got along—who wouldn’t, when the money is flowing?—the culture has turned brutal. “Hell,” one hedge-fund manager puts it succinctly. Just before things turned truly rotten, Fortress committed more than $300 million to the film finance company, Grosvenor Park, which last summer released the genre spoof Disaster Movie. “I think they are starring,” jokes a former investor.

But, for now, it appears that the principals are sticking together. Fortress’s filings note that several of its funds have “keyman” provisions, meaning that if one or more of the principals ceased to be actively involved in the business, that could give investors the right to get their money out—and, in the case of some of the hedge funds, might result in the acceleration of the debt. There are rumors that the principals might, as Cooperman predicted, buy their company back from the public. But it isn’t clear how they’d repay the $675 million in debt on the balance sheet at the end of the third quarter.

Fortress, for its part, denies any issues. “I have known Pete [Briger] for 15 years. I talk to Pete 20 times a day,” says Edens. “Any notion of divisiveness or a split is absurd.” Nor, in truth, does Edens seem like the kind of guy who would give up easily. He comes in early in the morning, works until late at night, and often spends his weekends at the office. He’d be the first to say that he doesn’t cure cancer or teach kids to read, but as he puts it, “I do take pensioners’ money and try to give them back a good return.”

For those basking in Schadenfreude—and, oh, it’s hard not to—it is unlikely that hedge funds are going away. “Our cynicism has bounds,” says AQR’s Asness. “We don’t think that no one has skill. It’s just that skill is more scarce than the hedge-fund industry sold it as.” There are plenty of funds, from the well known to the not so well known, that did just what they promised, even last year. Star manager Bruce Kovner’s Caxton fund returned a reported 13 percent. The tiny Bearing Fund, which is managed by Kevin Duffy, returned 72 percent in 2007 and 134 percent in 2008—net of fees.

And even for the funds that did lose big sums, some have loyal investors who have made enough over time that they’re willing to forgive one bad year. One manager, who posted a loss of more than 20 percent last year, says that 82 percent of his investors have been with him for more than five years. “I have gotten more handwritten notes saying, ‘Hang in there,’” he says. Another manager points to Steve Mandel, of Lone Pine Capital, who lost money last year—but got requests for only a sliver of the capital he manages. “That says it all,” says another manager.

Says Cooperman, despite his criticism of the industry, “They weren’t the gods you made them into, but they aren’t the whale turds they’re being portrayed as now.”

It’s also worth noting that, despite all the problems in hedge-fund land and the clamor for more regulation (and there will be more regulation), you don’t see any hedge-fund managers in Washington with their hands outstretched for a piece of the bailout pie.

Some managers, like Edens, even argue that, for those who survive the current shakeout, the future is more golden than ever before. After all, many hedge funds are gone, as are the in-house trading desks at many Wall Street firms that served as competitors to hedge funds. Meanwhile, opportunity abounds.

The hedge-fund king is dead. Long live the hedge-fund king.

Bethany McLean is a Vanity Fair contributing editor.

If only there were a Madoff to blame for the meltdown

2009-03-14T02:25:00.000-07:00

By Bethany McLean

The Guardian, March 14, 2009

http://www.guardian.co.uk/commentisfree/2009/mar/14/bernard-madoff-punished-crime

It would be therapeutic to nail the bad guys of the global collapse. We can't, of course - because there are just too many of them

On Thursday Bernard Madoff, the architect of what prosecutors now say was a $65bn Ponzi scheme, agreed to plead guilty to 11 criminal charges. Lawyers say Madoff, who is now 70, will probably spend the rest of his life in jail.

We should be grateful to Bernie Madoff. Seriously. I say that because he provides a target for our bloodthirst, our search for someone who can be held responsible for the overnight evaporation of what was supposed to be billions of dollars in wealth. There's something satisfying about the story of a villain and his victims when, in the end, the villain gets punished. Unfortunately, we may never get this same satisfaction out of the search to punish those who are responsible for the wreckage of the global financial system.

There are some unanswered questions about Madoff, such as who else might have been involved, but at its heart, his story is one of straightforward fraud. Madoff stole innocent people's money. He knows he's a bad guy who did bad things. "I am actually grateful for this opportunity to publicly comment about my crimes, for which I am deeply sorry and ashamed," he told US district judge Denny Chin. "I cannot adequately express how sorry I am for my crimes." Those at the packed hearing even got to see Madoff in handcuffs!

In contrast, a lot of what feels like white collar crime is actually "white collar how the hell isn't this a crime". That's because the rules and regulations of business and accounting leave large gaps between ethical wrongdoing and criminal actions. In the case of Enron, much of what shocked the public about the company was perfectly legal. Enron excelled at using the rules in order to camouflage reality.

Nor is there always a clear separation between villains and victims. Enron wouldn't have been possible without the Wall Street bankers who devised and executed some of its most insanely creative financial manoeuvres. Nor would it have been possible if the analysts at Wall Street firms and credit-rating agencies had done their jobs and actually analysed the business - and it wouldn't have happened without the suspension of disbelief on the part of investors.

There's also usually a hefty dose of self-delusion involved in white-collar crime. People try to cover up a minor problem, only to have the problem - and the cover-up - snowball. They convince themselves that the inevitable bad end won't come. Neither Jeffrey Skilling nor Kenneth Lay actually wanted to bankrupt Enron. There are echoes of this in the Madoff scandal. In Madoff's plea, he said: "When I began the Ponzi scheme, I believed it would end shortly and I would be able to extricate myself and clients from the scheme. This proved to be difficult and ultimately impossible." What distinguishes Madoff is that he actually said he's sorry. Often, the self-delusion continues even after the day of reckoning, resulting in people who did bad things but will never believe they did, and will never say they're sorry.

Much like in the Enron affair, the main causes of the current crisis are jaw-dropping to lay people, but they aren't crimes. That mortgages were given to people who couldn't afford them isn't illegal. That sub-prime mortgages could be repackaged into top-rated securities is sheer insanity - but it, too, isn't illegal. That Wall Street chiefs and traders could make enormous sums based on profits that turned out to be largely illusory is sickening. But again, it isn't illegal.

As for self-delusion, well, there was plenty of that at work, and there still is. People believed the good times wouldn't end. There have been a few instances of people who have come forward to say they aren't proud of their actions, but my guess is we won't see much accepting of accountability or many Madoff-like apologies.

This isn't to say there won't be people who get public hangings. Ralph Cioffi, who ran the ill-fated Bear Stearns hedge funds, has been indicted for allegedly misrepresenting the health of the funds to investors. Merrill Lynch is being investigated by Andrew Cuomo, the New York attorney general, for allegedly misleading Congress about the timing of its bonuses. The FBI is after other cases. But Cioffi's fund didn't cause the collapse of the entire system, and holding Merrill Lynch accountable won't make the bonuses that other Wall Streeters earned go away.

There will be no truly satisfying resolution, because too many of the actors in this terrible drama - from homeowners who took out mortgages they couldn't afford to mortgage companies who sold those products, to Wall Street firms who packaged them up, to the rating agencies who slapped "ultra-safe" on them, to investors who bought securities they couldn't analyse, to regulators who looked the other way - have dirty hands.

As a culture, we don't know how to deal well with blame that should be broadly distributed, instead of narrowly targeted. So try to find some satisfaction in Bernie Madoff's prison sentence. It's a nice reminder that sometimes, there is one really bad guy, and sometimes, he does get punished.

• Bethany McLean is a contributing editor at Vanity Fair and co-author of The Smartest Guys in the Room

FDIC forgot to collect premiums

2009-03-12T11:05:00.001-07:00

Now-needy FDIC collected little in premiums

http://www.boston.com/news/nation/washington/articles/2009/03/11/now_needy_fdic_collected_little_in_premiums

With fund going strong, banks didn't pay for decade

By Michael Kranish, Globe Staff | March 11, 2009

WASHINGTON - The federal agency that insures bank deposits, which is asking for emergency powers to borrow up to $500 billion to take over failed banks, is facing a potential major shortfall in part because it collected no insurance premiums from most banks from 1996 to 2006.

The Federal Deposit Insurance Corporation, which insures deposits up to $250,000, tried for years to get congressional authority to collect the premiums in case of a looming crisis. But Congress believed that the fund was so well-capitalized - and that bank failures were so infrequent - that there was no need to collect the premiums for a decade, according to banking officials and analysts.

Now with 25 banks having failed last year, 17 so far this year, and many more expected in the coming months, the FDIC has proposed large new premiums for banks at the very time when many can least afford to pay. The agency collected $3 billion in the fees last year and has proposed collecting up to $27 billion this year, prompting an outcry from some banks that say it will force them to raise consumer fees and curtail lending.

To possibly reduce the fee increase, the FDIC has asked Congress for the temporary authority to borrow as much as $500 billion from the US Treasury - up from the current $30 billion limit - in case the number of bank failures increases even more dramatically. If Congress approves the measure, to borrow more than $100 billion, the FDIC would still need permission from the Federal Reserve, the Treasury Department, and the White House.

As of Dec. 31, the FDIC had $18.9 billion in its insurance fund - down from $52.4 billion a year earlier - in addition to $22 billion that it has set aside for pending bank failures. The agency has projected it will need $65 billion to take over failed banks through 2013.

But if the FDIC suddenly had to take over a giant bank such as Citigroup or Bank of America, the fund would be drained "in a flash," said Cornelius Hurley, director of the Boston University law school's Morin Center for Banking and Financial Law.

Last week, FDIC chairwoman Sheila Bair wrote to Senate Banking Committee chairman Christopher Dodd, a Connecticut Democrat, that her agency could need more money because the existing fund "provides a thin margin of error" given the government's responsibility "to cover unforeseen losses." The March 5 letter, provided to the Globe, said the additional borrowing authority is necessary to "leave no doubt" that the FDIC can "fulfill the government's commitment to protect insured depositors against loss."

Bair said yesterday that the agency's failure to collect premiums from most banks "was surprising to me and of concern." As a Treasury Department official in 2001, she said, she testified on Capitol Hill about the need to impose the fees, but nothing happened. Congress did not grant the authority for the fees until 2006, just weeks before Bair took over the FDIC. She then used that authority to impose the fees over the objections of some within the banking industry.

"That is five years of very healthy good times in banking that could have been used to build up the reserve," Bair, a former professor at the University of Massachusetts at Amherst, said in an interview. "That is how we find ourselves where we are today. An important lesson going forward is we need to be building up these funds in good times so you can draw down upon them in bad times."

Hurley agreed with Bair's analysis of the FDIC's dilemma. "Typically you would build up a reserve during the halcyon days to protect yourselves during a recession," he said, calling the decision to stop collecting most premiums "a political one" that was pushed by banks and not based on strict accounting principles.

But James Chessen, chief economist of the American Bankers Association, said that it made sense at the time to stop collecting most premiums because "the fund became so large that interest income on the fund was covering the premiums for almost a decade." There were relatively few bank failures and no projection of the current economic collapse, he said.

"Obviously hindsight is 20-20," Chessen said.

House Financial Services Committee chairman Barney Frank agreed that officials believed at the time that the good times would last and that bank failures would not be a problem.

"We had this period where we had no failures," the Massachusetts Democrat said in an interview yesterday. "The banks were saying, 'Don't charge us anything.' "

Last October, to help restore confidence during the financial meltdown, Congress and then-President Bush agreed to raise the insured amount from $100,000 to $250,000 per depositor until Dec. 31, 2009. A small portion of the new fees on banks will go toward supporting that increase.

The FDIC has never failed to make good on its promise to pay for the insured deposits when a bank fails, and officials said that will not change. The fund ran short of money during the savings and loan crisis of the 1980s, prompting the agency to increase fees to make up for the shortfall.

Then, a booming economy left banks flush with cash, and by 1996 the insurance fund was considered so large that it could grow through interest payments and fees charged only to banks with high credit risk. Congress agreed that premiums didn't need to be collected if the fund was sustained at a level that was considered safe. Thus, about 95 percent of banks paid no premiums from 1996 to 2006, including some new ones that did not have to pay a premium, the FDIC said.

Congress mandates that the insurance fund must stay between 1.15 percent and 1.5 percent of all insured deposits. The reserve ratio on Dec. 31 was 0.40 percent, down from 1.22 percent at the end of 2007. The FDIC has increased premiums to increase the reserve ratio, as well as proposing a one-time emergency assessment that could raise as much as $15 billion.

The Looting of America’s Coffers

2009-03-12T00:01:00.001-07:00

http://www.nytimes.com/2009/03/11/business/economy/11leonhardt.html

By DAVID LEONHARDT

Sixteen years ago, two economists published a research paper with a delightfully simple title: “Looting.”

The economists were George Akerlof, who would later win a Nobel Prize, and Paul Romer, the renowned expert on economic growth. In the paper, they argued that several financial crises in the 1980s, like the Texas real estate bust, had been the result of private investors taking advantage of the government. The investors had borrowed huge amounts of money, made big profits when times were good and then left the government holding the bag for their eventual (and predictable) losses.

In a word, the investors looted. Someone trying to make an honest profit, Professors Akerlof and Romer said, would have operated in a completely different manner. The investors displayed a “total disregard for even the most basic principles of lending,” failing to verify standard information about their borrowers or, in some cases, even to ask for that information.

The investors “acted as if future losses were somebody else’s problem,” the economists wrote. “They were right.”

On Tuesday morning in Washington, Ben Bernanke, the Federal Reserve chairman, gave a speech that read like a sad coda to the “Looting” paper. Because the government is unwilling to let big, interconnected financial firms fail — and because people at those firms knew it — they engaged in what Mr. Bernanke called “excessive risk-taking.” To prevent such problems in the future, he called for tougher regulation.

Now, it would have been nice if the Fed had shown some of this regulatory zeal before the worst financial crisis since the Great Depression. But that day has passed. So people are rightly starting to think about building a new, less vulnerable financial system.

And “Looting” provides a really useful framework. The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.

Promised bailouts mean that anyone lending money to Wall Street — ranging from small-time savers like you and me to the Chinese government — doesn’t have to worry about losing that money. The United States Treasury (which, in the end, is also you and me) will cover the losses. In fact, it has to cover the losses, to prevent a cascade of worldwide losses and panic that would make today’s crisis look tame.

But the knowledge among lenders that their money will ultimately be returned, no matter what, clearly brings a terrible downside. It keeps the lenders from asking tough questions about how their money is being used. Looters — savings and loans and Texas developers in the 1980s; the American International Group, Citigroup, Fannie Mae and the rest in this decade — can then act as if their future losses are indeed somebody else’s problem.

Do you remember the mea culpa that Alan Greenspan, Mr. Bernanke’s predecessor, delivered on Capitol Hill last fall? He said that he was “in a state of shocked disbelief” that “the self-interest” of Wall Street bankers hadn’t prevented this mess.

