Zombie Banks, The FDIC and Directors’ and Officers’ Insurance Premiums

Those who cannot remember the past are condemned to repeat it.” George Santayana

There is a direct connection between the banks, legislative changes and directors’ and officers’ insurance premiums. Relaxation of regulation and poor policies and procedures intensified and increased the losses associated with the S&L Scandal of the 1980’s and early 1990’s. But just enough time passed since then to give decision makers the excuse to forget the lessons learned from that sorry episode. Not surprisingly all of the same issues have resurfaced prior to the onset of the Global Financial Crisis (GFC) thereby contributing to the causes of the GFC and importantly to the failure of US Banks so far and the extremely weakened condition of the entire banking sector.

The FDIC provides a chronology of S&L events on their website, and in a book,. These should be made mandatory reading for every employee of every bank, insurance company, rating agency, securities dealer, accounting firm and law firm. There are at least of few people in every level of a company who can smell a problem long before the executives are willing to do anything about it. And now, those employees can even profit from this knowledge.  The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law on July 21, 2010, includes a provision SEC. 21F, called “SECURITIES WHISTLEBLOWER INCENTIVES AND PROTECTION”. This provision looks to incent whistleblowers with an award of 10% to 30% of the monetary sanction over $1 million.  Therefore, if one were to take the average cost of the top six most recent FCPA settlements and multiply by the lowest award, it would means a $47 million compensatory windfall to the employee who blows the whistle on these bosses.

The FDIC book on the S&L scandal suggests that total FDIC recovery from 1986 through 1996 from professional liability suits was $5.1 billion (outside counsel costs were $1 billion – ie a significant incentive for lawsuits), with $1.3 billion of that coming from D&O claims, and, surprisingly, only $300 million from fidelity bond insurers. The account does not specifically say that the D&O recovery was from insurance policies, but there is no doubt that these insured losses were material to the insurance industry.

In those days, Insured vs. Insured exclusions, and trustee/regulator exclusions and limited severability were much more common in the D&O policy. And, the policies were not as heavily extended to cover loss of the corporate entity, and other parties and matters, as they are today. Also unique to that period was the length of time that D&O insurers had to prepare for potential loss. A noticeable uptick in bank failures was identifiable as early as 1982, but the actual assets losses and deposit insurance losses were not material until 1988.  The period of 1997 through 2007 saw so few bank failures that the slate was wiped clean as if the past never existed. But this time, the asset losses and deposit insurance losses, which, in the 1980’s took seven years to develop, happened in one year. And these losses occurred on the basis of only the modest increase in the number of banks that the FDIC, Fed, Treasury and the OCC have so far made public.

Therefore, with the speed of the recent downturn, the larger average size of the failed banks, the broader policy wordings (more coverage for the corporate entity), and the resources of plaintiff counsel, it might ultimately be impossible to compare the S&L debacle with the GFC.

NERA Economic Consulting released their “Failed Bank Litigation Report” in August 2010, providing a lot of details comparing and contrasting the S&L with recent bank failures, including the resulting D&O and Professional Liability litigation. The first part of the report presents statistics on recent bank failures and the characteristics of their assets, loan portfolios and performance relative to banks that have not failed.  The remainder of the report discusses failure factors and litigation in both periods.

This becomes an even more interesting having read Recovery Partners’ blog entitled “Hubris Meets Nemesis”, which estimates that “…the number of insolvent and/or severely impaired banks in the US to be well over 2000 institutions”, and goes on to point out that the suspension of FASB 157 (“the abolition of “mark-to market” accounting”)  and the failure to activate the Prompt Corrective Action Law. is hiding the true extent of the deterioration in bank balance sheets in the US.  If this analysis is in the ballpark, that will mean that the GFC hit in the US will vastly eclipse the losses from the S&L scandal. Of the 2,912 bank failures from 1980 to 1994, many were private and a lot smaller than the average failure today. It has been suggested that the scandal crisis cost over $150 billion and represented 3% of US GDP. Today, $150 billion is the cost to ‘bailout’ one insurer.  According to the DandO Diary blog, there have been 118 bank failures in 2010, and 165 in two full previous years. Recovery Partners estimates that the Deposit Insurance Fund losses from the GFC are currently in the range of some $500 to $700 billion. See also Chris Whalen’s Institutional Risk Analytics website for similar views on this issue.