He shouldn’t have been. The looting theory explains why his laissez-faire theory didn’t hold up. The bankers were acting in their self-interest, after all.

•

The term that’s used to describe this general problem, of course, is moral hazard. When people are protected from the consequences of risky behavior, they behave in a pretty risky fashion. Bankers can make long-shot investments, knowing that they will keep the profits if they succeed, while the taxpayers will cover the losses.

This form of moral hazard — when profits are privatized and losses are socialized — certainly played a role in creating the current mess. But when I spoke with Mr. Romer on Tuesday, he was careful to make a distinction between classic moral hazard and looting. It’s an important distinction.

With moral hazard, bankers are making real wagers. If those wagers pay off, the government has no role in the transaction. With looting, the government’s involvement is crucial to the whole enterprise.

Think about the so-called liars’ loans from recent years: like those Texas real estate loans from the 1980s, they never had a chance of paying off. Sure, they would deliver big profits for a while, so long as the bubble kept inflating. But when they inevitably imploded, the losses would overwhelm the gains. As Gretchen Morgenson has reported, Merrill Lynch’s losses from the last two years wiped out its profits from the previous decade.

What happened? Banks borrowed money from lenders around the world. The bankers then kept a big chunk of that money for themselves, calling it “management fees” or “performance bonuses.” Once the investments were exposed as hopeless, the lenders — ordinary savers, foreign countries, other banks, you name it — were repaid with government bailouts.

In effect, the bankers had siphoned off this bailout money in advance, years before the government had spent it.

I understand this chain of events sounds a bit like a conspiracy. And in some cases, it surely was. Some A.I.G. employees, to take one example, had to have understood what their credit derivative division in London was doing. But more innocent optimism probably played a role, too. The human mind has a tremendous ability to rationalize, and the possibility of making millions of dollars invites some hard-core rationalization.

Either way, the bottom line is the same: given an incentive to loot, Wall Street did so. “If you think of the financial system as a whole,” Mr. Romer said, “it actually has an incentive to trigger the rare occasions in which tens or hundreds of billions of dollars come flowing out of the Treasury.”

Unfortunately, we can’t very well stop the flow of that money now. The bankers have already walked away with their profits (though many more of them deserve a subpoena to a Congressional hearing room). Allowing A.I.G. to collapse, out of spite, could cause a financial shock bigger than the one that followed the collapse of Lehman Brothers. Modern economies can’t function without credit, which means the financial system needs to be bailed out.

But the future also requires the kind of overhaul that Mr. Bernanke has begun to sketch out. Firms will have to be monitored much more seriously than they were during the Greenspan era. They can’t be allowed to shop around for the regulatory agency that least understands what they’re doing. The biggest Wall Street paydays should be held in escrow until it’s clear they weren’t based on fictional profits.

Above all, as Mr. Romer says, the federal government needs the power and the will to take over a firm as soon as its potential losses exceed its assets. Anything short of that is an invitation to loot.

Mr. Bernanke actually took a step in this direction on Tuesday. He said the government “needs improved tools to allow the orderly resolution of a systemically important nonbank financial firm.” In layman’s terms, he was asking for a clearer legal path to nationalization.

At a time like this, when trust in financial markets is so scant, it may be hard to imagine that looting will ever be a problem again. But it will be. If we don’t get rid of the incentive to loot, the only question is what form the next round of looting will take.

Mr. Akerlof and Mr. Romer finished writing their paper in the early 1990s, when the economy was still suffering a hangover from the excesses of the 1980s. But Mr. Akerlof told Mr. Romer — a skeptical Mr. Romer, as he acknowledged with a laugh on Tuesday — that the next candidate for looting already seemed to be taking shape.

It was an obscure little market called credit derivatives.

Harvard: the Inside Story of Its Finance Meltdown

2009-03-11T09:39:00.001-07:00

From Forbes.com

http://www.forbes.com/forbes/2009/0316/080_harvard_finance_meltdown.html

Bernard Condon and Nathan Vardi 03.16.09, 12:00 AM ET

Stocks were tumbling last fall as the new school year began, but at Harvard University it was as if the boom had never ended. Workers were digging across the river from Harvard's Cambridge, Mass. home, the start of a grand expansion that was to eventually almost double the size of the university. Budgets were plump, and students from middle-class families were getting big tuition breaks under an ambitious new financial aid program. The lavish spending was made possible by the earnings from Harvard's $36.9 billion endowment, the world's largest. That pot was supposed to be good for $1.4 billion in annual earnings.

Behind the scenes, though, a different story was unfolding. In a glassed-walled conference room overlooking downtown Boston, traders at Harvard Management Co., the subsidiary that invests the school's money, were fielding questions from their new boss, Jane Mendillo, about exotic financial instruments that were suddenly backfiring. Harvard had derivatives that gave it exposure to $7.2 billion in commodities and foreign stocks. With prices of both crashing, the university was getting margin calls--demands from counterparties (among them, jpmorgan Chase and Goldman Sachs) for more collateral. Another bunch of derivatives burdened Harvard with a multibillion-dollar bet on interest rates that went against it.

It would have been nice to have cash on hand to meet margin calls, but Harvard had next to none. That was because these supremely self-confident money managers were more than fully invested. As of June 30 they had, thanks to the fancy derivatives, a 105% long position in risky assets. The effect is akin to putting every last dollar of your portfolio to work and then borrowing another 5% to buy more stocks.

Desperate for cash, Harvard Management went to outside money managers begging for a return of money it had expected to keep parked away for a long time. It tried to sell off illiquid stakes in private equity partnerships but couldn't get a decent price. It unloaded two-thirds of a $2.9 billion stock portfolio into a falling market. And now, in the last phase of the cash-raising panic, the university is borrowing money, much like a homeowner who takes out a second mortgage in order to pay off credit card bills. Since December Harvard has raised $2.5 billion by selling IOUs in the bond market. Roughly a third of these Harvard bonds are tax exempt and carry interest rates of 3.2% to 5.8%. The rest are taxable, with rates of 5% to 6.5%.

It doesn't feel good to be borrowing at 6% while holding assets with negative returns. Harvard has oversize positions in emerging market stocks and private equity partnerships, both disaster areas in the past eight months. The one category that has done well since last June is conventional Treasury bonds, and Harvard appears to have owned little of these. As of its last public disclosure on this score, it had a modest 16% allocation to fixed income, consisting of 7% in inflation-indexed bonds, 4% in corporates and the rest in high-yield and foreign debt.

For a long while Harvard's daring investment style was the envy of the endowment world. It made light bets in plain old stocks and bonds and went hell-for-leather into exotic and illiquid holdings: commodities, timberland, hedge funds, emerging market equities and private equity partnerships. The risky strategy paid off with market-beating results as long as the market was going up. But risk brings pain in a market crash. Although the full extent of the damage won't be known until Harvard releases the endowment numbers for June 30, 2009, the university is already working on the assumption that the portfolio will be down 30%, or $11 billion.

The strain of market turmoil is visible in staff turnover at the management company, which axed 25% of its staff recently and is on its fifth chief in four years. Mendillo, 50, came to Harvard last July after running Wellesley's small endowment. She declines to comment. But how much blame she should get is unclear; the big bets on derivatives and exotic holdings were in place before she got there. The bad bet on interest rates--a swap in which Harvard was paying a high fixed interest rate and collecting a low short-term rate--goes back to a mandate from former Harvard president Lawrence Summers.

Jack R. Meyer, 64, a revered money manager who headed Harvard's endowment until 2005, offers a few guarded comments. "The liquidity thing most concerns me--that should not have happened," he says. Though he wasn't there at the time, Meyer says Harvard Management bought the commodity and foreign stock derivatives as a way to get exposure to those asset classes while freeing up cash to put to work elsewhere. The strategy, he says, "drained liquidity" from the endowment in recent months. "Many endowments stretched too far, and I think Harvard did as well," he says.

The endowment will remain stretched. Harvard has been counting on it to fund more than a third of its $3.5 billion operating budget. Assuming the fiscal year ends with around a $24 billion endowment value, the university will be drawing down half again as high a percentage of its assets as it did in 2004, the last time the endowment was around that size. That can't go on forever. The strain on liquidity will continue, as the private equity partnerships compel Harvard to meet billions in capital calls in future years.

Why not just unload those partnerships along with the liabilities that stick to them? Because no one wants to buy them. Private equity stakes like Harvard's are selling at 40% to 60% discounts in various markets. "Endowments will be shocked at the valuations of their [private equity] portfolios," says Stewart Massey, an endowment consultant at Massey Quick. "It's going to be an absolute bloodbath."

Harvard's woes are in some ways no different from those at other universities or in the market generally (the S&P 500 is down 37% since last July 1). "A loss in these kinds of markets is inevitable," says Michael Eisenson, a former HMC staffer who now runs private equity firm Charlesbank. The average endowment is down 23% in the five months through November, according to a university trade group.

But Harvard was supposed to be different. In the 15 years through last June it returned an annual 15.7% versus 9.2% for the S&P. Meyer landed at Harvard in 1990 after scoring big investment returns at the Rockefeller Foundation. In an unorthodox move for an endowment chief, Meyer built a Wall Street-like trading operation and managed most of HMC's money in-house. It looked like a giant hedge fund, and it had paychecks to match. A high-level HMC manager would make as much as $35 million in good years. Those sums triggered what became an annual Harvard tradition: first, the disclosure (compelled by tax laws applying to nonprofits) of the HMC bonuses, followed by an outcry led by the late William Strauss and a group of Harvard alumni from his class of 1969.

HMC not only became a place to make big bonuses, it was also where you could make a name for yourself and become a "crimson puppy," meaning launching your own private equity firm or hedge fund with Harvard's backing. One of the puppies, Jeffrey Larson, left in 2004 to start Sowood Capital. That pile of smart money cratered in 2007, losing $350 million for Harvard.

Sidebar:
The Summers Swap

By September 2005 Meyer himself decided it was time to go. Some people say it was because of the persistent criticism about bonuses, which were reduced near the end of his tenure; others say he had run-ins with former U.S. Treasury secretaries Lawrence Summers and Robert Rubin, who assumed Harvard leadership positions at the start of the decade. Meyer denies both reasons and says 16 years at Harvard was simply enough.

Meyer formed his own hedge fund, Convexity Capital, which seems to have held up well in the current market. He took with him the Harvard heads of domestic and international fixed income, and both their staffs, as well as the chief risk officer, chief technology officer and chief operating officer. The survivors were demoralized. "You walked onto the trading floor, and it was just 10% full," says someone who was there at the time. "There was a sense that if you were good, you left."

Five months later Mohamed El-Erian, now 50, took over. The son of an Egyptian diplomat, he had risen to deputy director of the International Monetary Fund before joining giant bond manager Pimco. He seemed perfect for smoothing relations between HMC and the university. Filling the hole that Meyer left was another matter.

One solution: Don't even try, just hand over all of the endowment to outside money managers. But El-Erian insisted on keeping things intact. He talked of the "structural advantages" of investing a big endowment backed by an AAA-rated university, such as allowing you to borrow at low rates when making leveraged bets. The former Pimco emerging market superstar also believed that the developing countries offered big profits to smart investors like HMC because they had become less risky thanks to ample dollar reserves and a growing middle class.

So El-Erian upped HMC's exposure to emerging market stocks, which rose from 6% of assets when Meyer left to 11% two years later. He also used total return swaps to bet on developed world stocks and commodities on the cheap, freeing up money for other investments. Tapping former Stanford endowment staffer Mark Taborsky (an "important hire," El-Erian would later write in a book), El-Erian also took money from hedge funds he didn't like and redirected it to ones he thought were winners, putting hundreds of millions into funds in Latin America, Asia and the Middle East.

The moves looked brilliant. For the year ended June 2007 Harvard returned 23% versus 17.7% for 151 other big institutional investors (and 20.6% for the S&P 500). Fearing all markets could soon fall, El-Erian injected what he referred to as "Armageddon insurance" into HMC's portfolio for the first time by buying interest rate floors, or a wager that rates would fall, and betting, via credit default swaps, that companies could soon struggle to pay their debts.

For the following year, through June 2008, Harvard gained 8.6%, versus a 13% fall in the S&P. El-Erian's insurance accounted for much of HMC's outperformance. Hedge funds, however, were sucking up cash--HMC had increased investments in those areas to 19% from 12% a year earlier. The returns were flat.

It's unclear how much of the results--good or otherwise--were El-Erian's doing. He left at the end of 2007, six months before the results came in, citing a desire to move back near his wife's family in California and return to Pimco as heir apparent to founder Bill Gross.

Since July emerging market shares have been a disaster, falling 50%, as measured by the MSCI Emerging Markets Index, worse than U.S. stocks. Another problem: El-Erian's insurance has been partly taken off since he left, leaving HMC vulnerable when markets plunged this fall. The total return swaps, which easily could have been terminated, were left alone. The EFG-Hermes Middle East North Africa Opportunities Fund, a hedge fund launched in September 2007 with some $200 million of HMC cash, was down 35% in 2008. El-Erian's big hire, Taborsky, left HMC in September. He's since joined El-Erian at Pimco. El-Erian and Taborsky decline to comment.

By the time Jane Mendillo walked into HMC's offices in July 2008, she figured some changes needed to be made. A former consultant who worked for years at HMC under Meyer, Mendillo got the HMC gig partly as a result of Meyer's recommendation. She had spent the last six years running the $1.6 billion Wellesley College endowment, which was completely outsourced to external managers. Her detractors say that she was ill prepared for Harvard's liquidity crisis and slow to take cognizance of the swap exposure. But they concede that the crisis came fast on the heels of her arrival.

Mendillo did move quickly to deal with the private equity portfolio. One of her first moves at HMC, which she initiated before the markets started to fall in earnest, was to sell between $1 billion and $1.5 billion of Harvard's private equity assets in one of the biggest such sales ever attempted. The high bids on such assets have recently been 60 cents on the dollar, says Cogent Capital, an investment bank that advised Harvard on the sale. Cogent says the big discounts are due to "unrealistic pricing levels at which funds continued to hold their investments" and "fantasy valuations."

Defenders of Harvard's portfolio argue the secondary market is discounting private equity stakes too much. The market is made up of a dozen secondary funds with at most $15 billion available, says Bryon Sheets, a partner at San Francisco secondary firm Paul Capital. That makes it a buyer's market, given the slew of desperate banks, funds and endowments looking to unload assets to meet obligations.

So what are Harvard's private equity stakes worth? Most private equity investors like Harvard have been waiting for their money managers to finish marking down their assets following a brutal 2008. It is a slow process that lags the public markets by as much as 180 days, says William Frieske, a performance consultant at Northern Trust, which administers endowment accounts.

But one clue to what may be coming can be found in Harvard's own portfolio. It owns units of Conversus Capital, a publicly traded vehicle that holds slices of 210 private equity funds. Conversus has cut its net asset value by 21% since last summer to make a "best estimate." Yet stock investors think things are a lot worse. Conversus shares have fallen 67% since June 30 and are trading at a 62% discount to the net asset value. The Conversus stock drop translates into a potential $168 million loss for Harvard, which as of Jan. 31 was still listed as a "strategic investor."

Conversus is run by Robert Long, a former Bank of America exec who went to Boston and got $250 million from El-Erian to help him set up the firm and buy $1.9 billion of Bank of America's private equity assets.

Harvard also owns a piece of Garnett & Helfrich Capital, a $350 million fund opened in 2004. Garnett has purchased six companies but five years later has yet to realize any returns. The value of one of those investments, software maker Ingres, has been reduced by its minority owner to nothing "as a result of reported losses." Then there is Tallwood Venture II, a $180 million fund raised in 2002 to invest in semiconductors. It has hardly exited any of its portfolio companies, according to Thomson Reuters and sec filings.

The fact that a fifth of HMC's portfolio is in private-equity-like investments makes it vulnerable to the kind of problems HMC faced this fall. HMC has made $11 billion of capital commitments to investment partnerships through 2018, says Moody's. HMC used to make good on those commitments with income generated by the existing private equity portfolio. "Endowments are afraid capital calls will come quickly and far ahead of any liquidity from private equity funds," says Colin McGrady, managing director at Cogent Partners.

Watching all of this, the group of ten Harvard alumni from the class of 1969 feel vindicated. "The events of the last year show that the whole procedure of rewarding people so handsomely based on increases on paper value of the endowment was deeply flawed," says a spokesman for the group, which recently sent a letter to the Harvard president suggesting HMC staffers return $21 million of their latest bonuses. "Even now we don't really know how well it has done in the last ten years."

How to avoid another failure of risk management

2009-03-09T03:09:00.001-07:00

From The Times

March 9, 2009

Shahid Chaudhri and Richard Griffiths

The failure of financial institutions to manage risk and the role this has played in creating today's economic crises has created awareness of the need for a new risk-management approach. This may well become the new Holy Grail of financial economics. There are two essential constituents: first, developing a more diverse mindset regarding financial risk; and second, applying more powerful techniques to capture financial reality than risk managers have used in the past.

A new method for risk management does not mean that all elements of the present system must be replaced or that all the discredited financial instruments they spawned should be discontinued. Discrimination is needed: Many existing techniques have validity, but only in certain market conditions; and innovative financial products can contribute to wealth creation, but only if they are used judiciously.

A new approach must start by understanding the reasons for the failure of risk-management systems. Why did risk models grossly understate risks? Why did managements fail to understand this? And why did regulators fail to provide effective checks and balances against the banks' risk-management mistakes?

Financial risks were understated partly because the world economy enjoyed a long period of moderate growth and low financial volatility and this “great moderation” was wrongly assumed to be a permanent benefit of prudent central banking.

But there was a more fundamental error. Risk-management models used in banks were generally based on the simplified assumption that markets fluctuated randomly following a “normal” statistical distribution. This implied very low probabilities of extreme losses, ignoring financial history. Even complex models used to price more esoteric products such as credit derivatives were based on the same weak foundations — for example, using simulations based on random numbers, which in turn assumed a normal distribution.

Many of these simplistic models grew out of Modern Portfolio Theory (MPT), which was developed half a century ago and proved highly seductive due to its simplicity and ease of computation. While MPT was useful in stable markets, it failed in extreme market conditions. More advanced techniques were developed to anticipate successions of extreme events, but these were largely ignored. Even hedge funds and investment banks that used sophisticated techniques for their trading strategies still relied on “normal” distributions for their risk management reports. This produced over-optimistic risk-return profiles and may have contributed to the excessive leverage employed.

Risk managers proved as inadequate as their models for reasons familiar from behavioural economics: emphasis was placed on precise-sounding numbers from quantitative models, while non-quantitative judgments based on experience were ignored. And although risk models produced useful numbers, managements often failed to interpret these objectively, instead applying wishful thinking. For example, extreme events such as the 1987 stock market crash, or the Long-Term Capital Management collapse in 1998, which clearly invalidated the assumptions of conventional risk models — but these were either disregarded or rationalised later as “exogenous shocks”.

Finally, there was the failure of external regulators and rating agencies to monitor the banks' risk-controls. Despite deficiencies in bank management, some of the problems could have been averted with stronger checks and balances from the regulatory bodies charged to assess risk. But rating agencies undervalued risk when assessing new products. And regulators ignored the dangers of macroeconomic contagion, as well as failing to apply any independent checks to the risk models used by banks.

One driving force behind these policy errors was competition between governments to attract financial businesses with “light-touch” regulations. Another was excessive faith among regulators in investment bankers' skills. Risk-management methods developed long ago by investment banks, for example the normally distributed Value at Risk (VAR) models, were treated by regulators as a “gold standard” — long after sophisticated financial institutions had recognised their limitations and moved on.

What reforms in risk management are needed to overcome these limitations? The key is to combine quantitative statistical methods with qualitative, or judgmental, assessments — and then to use a multi-prong strategy, involving a wide variety of methodologically independent approaches, to reach comprehensive conclusions about financial risk. When several approaches highlight similar risks, these can be flagged. Because financial uncertainty evolves in many unexpected ways, no single model will work all the time and new approaches will be required.

A good guiding principle is a “none and all” mindset. This means that no approach is ever used exclusively and all approaches are respected for what they may contribute. A simple macroeconomic example might be the ratio of debt to GDP. The growth of this ratio to historic highs in many countries was not on its own a conclusive reason to tighten regulation, but simply ignoring this warning signal violated the rule that “all” models should be considered in judging financial risks. Such qualitative judgments may create “soft” risk management boundaries, but nonetheless are important in detecting the irrational and subjective elements in market behaviour. To avoid future disasters, regulators and managers must use such “soft” qualitative approaches alongside “hard” statistical tools.

Equally urgently, the financial world must embrace new mathematical techniques that capture market reality better than standard models.

One such approach, developed at Imperial College by Nicos Christofides, uses techniques from control engineering, including neural networks and dynamic programming to produce mathematically complex but highly intuitive results. This approach is visualised through a State Transition Graph (STG) — a path of possible future price movements with probabilities assigned to each outcome. An STG can be developed for any combination of traded assets and based on long periods of historical data, including several market dislocations. STGs produce probability distributions of future price moves, which, in contrast to standard models, do not assume continuous or “normally” distributed market movements.

By mixing continuous market behaviour with discontinuous market disruptions, STG models can produce realistic probabilities of large “shocks”. They allow illiquidity risks to be considered and produce natural clusters of volatile periods. They reflect precisely the high-risk conditions that can arise in turbulent markets, but which standard models ignore. The success of STG models has been demonstrated by their performance in the credit crunch, as well as in retrospective testing on the 1987 stock market, with the statistical analysis restricted to data before each event.

The STG is only one of several innovative approaches developed in recent years by academics and sophisticated financial institutions, but largely disregarded by bank managements and regulators. Instead, traditional risk-management models have continued to be employed, even though they are known not to work. To avoid a recurrence of the present crisis, this narrow-minded attitude must change. Risk management must be reformed not by seeking a new “right” answer to replace discredited VAR models, but by creating a broader mindset — what we call the “none and all” approach.

No risk model should be relied on completely and all evidence should be taken into account. Without such an inclusive approach, even the most powerful models will fail us, at least at certain times. But with a more comprehensive understanding of risk, involving both advanced quantitative models and “soft” qualitative judgments, the chances of avoiding future financial catastrophes could be much improved.

- Shahid Chaudhri and Richard Griffiths are founding partners of Innovation4Now, a risk-management consultancy

AIG Told U.S. Failure Would Cripple World’s Banks, Money Funds

2009-03-09T03:02:00.001-07:00

By Hugh Son and Scott Lanman

March 9 (Bloomberg) -- American International Group Inc. appealed for its fourth U.S. rescue by telling regulators the company’s collapse could cripple money-market funds, force European banks to raise capital, cause competing life insurers to fail and wipe out the taxpayers’ stake in the firm.

AIG needed immediate help from the Federal Reserve and Treasury to prevent a “catastrophic” collapse that would be worse for markets than the demise last year of Lehman Brothers Holdings Inc., according to a 21-page draft AIG presentation dated Feb. 26, labeled as “strictly confidential” and circulated among federal and state regulators.

“What happens to AIG has the potential to trigger a cascading set of further failures which cannot be stopped except by extraordinary means,’’ said the presentation by New York- based AIG. “Insurance is the oxygen of the free enterprise system. Without the promise of protection against life’s adversities, the fundamentals of capitalism are undermined.’’

Regulators revised AIG’s bailout last week to ease loan terms and extend $30 billion in fresh capital after the firm posted a $61.7 billion fourth-quarter loss, the worst in U.S. corporate history. Lawmakers are reluctant to give more support beyond the package already in place, worth about $160 billion, because they say regulators haven’t given enough detail about how the funds are being used or when the bailouts will end.

The Fed is “asking for an open-ended check’’ and is “not going to get” it, Senator Robert Menendez, a New Jersey Democrat, said last week in Congressional hearings.

Global Impact

AIG warned of turmoil around the globe if the government allowed the insurer to fail, adding “it is questionable whether the economy could tolerate another shock to the system that a failure of AIG would produce.” The value of the U.S. dollar might fall, Treasury borrowing costs could rise and the agency would face “doubts about the ability of the U.S. to support its banking system,” according to the presentation, parts of which were reported earlier by the New York Times.

Under the scenarios sketched by AIG, European banks that bought credit-default swaps might need to raise $10 billion in capital and could face rating downgrades. Life insurance customers, their faith shaken in the industry, would redeem some of their $19 trillion in U.S. policies, overwhelming firms already weakened by the credit crisis, AIG said.

The $38 billion in support provided by the firm to money- market funds would be in jeopardy, AIG said, possibly forcing some to “break the buck.’’ The term refers to a money fund that suffers losses so large that it must pay investors less than the traditional $1-a-share value that gives the short-term funds their reputation for safety.

Overseas Seizures

Outside the U.S., where AIG operates in more than 140 countries, a collapse could lead to the “immediate seizure’’ of its businesses by regulators and could impair “the entire insurance industry within certain regions,’’ the presentation said, which added that its conclusions were “speculative’’ and a matter of judgment.

“Who knows if what they’re saying is true?’’ said Phillip Phan, professor of management at the Johns Hopkins Carey Business School in Baltimore. “A lot of it sounds like conjecture, that if AIG collapses the rest of the industry will, too. It’s a way of creating a crisis atmosphere and the sense you have to respond quickly.’’

AIG’s latest rescue package includes equity, new credit and lower interest rates on existing loans designed to keep it in business. Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Timothy Geithner have said the government must prop up AIG to avoid damaging the financial system.

Fed spokeswoman Michelle Smith said the central bank “came to its conclusions based on our own analysis.” Christina Pretto, an AIG spokeswoman and Isaac Baker of the Treasury didn’t immediately have a comment.

Bailout Beneficiaries

New York Insurance Superintendent Eric Dinallo said at a March 5 hearing he’d received the presentation.

The document doesn’t say which other companies have benefited from AIG’s repeated rescues. Goldman Sachs Group Inc. and Deutsche Bank AG were among at least two dozen financial institutions that were paid $50 billion from the bailout funds received by AIG, the Wall Street Journal reported, citing a confidential document and people familiar with the matter whom it didn’t identify.

Goldman and Deutsche got about $6 billion each between September and December, the Journal said. Merrill Lynch & Co., Societe Generale SA, Morgan Stanley, Royal Bank of Scotland Group Plc and HSBC Holdings Plc were other counterparties that also received payments, the newspaper said, citing the document.

Taxpayer Wipeout

AIG’s presentation said that without more U.S. help, investment losses would mean “AIG will not be able to repay its obligations” and that cash previously provided by the U.S., which controls a 79.9 percent stake in the insurer, could be lost. Chief Executive Officer Edward Liddy, who took over the top job in September, has vowed that AIG will repay all of its debts to taxpayers.

At AIG itself, failure could have led to dismissals from its workforce of 116,000, the document said. At that level, the staff is unchanged from the end of 2007 before AIG’s bailout. The global credit crunch has led to at least 284,000 job cuts at the rest of the world’s financial companies, according to Bloomberg data.

The insurer’s first bailout package, crafted last September, later grew to $150 billion. After failing to sell enough subsidiaries to repay the government, AIG had to turn to U.S. taxpayers again. The company may need more support if financial markets don’t improve, the Treasury and Federal Reserve said last week in a joint statement.

To contact the reporters on this story: Hugh Son in New York at hson1@bloomberg.net; Scott Lanman in Washington at slanman@bloomberg.net.

Last Updated: March 9, 2009 00:15 EDT

Depression Dynamic Takes Hold as Markets, Banks Revisit 1930s

2009-03-09T02:46:00.001-07:00

By Rich Miller

March 9 (Bloomberg) -- The U.S. economy’s vital signs may not confirm a diagnosis of depression. The symptoms increasingly point to one.

As in the Great Depression, world trade is collapsing, wealth is evaporating and the banking system is broken. Deflation is a growing threat as companies slash production, pay and prices. And leaders worldwide are having difficulty making headway in halting the self-perpetuating decline.

“We are tracking 1929-1930,” says Barry Eichengreen, a professor of economics and political science at the University of California, Berkeley.

The result: This contraction may leave a lasting imprint on the economy and society, just as the Depression did. In the wake of the devastation of the 1930s, Americans swore off stocks, husbanded their own resources and looked to the government for help. Now, another generation might draw some of the same lessons from the deepest economic collapse of their lifetime.

“This is going to scar the collective psyche,” says Mark Zandi, chief economist at Moody’s Economy.com in West Chester, Pennsylvania. “People will become much more conservative in borrowing, lending and investing.”

There’s no official definition of what qualifies as a depression. In the 1930s, the unemployment rate rose to 25 percent and the economy shrank by more than a quarter.

No economist forecasts a return to the breadlines and shantytowns of that era, even as the economy gets closer to some of the metrics academics cite as constituting a depression, if not a “great” one.

Little Likelihood

Nobel Prize-winning economist Robert Barro defines a depression as a 10 percent fall in per-capita gross domestic product and consumption. The Harvard University professor sees roughly a 30 percent chance of that occurring now.

The economy contracted at a 6.2 percent annual rate in the last quarter of 2008 and will shrink at a 7 percent rate in the first three months of 2009, projects Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. in New York.

Bradford DeLong, a former Treasury official who is now a professor at Berkeley, says a depression is a two-year period with unemployment at 10 percent or above. He says that’s possible, though not likely. The jobless rate rose to 8.1 percent in February, a 25-year high.