The FDIC is starting to sue failed bank directors and outside professionals. FDIC filed two separate lawsuits in the Northern District of Georgia against outside law firms for the failed Integrity Bank of Alpharetta, Georgia. FDIC filed a separate suit against former directors and officers of Integrity Bank. They provide an updated list of failed banks on their website, and a separate list of authorized suits against individual directors and officers.

FDIC litigation in the S&L period was the primary source of litigation. Today the follow-on claims in private litigation by investors and creditors, and criminal proceeding by the DoJ, are very creative in order to avoid FDIC priorities and onerous pleading requirements (scienter hurdle of 10(b)-5.) This could mean that private litigation could cause even more “insured” loss than the FDIC. The “Failed Banks” topic section of the DandO Diary, provides significant detail and resources on the primary claims, third party professional claims, and on follow-on civil litigation.

The Canadians in this group are not insulated from this issue. A majority of the market share of D&O insurance premium written in this country is by insurers who are exposed to US claims. Even if they are not directly writing Bank D&O policies, bank failures affect the lawyers, accountants, pension and investment fund investors, and the ‘bricks, clicks and mortar’ companies who rely on these banks.  There has been a flight to safety for insurers, and that is why we have more than 27 companies writing directors’ and officers’ liability insurance in Canada. Every one of theses firms will have difficulty avoiding the direct and/or reinsurance costs of US losses in spite of the fact that insurance companies typically spread theor risks across all of their insureds, whether these insureds are inter-listed, large public, private or non-profit companies.

In addition to the direct and indirect US exposures, Canada is seeing a material change in homegrown loss experience. The decision in the IMAX class action securities case, was a denial of the defendant’s motion for leave to appeal the K.van Rensburg J. decision to certify class proceedings. We all know what happens to settlement amounts when a court decision goes in favour of the plaintiff class. The underlying securities litigation commenced September 20, 2006, when Siskinds LLP,  and Stutts, Strosberg LLP, brought their case alleging misrepresentation and breach of duty of care. This was the first case to be brought under Ontario’s new, at the time, “Bill 198”, aka, part XXIII.1 of the Ontario Securities Act (the “Act”), section 138.3, which provides a statutory cause of action for secondary market misrepresentation.

The insurance implication is that the IMAX 2005 information circular listed a D&O policy with a $70 million limit of liability. The circular does not provide a lot of detail, and I am not privy to any inside information, but it does say they had a split deductible of $100,000 “for each claim under the policy other than claims made under U.S. securities law as to which a deductible of $500,000 applies”, and paid an annual premium of $962,240.

There is no regulation of D&O or E&O policy wordings in Canada, and there are hundreds of versions of policy wordings, applications and endorsements that can mean the difference between coverage and personal financial loss. In the IMAX case, the split deductible (and the level of premium) would suggest that the policy provided at least some level of coverage for the separate and distinct loss of the corporate entity. If this policy structure, or an undisclosed policy, did not include a separate limit of liability for individual directors and officers, and their non-indemnified claims, then this $70 million is subject to erosion or even full exhaustion by loss incurred by the corporation.

Unfortunately, most directors and officers make a critical assumption that their D&O policy is designed to cover their personal liability. For many directors and executives, this “sharing of limits” problem is only identified after a lawsuit has been launched. The confusion is that this extension is marketed as “securities coverage”, which can be misleading to the individual directors. Some insurance brokers have sold this coverage by suggesting it is the only way to get coverage for claims brought by shareholders. Such a statement is absolutely false. The traditional D&O policy was always meant to apply to claims brought by shareholders, but only those claims brought against individual insured persons, not those brought against the corporation. 

Much more information on Canadian securities class actions can be found in the NERA report, here.