Some industries are already in a depression, led by housing, where the decline accelerated in recent months as the credit crisis intensified. During the last four years, residential investment is down by 37 percent. That compares with an 80 percent drop in spending on home building from 1929 to 1932.

‘Most Difficult’

“The past five months have been among the most difficult in U.S. economic history,” Robert Toll, chief executive of Horsham, Pennsylvania-based Toll Brothers Inc., said Feb. 11, after the largest U.S. luxury homebuilder reported a 51 percent sales drop.

In the auto industry, U.S. sales have fallen 55 percent from their July 2005 peak. Production of cars and trucks plunged in January to an annual rate of 3.9 million, the lowest since the Federal Reserve began keeping records in 1967, and 67 percent below the January 2005 level.

Things are so bad that auditors have questioned the ability of General Motors Corp., the biggest U.S. automaker, to continue as a going concern.

U.S. motor vehicle output slumped 75 percent from 1929 to 1932, according to statistics in the book “American Automobile Workers 1900-1933,” by Joyce Shaw Peterson.

‘Automotive Depression’

“We are in an automotive depression,” said Efraim Levy, an equity analyst for Standard & Poor’s in New York.

The financial-services industry has also been decimated. Since the crisis began in the middle of 2007, institutions worldwide have racked up $1.2 trillion in credit losses and writedowns. Announced job cuts have topped 280,000.

“You’ve had a major disruption of the financial system, just like the 1930s,” says Mark Gertler, a New York University professor who collaborated on research about the Depression with Fed Chairman Ben S. Bernanke. In the 30s, more than 10,000 banks went bust.

That disruption is making it hard for Bernanke and his fellow policy makers to get much traction in their efforts to stop the economic decline. Strapped with losses, banks are hoarding capital rather than lending.

This type of breakdown happens only two or three times a century and can lead to a “downward vortex” in which weaknesses in the economy and the financial industry feed on each other and are difficult to break, Lawrence Summers, director of the White House’s National Economic Council, said Feb. 26. “It’s the kind of vicious cycle Franklin Roosevelt talked about,” he told a forum in Arlington, Virginia.

Collapse of Jobs Market

Particularly worrying, says Stanford University professor Robert Hall, is the collapse of the jobs market. Over the past four months, payrolls have plunged 2.6 million.

Summers has also voiced concern about a return of deflation, which wreaked havoc on the economy during the Great Depression. As wages fell back then, workers had a harder time paying their debts, aggravating the banking industry’s woes.

In an echo of those troubles, GM, FedEx Corp. and casino company Wynn Resorts Ltd. are among businesses slashing pay for more than 100,000 workers as they cut costs to counter declining demand.

There are other echoes. Since hitting a peak in October 2007, the Dow Jones Industrial Average has fallen 54 percent. Over a similar length of time -- from 1929 to 1931 -- the average fell 55 percent. It ultimately dropped 89 percent from its 1929 high before beginning to recover in mid-1932.

Stock Market Free-Fall

Combined with collapsing house prices, the free-fall in the stock market will destroy $23 trillion worth of U.S. wealth, reckons Lawrence Lindsey, a former senior White House official who now heads his own consulting company in Arlington, Virginia.

Like the Great Depression, the current economic decline is global. The International Monetary Fund says this will be the first time since World War II that the U.S. and other industrial nations will suffer a simultaneous decline in their economies.

Worldwide trade is falling fast as the credit crunch curbs financing for exporters and importers. The volume of merchandise trade plunged at an annual rate of 22 percent in the fourth quarter from the third, according to the CPB Netherlands Bureau for Economic Policy Analysis. The peak-to-trough decline from 1929 to 1932 was 35 percent, as countries slapped big tariffs on imports.

“We’re in a depression, and we need policy makers to make the right decisions to ensure that it does not become great,” says Kevin H. O’Rourke, a professor at Trinity College in Dublin, who has studied the trade issue.

Quicker Response

Government officials, especially in the U.S., are moving more rapidly to tackle the turmoil than their counterparts did during the early years of the Great Depression. Bernanke has cut the benchmark interest rate to as low as zero, while President Barack Obama won congressional approval of a $787 billion stimulus package.

Massachusetts Institute of Technology professor Peter Temin says the trouble is that the economy seems to be collapsing faster than policy makers are reacting. “They’ve only done enough to cushion the downturn,” says Temin, author of the book “Lessons from the Great Depression.”

That leaves the U.S. -- and the rest of the world economy - -in danger of being mired in an extended period of little or no growth, much like that which afflicted Japan during the 1990s. Eichengreen says such an outcome would be equivalent to a depression.

Enduring Marks

Whatever it’s called, the economy’s continuing deterioration will likely leave enduring marks. U.S. households are already rebuilding savings in response to the crisis. The savings rate rose to 5 percent in January, the highest in almost 14 years.

“They’re buying what they need, and they’re being very smart about how they spend their money,” Myron Ullman, chief executive officer of Plano, Texas-based J.C. Penney Co., said on Feb. 20, after the third largest U.S. department-store chain forecast its first quarterly loss in almost five years.

In a Feb. 27 memo, “The Return of the Frugal Consumer,” Goldman Sachs economist Andrew Tilton projected a savings rate exceeding 8 percent by the end of 2010.

Americans may also turn more conservative about where they keep their money. Merrill Lynch & Co. says U.S. bonds owned by individuals likely will account for 2 percent of households’ financial assets by 2013, up from 0.2 percent now.

“We’re in the midst of a massive economic and financial crisis,” former Fed Chairman Paul Volcker said at a Columbia University conference on Feb. 20. “We’re going to hear reverberations about this for a long time.”

To contact the reporter on this story: Rich Miller in Washington rmiller28@bloomberg.net

Last Updated: March 8, 2009 20:00 EDT

Willem Buiter - worth reading despite some difficult terminology

2009-03-06T02:00:00.000-08:00

The unfortunate uselessness of most ’state of the art’ academic monetary economics

March 3, 2009 1:37pm

The Monetary Policy Committee of the Bank of England I was privileged to be a ‘founder’ external member of during the years 1997-2000 contained, like its successor vintages of external and executive members, quite a strong representation of academic economists and other professional economists with serious technical training and backgrounds. This turned out to be a severe handicap when the central bank had to switch gears and change from being an inflation-targeting central bank under conditions of orderly financial markets to a financial stability-oriented central bank under conditions of widespread market illiquidity and funding illiquidity. Indeed, the typical graduate macroeconomics and monetary economics training received at Anglo-American universities during the past 30 years or so, may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding. It was a privately and socially costly waste of time and other resources.

Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best. Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works - let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck.

Complete markets

The most influential New Classical and New Keynesian theorists all worked in what economists call a ‘complete markets paradigm’. In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. As a result, illiquidity - both funding illiquidity and market illiquidity - are also impossible, unless the guilt-ridden economic theorist imposes some unnatural (given the structure of the models he is working with), arbitrary friction(s), that made something called ‘money’ more liquid than everything else, but for no good reason. The irony of modeling liquidity by imposing money as a constraint on trade was lost on the profession.

Both the New Classical and New Keynesian complete markets macroeconomic theories not only did not allow questions about insolvency and illiquidity to be answered. They did not allow such questions to be asked.

It is clear that, when searching for an appropriate simplification to address the intractable mess of modern market economies, the starting point of ‘no markets’, that is, autarky or no trade, is a much better one than that of ‘complete markets’. Goods and services that are potentially tradable are indexed by time, place and state of nature or state of the world. Time is a continuous variable, meaning that for complete markets along the time dimension alone, there would have to be rather more markets for future delivery (infinitely many in any time interval, no matter how small) than you can shake a stick at. Location likewise is a continuous variable in a 3-dimensional space. Again rather too many markets. Add uncertainty (states of nature or states of the world), never mind private or asymmetric information, and ‘too many potential markets’, if I may ruin the wonderful quote from Amadeus attributed to Emperor Joseph II, comes to mind. If any market takes a finite amount of resources (however small) to function, complete markets would exhaust the resources of the universe.

Beyond this simple ‘impossibility of complete markets’ proposition, there is the deeper point, that the assumption of complete markets in most of the New Classical and New Keynesian macroeconomics assumes away the problem of contract enforcement. This problem is especially acute in trade over time or intertemporal trade, where the net value to each party to a contract of fulfilling the terms of the contract varies over time and can change sign. In a world with selfish, rational, opportunistic agents, able and willing to lie and deceive, only a small set of voluntary transactions will ever be observed, relative to the universe of all potentially feasible transactions.

The first set of voluntary exchange-based transactions we are likely to see are self-enforcing contracts - those based on long-term relationships, repeated interactions and trust. There are some of those, but not too many. The second are those voluntarily-entered-into contracts that are not self-enforcing (say because interactions between the same sets of agents are infrequent and market participants have a degree of anonymity that prevents the use of reputation as a self-enforcement mechanism) but are instead enforced by some external agent or third party, often the state, sometimes the Mafia (sometimes it’s hard to tell who is who). Third party enforcement of contracts is again often complex and costly, which is why it covers relatively few contracts. It requires that the terms of the contract and the contingencies it contains be third-party observable and verifiable. Again, only a limited set of exchanges can be supported this way.

The conclusion, boys and girls, should be that trade - voluntary exchange - is the exception rather than the rule and that markets are inherently and hopelessly incomplete. Live with it and start from that fact. The benchmark is no trade - pre-Friday Robinson Crusoe autarky. For every good, service or financial instrument that plays a role in your ‘model of the world’, you should explain why a market for it exists - why it is traded at all. Perhaps we shall get somewhere this time.

The Auctioneer at the end of time

In both the New Classical and New Keynesian approaches to monetary theory (and to aggregative macroeconomics in general), the strongest version of the efficient markets hypothesis (EMH) was maintained. This is the hypothesis that asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation. Even during the seventies, eighties, nineties and noughties before 2007, the manifest failure of the EMH in many key asset markets was obvious to virtually all those whose cognitive abilities had not been warped by a modern Anglo-American Ph.D. eduction. But most of the profession continued to swallow the EMH hook, line and sinker, although there were influential advocates of reason throughout, including James Tobin, Robert Shiller, George Akerlof, Hyman Minsky, Joseph Stiglitz and behaviourist approaches to finance. The influence of the heterodox approaches from within macroeconomics and from other fields of economics on mainstream macroeconomics - the New Classical and New Keynesian approaches - was, however, strictly limited.

In financial markets, and in asset markets, real and financial, in general, today’s asset price depends on the view market participants take of the likely future behaviour of asset prices. If today’s asset price depends on today’s anticipation of tomorrow’s price, and tomorrow’s price likewise depends on tomorrow’s expectation of the price the day after tomorrow, etc. ad nauseam, it is clear that today’s asset price depends in part on today’s anticipation of asset prices arbitralily far into the future. Since there is no obvious finite terminal date for the universe (few macroeconomists study cosmology in their spare time), most economic models with rational asset pricing imply that today’s price depend in part on today’s anticipation of the asset price in the infinitely remote future.

What can we say about the terminal behaviour of asset price expectations? The tools and techniques of dynamic mathematical optimisation imply that, when a mathematical programmer computes an optimal programme for some constrained dynamic optimisation problem he is trying to solve, it is a requirement of optimality that the influence of the infinitely distant future on the programmer’s criterion function today be zero.

And then a small miracle happens. An optimality criterion from a mathematical dynamic optimisation approach is transplanted, lock, stock and barrel to the behaviour of long-term price expectations in a decentralised market economy. In the mathematical programming exercise it is clear where the terminal boundary condition in question comes from. The terminal boundary condition that the influence of the infinitely distant future on asset prices today vanishes, is a ‘transversality condition’ that is part of the necessary and sufficient conditions for an optimum. But in a decentralised market economy there is no mathematical programmer imposing the terminal boundary conditions to make sure everything will be all right.

The common practice of solving a dynamic general equilibrium model of a(n) (often competitive) market economy by solving an associated programming problem, that is, an optimisation problem, is evidence of the fatal confusion in the minds of much of the economics profession between shadow prices and market prices and between transversality conditions that are an integral part of the solution to an optimisation problem and the long-term expectations that characterise the behaviour of decentralised asset markets. The efficient markets hypothesis assumes that there is a friendly auctioneer at the end of time - a God-like father figure - who makes sure that nothing untoward happens with long-term price expectations or (in a complete markets model) with the present discounted value of terminal asset stocks or financial wealth.

What this shows, not for the first time, is that models of the economy that incorporate the EMH - and this includes the complete markets core of the New Classical and New Keynesian macroeconomics - are not models of decentralised market economies, but models of a centrally planned economy.

The friendly auctioneer at the end of time, who ensures that the right terminal boundary conditions are imposed to preclude, for instance, rational speculative bubbles, is none other than the omniscient, omnipotent and benevolent central planner. No wonder modern macroeconomics is in such bad shape. The EMH is surely the most notable empirical fatality of the financial crisis. By implication, the complete markets macroeconomics of Lucas, Woodford et. al. is the most prominent theoretical fatality. The future surely belongs to behavioural approaches relying on empirical studies on how market participants learn, form views about the future and change these views in response to changes in their environment, peer group effects etc. Confusing the equilibrium of a decentralised market economy, competitive or otherwise, with the outcome of a mathematical programming exercise should no longer be acceptable.

So, no Oikomenia, there is no pot of gold at the end of the rainbow, and no Auctioneer at the end of time.

Linearize and trivialize

If one were to hold one’s nose and agree to play with the New Classical or New Keynesian complete markets toolkit, it would soon become clear that any potentially policy-relevant model would be highly non-linear, and that the interaction of these non-linearities and uncertainty makes for deep conceptual and technical problems. Macroeconomists are brave, but not that brave. So they took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved. This was achieved by completely stripping the model of its non-linearities and by achieving the transsubstantiation of complex convolutions of random variables and non-linear mappings into well-behaved additive stochastic disturbances.

Those of us who have marvelled at the non-linear feedback loops between asset prices in illiquid markets and the funding illiquidity of financial institutions exposed to these asset prices through mark-to-market accounting, margin requirements, calls for additional collateral etc. will appreciate what is lost by this castration of the macroeconomic models. Threshold effects, critical mass, tipping points, non-linear accelerators - they are all out of the window. Those of us who worry about endogenous uncertainty arising from the interactions of boundedly rational market participants cannot but scratch our heads at the insistence of the mainline models that all uncertainty is exogenous and additive.

Technically, the non-linear stochastic dynamic models were linearised (often log-linearised) at a deterministic (non-stochastic) steady state. The analysis was further restricted by only considering forms of randomness that would become trivially small in the neigbourhood of the deterministic steady state. Linear models with additive random shocks we can handle - almost !