With a relatively small premium base, when compared with the personal and commercial property and casualty market, the specialty casualty insurance marketplace can be materially affected by isolated industry events. Even within this isolated industry (if you can call US Banks an isolated industry) there was a significant historical learning opportunity. With the degree of correlation between contributing factors of the S&L event and the recent bank failures, it is not a stretch to suggest the S&L learning opportunity was completely ignored by far too many decision makers.

If the horse has already left the barn, (which, based on D&O losses to date, has not been determined), then there are two things to do: First, identify and mitigate the current and ongoing risks of this event; and then identify the contributing factors (and people) and take appropriate notice and initiate action, so the market can retain this information and use it to avoid similar situations in the future.

Based on, 1) larger bank asset losses, 2) larger FDIC losses, 3) higher D&O policy limits and broader wordings, 4) deeper pockets in the executive ranks, 5) a new profit incentive to blow the whistle to regulators and the media (and not report concerns to the audit committee and independent board members), 6) the motivation of significant plaintiff lawyer contingency damage awards, and 7) an increase in follow-on civil litigation, insured losses will increase and the risk of D&O and Professional Liability insurance premium increases and coverage limitations is therefore extremely material.

Policy expiry dates, market swings and claims rush forward very quickly. Therefore, timing is crucial. All directors, executives, officers, compliance and legal staff, and other outside professionals should be doing the following:

1)             Request a personal contractual indemnity agreement from the corporation or partnership. Indemnification provisions are built into the Canadian Business Corporations Act, the Ontario Business Corporations Act, many corporate by-laws, and into most of industry specific acts, but, they are not all created equal, and none of them are as good as a well vetted individual contractual indemnity;

2)             Recognize that D&O insurance is not a panacea. It should not be a priority over good commercial general liability, property or operation specific products, like professional liability, errors and omissions liability (“E&O”), environmental, fidelity/crime, and cyber/media/privacy insurance policies.  D&O is also not a priority over good governance, risk management and compliance (GRC) activities;

3)             Know the expiry dates of all policies. Notice I did not say renewal dates, because a D&O/Fidelity/E&O renewal is never guaranteed;

4)             Know your “notice” obligations and opportunities to report claims and “circumstances” to the insurers and trigger your current policy for future loss (no matter when that claim is eventually launched;

5)             Have your broker identify all areas of “limits sharing” within your policies. Limit sharing is very sneaky, because it is not isolated to an insuring agreement; it can be found in the applications (which forms part of the policy,) exclusions, allocation provisions, severability provisions, and even in the definitions;

6)             Treat the D&O purchase decision as it being based on the limit liability, not on the insurance premium. The limit of liability has, or should have, a value that is material to the corporation, often the premium does not. Even for a small non-profit, it is a one or two million dollar decision; for a small publicly traded company it is a five to twenty five million dollar decision; and for a large public company it can be a $100 million decision. The purchase decision deserves this level of attention; and,

7)             Examine the skill, ability and independence of your broker (not just your brokerage.) There are far too many brokers who are passing themselves off as experienced, when in fact they have limited or no direct experience with D&O policies and claims. There are also many brokers who marketed (even convince) themselves they are independent, even when they owned by, or have a material debt or non-standard remuneration agreement with, an insurance company. It is therefore appropriate to, a) request full disclosure of ownership and all potential conflicts of interest, including any “exclusive insurer” programs, b) ask all brokers to explain to your satisfaction the key issues regarding all coverage options as they relate to your operations, and, c) request of all brokers not approach any insurance markets on your behalf until you have made your choice of broker.

Through aggressive competition among insurance companies and under-educated and overzealous insurance brokers, policies have been “broadened” to such an extent that they are now a possible detriment to the appointment of directors. Claims made against the corporate entity and coverage for non-traditional parties and matters are now fair game under many D&O policies. This level of coverage can be very attractive to aggressive plaintiffs, and their even more attractive to aggressive plaintiff’s lawyers, because a broader policy means a better chance for at least a modest settlement. A modest settlement reduces the down-side risk of pursuing what might be a long-shot chance of discovering a smoking gun that will produce the home run settlement (entire policy limits, plus corporate contribution, plus third party contribution, plus individual director and officer contribution.)  However, there is only one limit of liability that will be shared by all parties for all claims.