Even this was not quite enough to get going, however. As pointed out earlier, models with forward-looking (rational) expectations of asset prices will be driven not just by conventional, engineering-type dynamic processes where the past drives the present and the future, but also in part by past and present anticipations of the future. When you linearize a model, and shock it with additive random disturbances, an unfortunate by-product is that the resulting linearised model behaves either in a very strongly stabilising fashion or in a relentlessly explosive manner. There is no ‘bounded instability’ in such models. The dynamic stochastic general equilibrium (DSGE) crowd saw that the economy had not exploded without bound in the past, and concluded from this that it made sense to rule out, in the linearized model, the explosive solution trajectories. What they were left with was something that, following an exogenous random disturbance, would return to the deterministic steady state pretty smartly. No L-shaped recessions. No processes of cumulative causation and bounded but persistent decline or expansion. Just nice V-shaped recessions.

There actually are approaches to economics that treat non-linearities seriously. Much of this work is numerical - analytical results of a policy-relevant nature are few and far between - but at least it attempts to address the problems as they are, rather than as we would like them lest we be asked to venture outside the range of issued we can address with the existing toolkit.

The practice of removing all non-linearities and most of the interesting aspects of uncertainty from the models that were then let loose on actual numerical policy analysis, was a major step backwards. I trust it has been relegated to the dustbin of history by now in those central banks that matter.

Conclusion

Charles Goodhart, who was fortunate enough not to encounter complete markets macroeconomics and monetary economics during his impressionable, formative years, but only after he had acquired some intellectual immunity, once said of the Dynamic Stochastic General Equilibrium approach which for a while was the staple of central banks’ internal modelling: “It excludes everything I am interested in”. He was right. It excludes everything relevant to the pursuit of financial stability.

The Bank of England in 2007 faced the onset of the credit crunch with too much Robert Lucas, Michael Woodford and Robert Merton in its intellectual cupboard. A drastic but chaotic re-education took place and is continuing.

I believe that the Bank has by now shed the conventional wisdom of the typical macroeconomics training of the past few decades. In its place is an intellectual potpourri of factoids, partial theories, empirical regulaties without firm theoretical foundations, hunches, intuitions and half-developed insights. It is not much, but knowing that you know nothing is the beginning of wisdom.

Eastern Europe approaching the abyss

2009-03-01T07:49:00.000-08:00

March 1 (Bloomberg) -- Eastern European leaders pleaded with richer western European countries to boost financial aid and keep trade flowing, warning that the recession risks splitting the European Union.

The worst slump since World War II is devastating the ex- communist economies in the EU’s east, sinking their currencies and driving two countries -- Hungary and Latvia -- to tap international aid to avert default.

“They are in a deep crisis and they need our solidarity,” Swedish Prime Minister Fredrik Reinfeldt told reporters before a meeting of EU leaders in Brussels today.

The EU’s $17 trillion economy will contract 1.8 percent in 2009, the European Commission predicts. Latvia, the bloc’s star performer only three years ago, will shrink 6.9 percent. Growth in Poland, the biggest eastern economy, will tumble to 2 percent, the slackest pace since 2002.

Called by Czech Prime Minister Mirek Topolanek to show the EU’s unity in the face of economic turmoil, the summit has turned into a crisis session over how to bolster the floundering eastern economies.

Nine eastern leaders held a pre-summit meeting early today to warn the West against putting up new walls in Europe, five years after the EU overcame the division of the continent by admitting its first eastern members.

“We all wish that Europe avoids the temptation of protectionism,” Polish Prime Minister Donald Tusk said after the eastern-only gathering.

East-West Clash

French President Nicolas Sarkozy triggered the east-west clash over protectionism by saying on Feb. 5 that it “isn’t justified” for recession-hit French carmakers to build plants in places like the Czech Republic instead of creating jobs at home. European regulators yesterday forced Sarkozy to guarantee that 6 billion euros ($7.6 billion) in loans to Renault SA and PSA Peugeot Citroen, France’s two largest carmakers, won’t put foreign rivals at a disadvantage.

The EU leaders were set to reject calls to dip into EU funds to prop up the car industry, which is likely to suffer an 18 percent drop in sales this year, according to EU forecasts.

Instead, the leaders will endorse “the reinforcement of European coordination” of national carmaker-aid plans and call for a system to monitor rescue packages in Europe and the U.S., according to a draft statement released at the start of today’s summit.

Poland’s Zloty

Investors fleeing eastern Europe to cover losses at home have pushed down Poland’s zloty by 28 percent against the euro in the past six months, Hungary’s forint by 21 percent, Romania’s leu by 18 percent and the Czech koruna by 12 percent.

Hungarian Prime Minister Ferenc Gyurcsany last week called for an EU aid package of as much as 180 billion euros for eastern European economies and banks, including funds for non-EU members Croatia and Ukraine.

Gyurcsany also called on the EU to extend the euro currency more quickly into eastern Europe by shortening the 24- month waiting period during which countries must peg their currency to the euro.

There is a precedent for bending the rules. When Italy won approval in May 1998 to become one of the 11 founding members of the euro, it had spent just over 17 months in the exchange- rate grid.

Estonian Prime Minister Andrus Ansip said the east deserves the same help as any other region and shouldn’t be treated as a special case. “I’m strongly against creating small blocs inside the European Union,” Ansip said. “We have to keep together and act together.”

Multiple Crises

As the EU confronts multiple crises, the World Bank, the European Bank for Reconstruction and Development and the European Investment Bank on Feb. 27 announced loans of up to 24.5 billion euros for eastern European banks.

The Luxembourg-based EIB is run as a project-financing bank by EU governments. The bank’s head, Philippe Maystadt, warned against taking a one-size-fits-all approach to eastern Europe’s economic woes.

“Some countries are in a better position than others,” Maystadt said today. “That’s the reason why we think we must keep a country-by-country approach.”

Banks in the 16-nation euro region have lent $1.25 trillion to eastern Europe. The most heavily exposed banks in Austria and Sweden may face credit-rating downgrades as the economy deteriorates, Moody’s Investors Service warned on Feb. 17.

The spillover of the economic crisis to eastern Europe has overshadowed other summit business, including discussions of EU guidelines on recapitalizing banks and a proposal for new agencies to coordinate bank supervision.

Tighter Regulation

The leaders’ reactions to the call for tighter regulation will feed into proposals to be sketched out next week by the Brussels-based commission, the EU’s executive arm. Work on the new structures would get under way later this year.

EU leaders are also at odds over how to finance and where to spend a proposed 5 billion euros for energy and infrastructure projects as part of a bloc-wide stimulus package. A decision isn’t due until the next summit, on March 19-20, when the EU maps out its strategy for the April 2 Group of 20 meeting on the financial crisis in London.

So far, national stimulus packages, welfare spending and cash from the EU’s central budgets have pumped 3.3 percent of EU- wide GDP into the economy, the commission estimates.

The draft summit statement set no deadline for governments to erase swelling budget deficits. The aggregate gap in the 27- nation EU will rise to 4.4 percent of gross domestic product in 2009 from 2 percent last year, the EU forecasts.

The statement pledged to “assure the long-term viability of public finances,” without setting a timeframe. A deadline for euro-area countries to eliminate their deficits has regularly been pushed back since 2002.

To contact the reporter on this story: James G. Neuger in Brussels at jneuger@bloomberg.net

Last Updated: March 1, 2009 08:52 EST

Excellent article about Tim Geithner etc

2009-02-25T09:23:00.001-08:00

In Geithner We Trust Eludes Treasury as Market Fails to Recover

By Yalman Onaran and Michael McKee

Feb. 25 (Bloomberg) -- It was 2004 and Tim Geithner, president of the Federal Reserve Bank of New York, had a message for the Federal Open Market Committee in Washington. He told his 18 colleagues gathered around the long mahogany table that a clearinghouse was needed to monitor risks in the burgeoning $5 trillion market for credit-default swaps -- the over-the-counter derivatives that would later spin out of control and help take down Wall Street.

In a move that may have foreshadowed his role as President Barack Obama’s Treasury secretary, Geithner over the next two years nudged financial firms to voluntarily clear a backlog of swap trades. They stopped short of creating a clearinghouse to bring more transparency to the market.

“Geithner was making noise on reining in derivatives, but he didn’t push hard enough,” says Jane D’Arista, a former economist at the Congressional Budget Office in Washington and a longtime Fed observer. “Maybe he’ll be more forceful now that he’s in a position with real power. But I’m not so sure.”

From his years as a Dartmouth College student and mid-level Treasury official through his stint at the New York Fed, Geithner, 47, has thrived as a backroom negotiator and conciliator. Now, as he struggles to rescue Wall Street from a crisis that happened on his regulatory watch, investors and economists question whether the 75th Treasury secretary can transform himself into a bold leader equal to the challenges ahead.

Wall Street executives have cheered Geithner’s nomination.

Brief Honeymoon

“Treasury Secretary Geithner possesses the intelligence and experience needed to partner with President Obama and his economic team to lead us to a recovery,” says Robert Wolf, head of UBS AG’s Americas unit based in Stamford, Connecticut.

The rookie secretary has already learned that the honeymoon won’t last long. After Geithner presented a $2.5 trillion financial rescue plan on Feb. 10, the Dow Jones Industrials tumbled 4.6 percent because investors found it bereft of details. Geithner also gave no indication that he would act quickly to dismantle the weakest of the banks, a move that Joseph Mason, a former bank regulator who teaches finance at Louisiana State University, says he should take now.

Japan prolonged its credit crunch and recession for almost a decade before it finally nationalized two of its biggest banks, the Long-Term Credit Bank of Japan and Nippon Credit Bank, in 1998.

“The key to all our problems is the zombie banks,” Mason says. “We’re giving them money, which is not going to solve anything. We’re repeating the mistakes of Japan, which wasted a decade by not moving decisively against its zombie banks.”

Henry Morgenthau

No Treasury secretary since Henry Morgenthau, who served from 1934 to ‘45 under President Franklin D. Roosevelt, has faced so many crises at once. After receiving $800 billion in loans, guarantees and capital injections since October, the financial industry is still hunkered down, unwilling or unable to put the wind back into the sails of capitalism. Geithner played a role in shaping the $787 billion stimulus plan, and now he and Lawrence Summers, head of the National Economic Council, must recommend to President Obama whether to give General Motors Corp. and Chrysler LLC an additional $14 billion in loans on top of the $17.4 billion Bush administration bailout or force them into bankruptcy. At the White House, the new Treasury secretary may have to compete for the president’s attention with Summers, his former mentor, and Paul Volcker, who has been clamoring for more power as chairman of the Economic Recovery Advisory Board.

Methodical Style

Geithner’s strengths -- his methodical style and bureaucratic savvy -- were honed over 21 years in government, as he dealt with crises from Asia to New York.

“He really understands process and decision making and how to advance an agenda,” says Michael Froman, who was former Treasury Secretary Robert Rubin’s chief of staff. “Some people are just better at it than others, not just having the big idea but breaking it down into the several dozen steps that need to make it work. That’s Tim.”

The Treasury secretary’s experience at the New York Fed from 2003 to ‘08 gave him an inside view of Wall Street that will help him choose the best remedies for today’s crisis, says Alex Pollock, resident fellow at the American Enterprise Institute in Washington and a former president of the Chicago Federal Home Loan Bank. “He’s very well qualified,” Pollock says.

‘He’s Not Change’

David Kotok, chief investment officer at Cumberland Advisors Inc., says Geithner’s insider status -- he selected former Goldman Sachs Group Inc. lobbyist Mark Patterson as his chief of staff --is a liability. Geithner was at the helm of the New York Fed when Wall Street ran amok, and he had a seat at the table when Federal Reserve Chairman Ben S. Bernanke and former Treasury Secretary Henry Paulson came up with remedial measures that haven’t worked.

“He’s not change, as Obama promised, but just the same old stuff,” says Kotok, who manages $1 billion in Vineland, New Jersey. Geithner declined to comment for this article.

As New York Fed chief during one of Wall Street’s greatest bull markets ever, Geithner shared authority over some of the country’s biggest commercial banks with the Comptroller of the Currency. While the banks loaded up on mortgage-backed securities and derivatives, Geithner failed to use his power to force the firms to build adequate capital cushions and risk controls, says Allan Meltzer, a professor at Carnegie Mellon University in Pittsburgh who monitors the Federal Reserve. Citigroup Inc. led the buying frenzy on Wall Street, holding $544 billion in securities and derivatives by 2007 before unraveling under their weight.

Lax Oversight

“The oversight of Citi was shamefully lax,” says Janet Tavakoli, founder of Chicago-based advisory firm Tavakoli Structured Finance and author of books on financial risk. “If they didn’t see the problems beforehand, we don’t have the right people. If they did see them but didn’t care to do anything, then again we have the wrong people.”

By 2008, the New York Fed president was forced to face the consequences of slack regulation. As Bear Stearns Cos. neared bankruptcy, he worked closely with Paulson and Bernanke on a bailout in March, and, after Lehman Brothers Holdings Inc. died six months later, the trio came up with TARP -- the $700 billion Troubled Asset Relief Program. Geithner told Congress in February that he took responsibility for not doing enough to prevent the financial crisis.

Geithner’s Conundrum

“There were systematic failures in supervision and regulation across our system,” he said. “Every supervisor and regulator as part of the system could have done more to prevent this.” He also said the government’s rescue effort so far had been inadequate. “The force of government support was not comprehensive or quick enough to withstand the acute pressure brought on by the weakening economy,” he said in announcing his new plan on Feb. 10.

While the Treasury secretary has given his initiative a new name, the Financial Stability Plan, it’s mostly an extension of TARP. The centerpiece is a $1 trillion Fed loan fund that will be used to induce hedge funds and buyout firms to purchase toxic assets from banks so they can begin lending again.

So far, banks have been unwilling to lower the asset prices enough to make them attractive to distressed debt investors. Geithner faces a conundrum: If banks trim prices, their losses will grow; if the government offers investors guarantees for assets whose value is impossible to calculate, taxpayers may pay a big price.

“It’s an incredibly difficult thing to do and to get right,” Geithner told Congress in January. “And getting it right will be central to the basic credibility of the program.”

$2.5 Trillion In Writedowns

Confronted with the same issues last year, Paulson dropped his plans to purchase MBSs.

“I get a similar feeling from the Geithner Treasury,” says Jeffery Harte, banking analyst at Sandler O’Neill & Partners LP in Chicago. “As they go through the logistics, they realize it doesn’t all work.”

Before giving more capital to banks, Geithner is sending examiners into the 18-20 biggest firms to perform newly designed “stress tests.” Nouriel Roubini, an economist at New York University, forecast in January that financial firms would write down another $2.5 trillion on top of the $1.1 trillion since 2007.

Banks that get additional funding from the $350 billion remaining in the TARP won’t be forced to lend the money, only to report on their lending activity.

No Big Steps

“Frankly, we don’t have as accurate an assessment of the situation of a number of institutions as we’d like,” Summers told Bloomberg TV in February. He didn’t rule out the possibility that some banks that fail the test might be shuttered. “U.S. policy has been the same for many years,” Summers said. “When supervisors deem it appropriate, then institutions are intervened.”

Geithner is too cautious and too protective of Wall Street to take over big banks, says Paul Miller, banking analyst at Friedman, Billings, Ramsey Group Inc. in Arlington, Virginia.

“His philosophy is don’t wipe out the shareholders because they’ll never come back,” Miller says. “But the only way to get to the problem is to dilute shareholders away. These guys are unwilling to take these big steps.”

The government may soon boost its stake in Citigroup while trying not to take majority control of the bank. Executives and government official are discussing the possibility of converting some of the $52 billion of preferred shares the government owns to common stock to help strengthen the bank’s capital quality, according to a person familiar with the talks.

Shadow Banking

The Treasury secretary also plans to kick-start the securitization market, or the bundling of asset-backed securities for resale that inflated the credit bubble before it burst in 2008. This shadow banking system accounted for 33 percent of the credit supplied to the U.S. economy in 2007.

To resurrect the market, the Fed will expand its Term Asset-Backed Securities Loan Facility to as much as $1 trillion from $200 billion. TALF, which was scheduled to begin in February, will finance the purchase of student and auto loans and credit card and mortgage-backed debt.

“Permitting these securities to be issued got us to where we are now,” says James Galbraith, an economist at the University of Texas at Austin. “Securitization is useful, but it has to be done properly, and regulators need to be on top of it. Securitization of subprime mortgages is clearly unsafe.”

Foreclosures

Obama’s housing plan is the biggest break with the Bush administration, which refused to use TARP to curb foreclosures. The government will try to induce mortgage companies to cut interest rates on loans for about 4 million homeowners by using $75 billion to cover a portion of their losses. Under the plan, the government will buy an additional $200 billion in preferred stock in lenders Fannie Mae and Freddie Mac, giving them capital to help 5 million borrowers refinance home loans.

The Treasury also is asking Congress to allow bankruptcy judges to modify loan terms, a move that the American Bankers Association says would cripple the secondary mortgage market.

“The plan ought to help reduce the foreclosure rate,” says John Lonski, chief economist at Moody’s Capital Markets Group in New York. “But it’s doubtful that by itself it will stabilize housing. More will have to be done.”

As Geithner takes his second crack at fixing Wall Street, he has both an ally and foil in Summers. Compared with the disheveled Summers, who often appears around Washington with his shirttail untucked, Geithner is buttoned up. Solid bright ties are his one flashy touch. He’s ruthless about keeping his desk clutter free, colleagues say, a sign of the self-discipline also known to his tennis partners, including Summers.

Tennis Partners

For years, Geithner, Summers and other colleagues have gone to Nick Bollettieri’s tennis camp in Florida in March. Bollettieri has coached Grand Slam champions Andre Agassi and Boris Becker.

“Tim’s controlled, consistent, with very good ground strokes,” says Lee Sachs, a former Treasury official who goes to the camp with Geithner. This year’s trip, scheduled for March, was canceled. “For obvious reasons,” Sachs says.

Summers, on the other hand, is famous for his lack of restraint. While working at the Treasury in 1997, Summers told reporters that people who supported lower estate taxes were selfish, and the next day he publicly apologized for making the comment. Nine years later, he had to resign as president at Harvard after saying it might be worth exploring whether women lacked the aptitude for math and science.

Media Shy

Geithner, by contrast, shuns publicity. In 1997, he begged a reporter in Hong Kong not to cover his first speech as assistant Treasury secretary at an annual meeting of the International Monetary Fund and World Bank.

“He’s definitely publicity averse,” says Sheryl Sandberg, chief operating officer of Facebook Inc., who served as chief of staff to Summers at Treasury. “Tim will develop what he needs. If he needs to be more outspoken, he’ll do it.”

When Geithner served as a special assistant to Summers at the Treasury in the ‘90s, helping his boss gather research and frame issues, their different styles meshed well. Summers, who sometimes called Geithner “young Tim,” was a font of ideas; Geithner’s job was to implement them, and at times would go toe- to-toe with his boss, earning his respect, former colleagues says.

“Tim is definitely not the loud guy in the room,” says a former Treasury official who worked with both men. “He’s the guy who is more likely to steer a conversation with the occasional interjection but not try to dazzle or suck the oxygen out of things. That would be Larry. He’s kind of the anti- Larry.”

John Sherman

Now in the White House, Summers, 54, has been stacking the National Economic Council with former Treasury heavyweights, sending a signal in Washington that he’s the presidential confidant with the most sway on the economy. He hired Froman, the former Rubin deputy and Citigroup executive, and David Lipton, who preceded Geithner as undersecretary for international affairs.

While Summers was building his team in January, Geithner was defending himself before Congress for not paying his taxes. He didn’t make Social Security and Medicare contributions from 2001 to ‘04 while he was working at the IMF. In 2006, after an audit, he repaid $16,732 for 2003-04. During his vetting for the Treasury job, Obama staffers found he also owed taxes going back to 2001, and Geithner immediately repaid $31,536.

With some lawmakers skeptical of Geithner’s explanation that he’d made careless mistakes, he was confirmed 60-34, the closest recorded margin for a Treasury secretary since Rutherford B. Hayes’s nominee, John Sherman, won approval in 1877.

Rubin, Mentor

During his time at the New York Fed, which began in 2003, Geithner played a critical if largely invisible role, supervising banks in his district to ensure their solvency. The New York Fed is the most powerful of the 12 U.S. regions because of its Wall Street jurisdiction and permanent seat on the monetary-policy-setting FOMC. The regional Feds have split personalities: They are owned by the banks they regulate, and they are also partly controlled by the Federal Reserve in Washington, which appoints three of their nine board members.

Geithner’s oversight of Citigroup was made more complex because Rubin, one of his mentors, was an executive at the New York-based bank. As the Treasury secretary from 1995 to ‘99, Rubin promoted Geithner to undersecretary for international affairs, the No. 3 job at the department. Rubin and Summers, as members of the New York Fed’s selection committee, later recruited Geithner to lead the New York regulator.

‘Old Boys’ Network’

“You have the old boys’ network here,” says Chris Whalen, a New York Fed official in the 1980s and co-founder of Institutional Risk Analytics, a Torrance, California-based risk advisory firm. “So it would be unnatural for Geithner to turn around to any of these guys at Citi and say, ‘Hey, you have a problem.’”

Geithner wasn’t the committee’s first choice to replace William McDonough as president. Peter Fisher, a former Treasury and New York Fed official, and Stanley Fischer, a former deputy managing director of the IMF, withdrew from consideration for the job, a person familiar with the situation said.

The new New York Fed president stepped into a Wall Street that was making money like never before. The economy grew at a 3.6 percent rate in 2004 after Federal Reserve Chairman Alan Greenspan, dubbed the “maestro,” dropped interest rates to 1 percent after a brief recession in 2001.

Wall Street was near the middle of a five-year run in which net income for the five biggest securities firms would more than triple by 2006. The Standard & Poor’s 500 Index was on its way to its peak of 1,565 in October 2007.

Sandy Weill

The Wall Street boom was spurred partly by the anti- regulatory moves of Bill Clinton’s administration. In 1998, then Treasury Secretary Rubin and his deputy Summers fended off a proposal by Brooksley Born, who headed the Commodity Futures Trading Commission, to regulate over-the-counter derivatives. A year later, both men advocated that Congress repeal the 1933 Glass-Steagall Act, which had separated the activities of investment and commercial banks. Nine days before Congress acted, Rubin joined Citigroup as chairman of the executive committee.

Under CEO Sanford “Sandy” Weill, Citi took advantage of the deregulation, buying securities companies and building the world’s largest financial services company. Rubin declined to comment for this article.

No Clearinghouse

As early as 2004, Geithner saw that CDSs were in need of transparency. The derivatives, which guarantee payment in case a bond defaults, are used by traders to speculate on a borrower’s ability to pay off debt. Hedge funds and banks were snapping up the swaps as insurance for their bets on MBSs and corporate debt.

“The growth in the over-the-counter derivatives market has advanced much more rapidly than the speed of improvement of important parts of the infrastructure that support the market,” Geithner said in a speech at the Swift International Banking Operations Seminar in 2004 in Atlanta.

In September 2005, Geithner brought together representatives of the 14 largest financial institutions with U.S. and European regulators to devise a self-regulatory plan. One year later, the banks cleared away the backlog of unsigned derivative contracts by completing the paperwork. Geithner didn’t convince the banks to take the big step of setting up a clearinghouse.

Freeing Citi

“He started strong with the signing of the incomplete contracts, but his energy dissipated after that,” says Julian Mann, an asset-backed-bond manager at Los Angeles-based First Pacific Advisors LLC with $9 billion under management. “He could have insisted for more.”

Geithner told Congress in January that the banks made improvements that strengthened the ability of the derivatives market to withstand a shock.

“They could have had more traction, of course, and if more had been done earlier and had been more responsive to those efforts, then this crisis would have been less severe,” Geithner said.

In December 2006, the Federal Reserve, with the support of the New York Fed, lifted a reporting requirement on Citi. After the New York Fed found that the bank had helped Enron Corp. set up off-balance-sheet entities, the Federal Reserve in 2003 forced Citi to file quarterly reports documenting how it was improving risk management. The Fed ended the reporting requirement three years later, saying Citi had improved.

Bear Stearns

After a five-year sprint, Wall Street’s money machine finally ground to a halt in late 2007. The housing market’s historic plunge dragged down the value of MBSs, and Bear Stearns, which held $30 billion of these assets, was the first to disappear. Over a frenetic weekend of meetings in March 2008, Geithner, working with Bernanke and Paulson, came up with a solution: The Fed would take over $29 billion of Bear Stearns’s toxic assets -- enough to convince JPMorgan Chase & Co. to buy the firm.

During that same weekend, the Fed also made loans available to the four largest remaining brokers: Merrill Lynch & Co., Goldman Sachs, Lehman Brothers and Morgan Stanley. As part of the deal, Geithner installed examiners in the firms to look at their books in detail, including mortgage-related securities activity, according to former Lehman executives. Lehman Brothers had $84 billion in troubled assets, exceeding Bear Stearns’s total.

Lehman Brothers

Geithner and Paulson pressed Lehman officials to sell part of the firm, but not the entire bank, until it was too late, in September, according to Lehman executives. By then, clients were fleeing.

“When Bear failed, Geithner and company thought they were out of the woods,” says Whalen of Institutional Risk Analytics. “So they didn’t do anything on Lehman. Forget what they knew as regulators, why couldn’t they even figure out what every trader on Wall Street understood?”

Paulson, Bernanke and Geithner each have said that the government didn’t have the authority to inject capital into Lehman, a power they say was granted a month later with the approval of the TARP in October.

“We could not force any institution to come in and buy Lehman Brothers or guarantee their obligations, and no one was willing, without the government taking a very, very substantial capital position, and we did not have the authority at that point to do that,” Geithner told Congress in January.

‘Big Mistake’

Glenn Hubbard, dean of Columbia Business School and a former chairman of the Council of Economic Advisers, says the Fed could have bought Lehman’s troubled assets as it did with Bear Stearns. “Certainly for them to say there was nothing they could do is simply false,” he says. “It was a big mistake.”

The Lehman bankruptcy dealt a knockout blow to global finance, freezing the overnight credit market when lenders realized that the government wouldn’t necessarily protect loans to financial institutions. The credit-default-swap market, the global bazaar that Geithner had tried to make more transparent in 2004, also tanked. Without a clearinghouse, institutions had to scramble for several weeks to find counterparties to replace Lehman.

The benchmark CDS Index, which shows the cost of insuring firms against default, almost doubled to 284 basis points on Nov. 20 from 152 prior to Lehman’s demise. (A basis point is 0.01 percentage point.)

AIG’s Swaps

Two days after Lehman’s downfall, CDSs claimed their biggest victim, American International Group Inc. Paulson, Bernanke and Geithner changed course and rescued AIG with an $85 billion Fed loan. They said the failure of the insurance giant, which couldn’t pay its swap obligations, would devastate financial firms globally.

Starting in mid-September, Geithner spent 43 consecutive days on the job without any break, according to people who know him. He slept many nights in a small bedroom in the New York Fed building. Never a big eater, he lived on soup, sandwiches, carrots and yogurt during his sometimes 20-hour workdays.

When Justin Rudelson, his former classmate at Dartmouth College, asked him how he was holding up, Geithner told his friend: “We live for this kind of emergency. This is when we feel most important, most needed as a central banker, regulator. It’s the crises that make our jobs worthwhile.”

In November, in nominating Geithner to lead Treasury, Obama praised his unique insights into Wall Street’s failures. Days before the nomination, Geithner, still wearing his New York Fed hat, was cleaning up another mess at Citigroup. He took part in discussions with Paulson and Bernanke that led the government to guarantee $306 billion of Citi’s troubled mortgage assets and inject an additional $20 billion into the firm following the first TARP bailout in October.

Citi Breakup

In January, Citi said it would sell majority control of its retail brokerage unit to Morgan Stanley and break itself in two, dumping the money-losing assets and non-core units into a separate entity. Rubin, 70, also announced his resignation that month, after getting paid more than $150 million during his 10 years at the bank.

Geithner offered a mea culpa for dropping the ball on Citi. “Citigroup’s supervisors, including the Federal Reserve, failed to identify a number of their risk management shortcomings and to induce appropriate changes in behavior,” he told Congress in January.

Timothy Franz Geithner has public service in his bloodlines. His maternal grandfather, Charles Moore, served as a speechwriter for Republican President Dwight Eisenhower in the late 1950s. Jonathan Moore, an uncle who worked as a state department diplomat, advised Republican presidential hopefuls Nelson Rockefeller and George Romney, in the late 1960s.

Following Dad

Geithner’s father, Peter, worked in Africa for the U.S. Agency for International Development and for the Ford Foundation as an Asia specialist, raising his family overseas. Before he turned six in the mid-1960s through high school, Geithner learned to negotiate his way through different cultures in present-day Zimbabwe, India and Thailand.

He visited refugee camps in Cambodia, taking black-and- white photographs of people displaced by Pol Pot’s campaign of genocide. Geithner graduated from the International School Bangkok, where he studied with children of expatriates from around the world.

With his enrollment in Dartmouth in 1979, Geithner followed the same path as his father, grandfather and uncle -- all of whom graduated from the Ivy League school in Hanover, New Hampshire. He majored in government and Asian studies, his dad’s field, and was known for his sobriety, spending nights with friends dissecting the unilateral foreign policies of President Ronald Reagan rather than drinking at fraternity parties, classmates say.