We have yet to see how US bank failures will play-out for D&O insurance buyers, but given what we already know, it behooves executives, directors, corporate risk managers and their advisors to meet this issue proactively and forcefully.

This is a guest blog by Greg Shields, a Partner and commercial insurance broker with Mitchell Sandham Insurance Services in Toronto, specializing in D&O, E&O and Fidelity insurance. His blog posts can be found at http://mitchellsandham.wordpress.com/, and he can be reached directly at gshields@mitchellsandham.com, or at 416 862-5626.

Posted in Bank Loans, Bankruptcy, Canada, Crisis, Insurance, Loan Losses | No Comments »

The Men Who Killed the Greenback

“We have met the enemy and they is us”    Pogo

When German finance minister, Wolfgang Schaeuble, called US monetary policy “clueless” in early November of 2010, he opened a new chapter in the World’s response to the decades-old control that the United States of America has enjoyed over global economic policy.

European criticism of American politics is not new. After all, the elites of Berlin, Paris or Rome have a history of voicing their opinion on American matters. But the fact that a European political heavyweight essentially calls an entire government and one of its revered institutions “clueless” sets a new standard and amounts to a direct attack on the trio of Fed Chairman Bernanke, Treasury Secretary Geithner and President Obama — the three individuals that been have advertised by the mainstream media as saviors of the global economy. (the fact that Bernanke and Geithner were at the controls well before the crash occurred and that they therefore share some blame for the crisis itself is conveniently ignored).

In past decades, one could not imagine a senior European political leader so openly attacking the US, but Obama’s “Yes, We Can” approach seems to  invite criticism and challenge to US hegemony. Not in the least, these new attitudes are gaining traction because the world must now struggle through the consequences of American policy-making that fomented the madness of giving mortgages to American “NINJAs” ultimately transferring the credit risk associated with insane balance sheet management decisions onto the backs of taxpayers around the world, including the those in the US.

Increasingly, political leaders around the globe have come to the conclusion that blame must be accorded the United States of America for causing the biggest collapse the global financial system has ever seen. There seems to be a new desire to challenge the United States in its hence undisputed global leadership role and to emancipate the rest of the world from the American ideal and its grip on World affairs. None of this portends a rosy or even stable future path for the world economy and the evolution of geopolitical relationships.

Misguided US Policy

Mr. Schaeuble is right in calling American policy clueless. Printing money and creating more liquidity is not ever going to solve America’s own economic or fiscal problems.

Quantitative Easing has not worked in round one, as can easily be seen in the slow recovery of the U.S. economy. Yes, the liquidity created by the Fed in QE1 has made financial markets happy, creating plenty of liquidity to drive asset prices higher, but it certainly has not produced any jobs. Nor has QE2.

 The monetary policy stance has simply blown new bubbles in a variety of global markets and convinced market participants the that “Bernanke put” is still operative. However the raw numbers do not lie. While wealthy America enjoys better times on Wall Street, the unemployed or underemployed America continues to suffer from the protracted slump on Main Street.

The first decade of the 21^st Century has seen official US federal debt cross the $10 trillion mark (this does not include the $50 odd Trillion of off-balance sheet commitments) which is being left to tick away like a debt bomb while the politicians convince themselves that they are being prudent and parsimonious. No wonder that the Fed and the Treasury are manipulating  interest rates by flooding the market with ever cheapening dollars. Debasing the currency is in fact an act of desperation, but it comes with the side effect of keeping the specter of higher interest rates at bay, while at the same time creating a ready demand for the vast supply of Treasury paper. This balancing act has been on a fuse from day one. Unfortunaltely the US leadership chooses to ignore this reality.

 How far removed American policy makers are from reality was further demonstrated by the 2012 budget that President Obama tabled just last week. According to the plan crafted by the White House, the United States will not see a balanced budget for another 15 years and will continue to pile up new debt at a rate exceeding $1trn per year. Obama seems to have replaced his “Audacity of Hope” message with an “Audacity of Desperation” when he publicly (and quite possible cynically) announced that the US Government would stop “racking up the credit card”. Not only is this statement an audacious misrepresentation in and of itself,  it also demonstrates a total lack of political leadership coming from this Administration that is truly appalling. How long this game can go on is anybody’s guess, but if history is any guide (and we have plenty of data on Sovereign default) we are already well into the danger zone.