Fluent In Chinese

On campus, Geithner displayed his internationalist bent, wearing a traditional Thai sarong around the waist at freshman orientation. He studied Chinese for four years and became fluent, says his former Chinese professor, Susan Blader.

“He was always the guy in class who did unbelievably well,” says Robert Boorstin, who studied the language with Geithner in an overseas program in China and later worked with him at Treasury.

Last year, Geithner sent an e-mail to Blader, saying he was proud to be able to speak the language with China’s prime minister.

Geithner’s knack for diplomacy surfaced in the midst of student demonstrations over affirmative action. The Dartmouth Review, a student biweekly, was edited by Dinesh D’Souza, a social conservative who later rose to prominence with books attacking multiculturalism and feminism.

‘Natural Mediator’

The Review lambasted what it called Dartmouth’s liberal bias and its minority admission policies, riling many students. During gatherings in which some students said D’Souza should be attacked, Geithner calmed them down, proposing that they start an alternative publication, says Rudelson, the former roommate. Geithner kept his distance from the new publication, called the Harbinger, occasionally taking photos for it.

“He was always the natural mediator,” Rudelson says. “He had this amazing ability to listen to people, no matter how extreme their views might be.”

After Dartmouth, Geithner followed his dad’s lead once again, entering a master’s program at the Johns Hopkins School of Advanced International Studies in Washington. He studied international economics, East Asia and the Japanese language. Within a month of graduating in 1985, he married his Dartmouth sweetheart, Carole Marie Sonnenfeld, who worked at the nonprofit group Common Cause. His father was the best man. Today, his wife is a clinical social worker.

Kissinger Associates

Kissinger Associates, the consulting firm that’s employed former White House luminaries such as Brent Scowcroft, gave Geithner his first job out of grad school. He worked as a researcher and writer for three years before taking a mid-level, $40,000 job in the Treasury’s trade and investment policy division in 1988.

Two years later, Geithner won a promotion to the U.S. embassy in Tokyo to serve as its deputy financial attache. He worked on a bilateral treaty with Japan, and his ability to converse in Japanese made him more popular than most U.S. officials in Tokyo, says Eisuke Sakakibara, then a Finance Ministry official who now teaches at Waseda University in Tokyo.

“You could say he has a bit of an Asian negotiation style,” Sakakibara says. “He expresses his opinions, but he also tries to reach a consensus.”

Promoting Geithner

Geithner returned to the U.S. in 1991 for a job given to the department’s up-and-comers: special assistant. He served David Mulford, the Treasury’s undersecretary for international affairs, now the ambassador to India.

“Tim had the right temperament,” says Mark Dow, a former Treasury colleague. “He never let you see him sweat.”

The election of Democrat Bill Clinton in 1992 would help propel the young Republican to the top job at the Treasury. Clinton chose Summers, then the World Bank’s chief economist, to replace Mulford, and the new official inherited Geithner as his assistant.

“The two of them got along not so much because Tim would stand up to him, but Tim would say unexpected and interesting things that were good on the merits rather than just pandering to Larry,” says Anna Gelpern, Geithner’s former special assistant at Treasury. “But Larry stimulated Tim to think in bigger ways.”

After Rubin took over at Treasury in 1995, Congress approved Summers to be his deputy secretary. Summers had elevated Geithner to deputy assistant secretary a year earlier. During a get-acquainted meeting, Rubin asked his new staff to describe their backgrounds.

Meeting Rubin

After some economists listed their impressive achievements, the youthful-looking Geithner noted he had been in junior positions at Treasury for a few years.

“Before that I was in high school,” Geithner added, cracking up the room, according to Dan Israel, a former Treasury spokesman.

Summers recommended Geithner for his first political appointee post, assistant secretary for international affairs, in 1997. He switched his party to Independent from Republican after his appointment, former co-workers say, a job that required a presidential nomination and Senate confirmation.

“He has no overt political philosophy,” says Boorstin, the former Treasury official.

Man of Action

He took the oath of office from Rubin in a hotel room in Hong Kong just as Asian currencies were melting down. In Thailand, Indonesia, Malaysia and the Philippines, investors were fleeing as a mounting pile of bad loans engulfed their economies, leading their currencies to collapse.

For months, Geithner and other Treasury officials shuttled across Asia, helping to contain the panic. During one long absence from home, Geithner told acquaintances that his two children, Elise and Benjamin, had looked up his picture on the Treasury Department Web site to remind them of what he looked like.

In Tokyo, Geithner worked with the IMF to negotiate a $16 billion loan package for Thailand. The IMF and U.S. had demanded that it close insolvent banks and cut spending in exchange for the funds.

“Tim’s value was the ability to get things done, to translate broad ideas into actual action,” Froman says.

As Treasury secretary, Geithner now has the chance to lead the biggest overhaul of the financial architecture since Roosevelt created the Federal Deposit Insurance Corporation in 1933 and the Securities and Exchange Commission the following year.

Volcker’s Ideas

“We need a fundamental redesign,” Geithner told lawmakers in January. “We will seek to improve the regulatory structure in a way that provides the safeguards we need without creating undue burden on financial market participants.”

Administration officials, lawmakers and lobbyists have already begun fighting over how best to control Wall Street. Volcker, whose group is charged with providing Obama with an outside perspective on regulation, is pushing the most-far- reaching proposals.

The former Fed chief, 81, says commercial banks shouldn’t be permitted to trade in capital markets. The proposal, which amounts to a partial resurrection of Glass-Steagall, would stop a major revenue stream for banks. At the end of 2007, about 40 percent of Citigroup’s and JPMorgan’s balance sheets consisted of trading assets.

“Paul is a man who has his own ideas and is a strong proponent of them,” Carnegie Mellon’s Meltzer says. “He and Geithner are likely to clash.”

Lynch Mob

While Geithner and Volcker agree the current system of multiple and overlapping banking regulators should be streamlined to increase accountability, they disagree over who should have the power. Geithner, as the New York Fed president, favored giving the authority to the central bank. Volcker told Congress in February that such a move might distract the Fed from making monetary policy. Volcker declined a request for an interview.

The Treasury secretary wants to strengthen banks’ capital requirements -- the amount of cash they keep to offset risks.

“Perhaps most important from the perspective of financial stability was the failure of risk management,” Geithner testified in January. “Ensuring that U.S. banks maintain adequate capital reserves is a critical component of a well- functioning banking system.”

The financial services forum, which comprises the chief executive officers of 17 big commercial banks, securities and mutual fund firms and insurers, is already lobbying to fend off mandated risk management procedures and other regulations.

Better Solutions

“Our members fear a lynch mob mentality on Capitol Hill,” says John Dearie, the Forum’s policy director and a former New York Fed official. “There are a lot of committees on the Hill we’re spending a lot of time educating.”

Geithner’s long push for a derivatives clearinghouse is finally making progress. In October, with prodding from the Fed, dealers and Intercontinental Exchange Inc. agreed to create one. But the difficulty in pricing some of the infrequently traded contracts has delayed final approval by the government.

The future shape of Wall Street rests to a large degree with Geithner, whose early stumbles, along with those of his superiors in Washington, left investors uneasy.

“There have been many mistakes made,” says Joseph Stiglitz, winner of the 2001 Nobel Memorial Prize in Economic Sciences. “The big question is to what extent will the mistakes help Geithner figure out the right things to do in his new job. He has some important skills, such as listening to different viewpoints. Let’s hope he can use those to come up with better solutions.” As the recession in the U.S., Japan and Europe deepens, the world is rooting for the protege to prove that he can lead.

To contact the reporters on this story: Yalman Onaran in New York at yonaran@bloomberg.net; Michael McKee in New York at mmckee@bloomberg.net

Last Updated: February 25, 2009 00:00 EST

Sovereing Credit Default Swaps and currencies

2009-02-24T01:39:00.001-08:00

By Chris Fournier

Feb. 23 (Bloomberg) -- Six months ago, Lee Hardman didn’t care how much it cost to protect government bonds from losses. Now the Bank of Tokyo-Mitsubishi UFJ Ltd. strategist studies derivatives that provide such insurance to predict currency moves -- and he’s betting against the yen and the pound as a result.

“We wouldn’t really have looked at sovereign credit-default swaps in any great detail before” the September bankruptcy of Lehman Brothers Holdings Inc. caused credit markets to freeze, said Hardman, who is based in London. “It’s an area which potentially is going to see increasing focus as a driver of currency rates.”

Traders are starting to use the speculative contracts blamed for fueling Wall Street’s meltdown last year to measure currency strength as countries increase debt sales after pledging at least $2.4 trillion to kick-start their economies. Interest rates are becoming less useful for predicting foreign exchange as central banks slash borrowing costs to zero, narrowing differences between government debt yields.

“The credit-default swap market has taken a lot of bad press,” said Andrea Cicione, a credit strategist in London at BNP Paribas SA, in a Feb. 20 telephone interview. “The traders and the investors who have been involved in the CDS market understand that it’s operating just fine and there’s no need to throw it down a hole.”

Correlated Yen

Originally conceived to protect against corporate defaults, credit-default swaps are now being used to predict the direction of everything from the Canadian to New Zealand dollars. The swaps pay buyers the face value of a bond in exchange for the underlying securities or the cash equivalent if borrowers fail to adhere to debt agreements. Prices of the contracts, increasingly used to speculate on government bonds, rise as the perception of an issuer’s ability to pay decreases.

Since January, the correlation between the yen and the cost of protecting against a default on Japanese government bonds swung to negative 43 percent, showing investor concerns are increasing. The yen and cost of credit-default swaps moved in tandem 88 percent of the time last year.

Government reports show Japan is sinking deeper into recession, with fourth-quarter gross domestic product contracting at an annual rate of 12.7 percent, the most since the 1974 oil shock. The yen slumped 4.2 percent against the dollar this year to 94.69, and is headed for its worst month since April. The yen appreciated 23 percent in 2008.

‘In Play’

The pound traded at a negative correlation of 94 percent in the past year against U.K. debt swaps, showing the currency is weakening as credit perceptions worsen. Sterling dropped 26 percent in that period to 1.4589 per dollar.

Ron Leven, an executive vice president and senior currency strategist at Morgan Stanley in New York, doesn’t buy the argument that swap prices influence currency movements.

“If anything, the currencies are telling you what the swap spreads are going to do,” Leven said in a Feb. 9 interview. Still, every couple of days he updates his charts that show differences in prices of swaps on U.K. and U.S. debt and between New Zealand and U.S. bonds. A year ago he never looked at sovereign swaps.

Eric Lascelles, chief economics strategist at TD Securities Inc. in Toronto, said sovereign swaps don’t trade enough to make a good forecasting tool. Prices are often unavailable in the Canadian swap market, he said in a Feb. 9 interview.

Government bond swaps are “in play and getting the attraction that a moving variable deserves” because the global recession and increasing bond sales boosted the default risks for many countries, Lascelles said.

Regulatory Reform

Credit-default swaps dealers are under pressure from governments and central banks to increase transparency in the unregulated $28 trillion market and to create a body that will arbitrate disputes. The firms agreed to process the derivatives transactions through a clearinghouse following the failure of Lehman, one of the largest dealers.

Derivatives are financial contracts whose value is derived from interest rates, the outcome of specific events or the price of underlying assets such as debt, equities and commodities.

The cost of protecting against default by Lehman, Bear Stearns Cos. and American International Group Inc. rose as high as 7.07 percent before the companies collapsed. Richard Fuld, the former chief executive officer of Lehman, blamed speculation in the market for helping to speed the companies’ demise.

Swap Prices

While swaps don’t suggest Japan is close to default, the cost of protecting Japanese government bonds more than doubled to 1.21 percent of the face value on Feb. 17, from 0.49 percent on Jan. 30, according to CMA Datavision. A basis point, or 0.01 percentage point, on a credit-default swap contract protecting $10 million of debt for five years is equivalent to $1,000 a year, or $121,000 for the Japanese bond.

The U.K.’s swap price increased to 1.75 percent, or $175,000, on Feb. 17, from 1.23 percent. The pound declined 0.8 percent since Jan. 30.

Before Lehman’s failure, neither country’s swap price exceeded 0.74 percent. Hardman said the ballooning costs signal further depreciation. He expects the pound to drop to 1.35 per dollar by the end of the first quarter and yen to weaken to 100 per dollar by the end of 2009.

Japan’s Prime Minister Taro Aso announced plans in December to inject as much as 12 trillion yen ($127.6 billion) into the nation’s banks. The government cut its assessment of the economy for a fifth month last week, fanning speculation more fiscal stimulus will be needed.

‘Falling Apart’

“Should these conditions continue, we could say that the Japanese economy is at risk of falling apart,” Finance Minister Kaoru Yosano said in the Diet in Tokyo on Feb. 18.

The British currency fell to a two-week low that day after the Daily Telegraph said the country’s credit rating may be lowered by Standard & Poor’s as the government increases borrowing to bail out banks. U.K. policy makers voted 8-1 on Feb. 5 to cut the main interest rate by half a percentage point to 1 percent.

President Barack Obama enacted a $787 billion economic- stimulus package last week. China is rolling out 4 trillion yuan ($586 billion) to prop up domestic demand. European leaders pledged to spend a combined 200 billion euros ($257 billion) to haul their economies out of recession.

Traders are looking at credit-default swaps in part because interest rates are losing their effectiveness as a tool for predicting currencies’ direction after central banks in 11 of the world’s largest economies lowered borrowing costs an average 2.2 percentage points last year, according to data compiled by Bloomberg. Rates are below 1 percent in the U.S., Japan and Switzerland.

‘Nothing to Distinguish’

“You have nothing to distinguish any more in terms of monetary policy,” said Michael Hart, a London-based analyst at Citigroup Inc. “Several countries are at or near zero, so interest rates are reflecting credit concerns much more than anything else.”

The market for sovereign contracts had 132,200 outstanding contracts with an underlying value of $1.69 trillion as of Feb. 13, representing about 5.9 percent of the total market for credit default swaps, according to the Depository Trust and Clearing Corp.’s Web site. Swaps on financial institutions are the largest segment, with a notional value of $3.2 trillion.

Swap prices have increased the most for the U.K., Sweden and Australia since Lehman’s collapse, according to Hart. Currencies of those countries were three of four worst performers since August, when measured in trade-weighted terms, Hart said in a Feb. 2 report. The New Zealand dollar was the other.

“Default swaps will become increasingly important, given the issuance tsunami awaiting us,” Hart said in an interview. “The credit-default market is a better indicator of fiscal concerns with respect to each country.”

Why Obama’s new Tarp will fail to rescue the banks

2009-02-22T12:10:00.000-08:00

By Martin Wolf

Published: February 10 2009 18:06 | Last updated: February 10 2009 18:06

Has Barack Obama’s presidency already failed? In normal times, this would be a ludicrous question. But these are not normal times. They are times of great danger. Today, the new US administration can disown responsibility for its inheritance; tomorrow, it will own it. Today, it can offer solutions; tomorrow it will have become the problem. Today, it is in control of events; tomorrow, events will take control of it. Doing too little is now far riskier than doing too much. If he fails to act decisively, the president risks being overwhelmed, like his predecessor. The costs to the US and the world of another failed presidency do not bear contemplating.

What is needed? The answer is: focus and ferocity. If Mr Obama does not fix this crisis, all he hopes from his presidency will be lost. If he does, he can reshape the agenda. Hoping for the best is foolish. He should expect the worst and act accordingly.

Yet hoping for the best is what one sees in the stimulus programme and – so far as I can judge from Tuesday’s sketchy announcement by Tim Geithner, Treasury secretary – also in the new plans for fixing the banking system. I commented on the former last week. I would merely add that it is extraordinary that a popular new president, confronting a once-in-80-years’ economic crisis, has let Congress shape the outcome.

The banking programme seems to be yet another child of the failed interventions of the past one and a half years: optimistic and indecisive. If this “progeny of the troubled asset relief programme” fails, Mr Obama’s credibility will be ruined. Now is the time for action that seems close to certain to resolve the problem; this, however, does not seem to be it.

All along two contrasting views have been held on what ails the financial system. The first is that this is essentially a panic. The second is that this is a problem of insolvency.

Under the first view, the prices of a defined set of “toxic assets” have been driven below their long-run value and in some cases have become impossible to sell. The solution, many suggest, is for governments to make a market, buy assets or insure banks against losses. This was the rationale for the original Tarp and the “super-SIV (special investment vehicle)” proposed by Henry (Hank) Paulson, the previous Treasury secretary, in 2007.

Under the second view, a sizeable proportion of financial institutions are insolvent: their assets are, under plausible assumptions, worth less than their liabilities. The International Monetary Fund argues that potential losses on US-originated credit assets alone are now $2,200bn (€1,700bn, £1,500bn), up from $1,400bn just last October. This is almost identical to the latest estimates from Goldman Sachs. In recent comments to the Financial Times, Nouriel Roubini of RGE Monitor and the Stern School of New York University estimates peak losses on US-generated assets at $3,600bn. Fortunately for the US, half of these losses will fall abroad. But, the rest of the world will strike back: as the world economy implodes, huge losses abroad – on sovereign, housing and corporate debt – will surely fall on US institutions, with dire effects.

Personally, I have little doubt that the second view is correct and, as the world economy deteriorates, will become ever more so. But this is not the heart of the matter. That is whether, in the presence of such uncertainty, it can be right to base policy on hoping for the best. The answer is clear: rational policymakers must assume the worst. If this proved pessimistic, they would end up with an over-capitalised financial system. If the optimistic choice turned out to be wrong, they would have zombie banks and a discredited government. This choice is surely a “no brainer”.

The new plan seems to make sense if and only if the principal problem is illiquidity. Offering guarantees and buying some portion of the toxic assets, while limiting new capital injections to less than the $350bn left in the Tarp, cannot deal with the insolvency problem identified by informed observers. Indeed, any toxic asset purchase or guarantee programme must be an ineffective, inefficient and inequitable way to rescue inadequately capitalised financial institutions: ineffective, because the government must buy vast amounts of doubtful assets at excessive prices or provide over-generous guarantees, to render insolvent banks solvent; inefficient, because big capital injections or conversion of debt into equity are better ways to recapitalise banks; and inequitable, because big subsidies would go to failed institutions and private buyers of bad assets.

Why then is the administration making what appears to be a blunder? It may be that it is hoping for the best. But it also seems it has set itself the wrong question. It has not asked what needs to be done to be sure of a solution. It has asked itself, instead, what is the best it can do given three arbitrary, self-imposed constraints: no nationalisation; no losses for bondholders; and no more money from Congress. Yet why does a new administration, confronting a huge crisis, not try to change the terms of debate? This timidity is depressing. Trying to make up for this mistake by imposing pettifogging conditions on assisted institutions is more likely to compound the error than to reduce it.

Assume that the problem is insolvency and the modest market value of US commercial banks (about $400bn) derives from government support (see charts). Assume, too, that it is impossible to raise large amounts of private capital today. Then there has to be recapitalisation in one of the two ways indicated above. Both have disadvantages: government recapitalisation is a bail-out of creditors and involves temporary state administration; debt-for-equity swaps would damage bond markets, insurance companies and pension funds. But the choice is inescapable.

If Mr Geithner or Lawrence Summers, head of the national economic council, were advising the US as a foreign country, they would point this out, brutally. Dominique Strauss-Kahn, IMF managing director, said the same thing, very gently, in Malaysia last Saturday.

The correct advice remains the one the US gave the Japanese and others during the 1990s: admit reality, restructure banks and, above all, slay zombie institutions at once. It is an important, but secondary, question whether the right answer is to create new “good banks”, leaving old bad banks to perish, as my colleague, Willem Buiter, recommends, or new “bad banks”, leaving cleansed old banks to survive. I also am inclined to the former, because the culture of the old banks seems so toxic.

By asking the wrong question, Mr Obama is taking a huge gamble. He should have resolved to cleanse these Augean banking stables. He needs to rethink, if it is not already too late.

martin.wolf@ft.com

More columns at www.ft.com/wolf

U.S. Wants UBS to Break Swiss Law By Naming Clients, Bank Says

2009-02-21T10:58:00.001-08:00

By David Voreacos and Carlyn Kolker

Feb. 21 (Bloomberg) -- U.S. efforts to force UBS AG, Switzerland’s largest bank, to disclose the names of 52,000 American customers would require the bank to violate Swiss sovereignty and criminal law, bank lawyers said.

A U.S. lawsuit filed yesterday improperly seeks to enforce summonses from the Internal Revenue Service for the identities of account holders and would trample on Swiss sovereignty, according to a UBS filing yesterday in federal court in Miami.

“Swiss law strictly prohibits UBS and its employees from disclosing to the IRS the account information located in Switzerland that the IRS seeks,” UBS lawyers wrote. “The IRS’s petition does not acknowledge these restrictions and instead simply ignores the existence of Swiss law and sovereignty.”

The filing is the bank’s first legal response to a lawsuit that would enhance tax collection by striking a blow at historic Swiss bank secrecy. The U.S. sued one day after Zurich-based UBS agreed to pay $780 million and disclose the names of about 250 customers to defer prosecution on a charge that it conspired to help wealthy Americans evade U.S. taxes over several years.

By trying to force disclosure, the IRS seeks to expose bank employees to “substantial prison terms, as well as fines, penalties and other sanctions,” bank lawyers wrote. The IRS also wants a judge to force UBS “to violate Swiss law in a manner that will expose it to penalties, civil liability and the possible revocation of its banking license.”

323 Account Holders

UBS claimed the Justice Department is bypassing “carefully negotiated” treaties that lay out procedures for the IRS to get information on tax fraud in Switzerland by U.S. taxpayers. It said that UBS already has given information on 323 U.S. account holders to the IRS since last July.

“The IRS asks this court to rewrite the relevant treaties between two sovereign nations,” according to the filing. “To the extent that the IRS is not satisfied with treaties that the U.S. government has negotiated, that concern should be remedied through diplomacy, not an enforcement action.”

In a response yesterday, the Justice Department urged the judge not to delay the case.

“Delay serves the cause of those U.S. taxpayers who continue to hide behind the actions” of UBS and “its spurious claims that it can do business within the United States with impunity, and still rely on Swiss bank secrecy law,” according to the Justice Department filing.

‘Impunity’

The IRS “should not have to sit idly by while thousands of its citizens violate U.S. law with impunity,” according to the filing by Justice Department senior litigation counsel Stuart B. Gibson.

Alicia Valle, spokeswoman for the U.S. attorney for the Southern District of Florida, R. Alexander Acosta, declined to comment.

In its filing, UBS argued that it signed an agreement with the IRS in 2001 that allowed it serve as a “Qualified Intermediary” that would permit it to withhold the identities of U.S. taxpayers from the federal tax collectors.

“The IRS seeks to repudiate its own contract and demands the production of the very account information that the IRS agreed would remain confidential,” wrote UBS lawyers from the law firm of Stearns Weaver Miller Weissler Alhadeff & Sitterson in Miami. They are working with lawyers from Wachtell, Lipton, Rosen & Katz in New York.

In avoiding prosecution, UBS admitted a series of lapses, including extensive violations of the Qualified Intermediary agreement while pursuing a cross-border banking business to woo wealthy Americans, according to a statement of facts.

Encrypted Laptops

As many as 60 Swiss-based private bankers who were not licensed to operate in the U.S. traveled to the United States with encrypted laptop computers to maintain client secrecy and got training on how to avoid detection by U.S. authorities, according to the statement filed Feb. 18.

The Justice Department response urged the judge to note that “only two days ago UBS admitted to conspiring with its U.S. clients to violate that agreement, and thereby assist U.S. taxpayers to evade their U.S. tax obligations.”

On July 1, a judge in Miami authorized the IRS to issue so- called “John Doe” summonses for the identities of UBS account holders. The lawsuit filed yesterday asks a judge to enforce that summons.

In its filing yesterday, UBS asked U.S. District Judge Alan Gold to deny the IRS request to handle the matter on an expedited basis. Gold has scheduled a telephone conference for Feb. 23.

The bank asked Gold to lay out a schedule for written arguments, the collection of evidence, “the nature of the hearing that might take place in this matter, and the role of the governments of both Switzerland and the United States in these proceedings,” according to the filing.

The case is U.S. v. UBS AG, 09-20423, U.S. District Court, Southern District of Florida (Miami).

The mechanistic approach to economics has failed.

2009-02-16T01:34:00.000-08:00

From The Guardian, Monday February 16, 2009

By Larry Elliot

It has been 75 years since the world economy has had a real depression. There have been plenty of recessions, some of them painful, but nothing to match the slump suffered in the 1930s.

But consider the following. Imports into China are down 45% year on year. Unemployment in the United States is rising at 600,000 a month. The German economy shrank by 2.1% in the final three months of last year. Factory output in Britain is dropping at a rate not seen since industry was on a three-day week during the miners' strike of 1974.

So is this the "Big One"? The honest answer is that we don't know and we might as well admit it. One reason we are in this mess is that we assumed far greater foresight than actually existed. All the fancy models purporting to show only a minuscule risk of financial blow-out were flawed. They assumed the complexity could be captured by mathematics and pseudo-science. One silver lining to the storm cloud over the global economy is that there will now be an overdue revolution in how we do economics. Already, the cutting edge of the profession is looking to other disciplines - biology and psychology in particular - to explain why models that work in theory come a cropper in practice.

Passions

As Richard Bronk notes in his fascinating new book*: "Standard economics assumes that economic agents are perfectly rational; that is the basis of its predictive equilibrium-based models. Modern versions generally allow for certain types of information problem and market failure, and recognise that institutions and even history play a role; but they still assume that these factors do not call into question the underlying model of agents as rational utility maximisers within those constraints."

Bronk's book is about the lessons economists can learn from the Romantic movement, from Wordsworth's poetry and the philosophy of Nietzsche. We all have passions, paranoias, dreams and delusions, he says, and these shape our future. "In many cases, economic activity is as much a function of creativity, imagination and sentiment as is the act of writing a poem or painting a picture."

There have been many economists down the years who have expressed scepticism about reducing their discipline to a mechanistic subject. Malthus told Ricardo to be wary of becoming too attached to abstract hypotheses; Schumpeter talked of creative destruction; Hayek saw the market as a voyage of discovery; Keynes stressed the importance of "animal spirits".

Somewhere down the years, these insights have been lost. It is as if physicists still thought that the Newtonian view of the world was all that mattered, and that Einstein had never been born.

In retrospect, Chuck Prince of Citigroup best summed up why life does not always turn out the way the models say it should. Three weeks before the crisis broke, Prince said there was so much liquidity around that the financial markets could not be disrupted by the turmoil already evident in the US sub-prime market. "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing."

Prince's comment is now seen as the height of folly, but it was not seen as such at the time. One commentator noted that defaults on junk bonds were running at their lowest rate since 1995 and it made sense for Citigroup to make money while the going was good. Most other players in the financial markets behaved the way Prince did, and those that didn't were investors who put their trust in judgment, feel and experience rather than on market signals.

Dispensing with rationality

What we now know is that even the very recent past is an unreliable guide to the future; that risks are not distributed in a linear and predictable way; that human beings do not always act rationally even when they think they are; and that shocks are much more likely than economic orthodoxy would suggest.

All of which explains why it is virtually impossible to say where the global economy goes from here. The big picture is of globalisation going into reverse, with industrial production and trade flows collapsing. Dharval Joshi, economist at RAB Capital, says that if history is any guide the UK and the US could well be braced for the Big One.

On the four occasions in the past 100 years when households in a major country have seen their net worth shrink there has been a strong correlation with lost output. For every three percentage point drop in net household worth in the US during the Great Depression, the Japanese crash of the 1990s, the UK housing collapse of the late 1980s and the US dotcom bust, there is a subsequent one point drop in output.

In the downturn, lower house and equity prices have seen wealth as a percentage of GDP fall by 90% in the US and 80% in the UK. That would imply a 25-30% shortfall in output in the US and Britain relative to trend - which would fully justify Ed Balls's comment that this could be the most serious global recession in more than 100 years.

This is not yet the conventional wisdom, though the mood is getting gloomier. Mervyn King says Britain is in a deep recession; he says cheap money, fiscal expansion and the "unconventional measures" the Bank of England has up its sleeve will eventually work. Even so, at its worst point later this year, King thinks the economy will be contracting at an annual rate of 4% - with the risk that it could be worse than that.

Interestingly, the governor cited Keynes at the Bank's inflation report press conference, noting that animal spirits were currently depressed. With confidence so weak, it is hard to envisage an early or a robust recovery.

Having said that, we may be as blind to the potential for an upswing as we were to the looming crisis. Baroness Vadera was recently pilloried for mentioning "green shoots", yet there have been a few in recent weeks - signs of buyer interest returning to the housing market, surveys of manufacturing, services and construction that were slightly less dreadful than the previous month, a gradual thaw in the credit markets.

Clearly the good news is outweighed by the bad, but it should not be dismissed out of hand. The consensus is that 2009 is a write-off and that 2010 will not be much better, and if I had to stake my life on it that's probably what I would say. But the consensus is invariably wrong, and anybody claiming to know for sure where the economy is heading is lying. We have had more than enough strident professions of certainty, it is time to admit we know a lot less than we think. Let's read some Wordsworth instead.

• Richard Bronk; the Romantic Economist; Cambridge University Press £17.99

larry.elliott@guardian.co.uk