To compound the complexity of the situation that the US authorities have created for themselves, there is now a widespread understanding of the  connection between QE and the unprecedented rise in commodity and food prices. In fact, the rising cost of basic food items denominated in US dollars renders the linkage between US monetary policy and the eruptions of unrest across the Middle East and parts beyond fairly obvious. 

In addition, no matter how much the White House and most leaders in the West cynically celebrate these revolutions as spontaneous “acts of liberation” by the people from repressive regimes and the first step towards a spread of democracy in the Middle East, a more sober view of recent events should focus on the geopolitical risks and on what instability in the Middle East means. For example, there is a non-trivial risk that we could see a repeat of post Shah Iran where elements of Islamo-fascism are behind or are planning to hijack the processes by which governments are being replaced or have been replaced in a number of these countries.  The Obama Administration must bear some responsibility for these unexpected developments both as a result of expansive monetary policy which has boosted food prices and incited the hungry masses to action, but ironically, also because of Obama’s early term kowtowing and proselytizing to these same masses which has encouraged America’s enemies in that part of the World.

America’s Decline and China’s Rise

Since emerging from WWII as the world’s strongest economy both militarily and financially, the United States have spent the better part of the last 60 years becoming the largest debtor country the World has ever seen. It hardly comes as a surprise that all of this encourages world leaders to question US leadership. Bernanke’s QE exploits and the perversion of the US bond auction process may well become the tipping point in a developing story where the greenback can no longer serve as the world’s only reserve currency. Chatter is increasing of central banks around the globe putting together a basket of leading currencies, logically including the euro, Swiss Franc, Remimbi and other emerging market tender, that can either supplement or even take over the role of the U.S. dollar.

 China has recently started opening the Remimbi as a trading currency across Asia. This is widely seen as a first step towards China asserting a larger international role for its currency. China is demonstrably on the path of securing long-term sustainability of its rise to global economic power. China also understands that it is in her best interest not to increase the trade deficit with the United States further but to soften its impact. While the US spends and prints money, the Chinese are prudently applying the economic brakes. If recent meetings of global leaders are any guide, it remains unclear whether prudence and restraint from the Middle Kingdom, and Europe for that matter, will be enough convince Washington to turn away from desperate and ill advised policies. However, this point may soon become moot as China discovers for itself the power a creditor can exert over debtors; a game which the US has practiced with impunity in the Postwar period – unitil now.

Loss of Leadership

After driving the world to the brink of financial collapse in 2008, the United States may indeed have lost both credibility and legitimacy as the steward of the reserve currency and global monetary system. Many see the creation of a new international currency system as the ultimate solution to monetary warfare and to stabilizing the world economy.  The United States may not like this infringement on their global dominance. In the best case the US authorities may come to realize that the creation of an alternative global monetary mechanism may allow them to share the burden that the global role of the Greenback signifies for America. This would be a World in which all nations, including the US, understood their role, their standing amongst peers and foreswore any attempts to exercise dominion over other countries and peoples. What a wonderful World that would be, would it not?

Unfortunately life is not that simple, and the US will not yield easily. The reserve currency debate spans across all major international organizations, reaching from the UN to the IMF and the G20. It has been a while since we have seen the world engaged so deeply in devising a new global monetary policy — and never before have we seen the United States not at the forefront of financial issues and leading the agenda. It could be that at a structural level, ossification has set in and US institutions are too wracked by political inertia to come to the correct decisions in a short enough period of time to be able to effectively deal with the various problems. This is certainly appears to be part of the issue. However personalities also play a role. And here we have to conclude that from President Obama on down, the individuals in key positions of authority and responsibility in this Administration simply are not “Men of the Moment”……and they are therefore not up to the task of fixing the problems that they have helped create.

How this will all play out is anybody’s guess.

By: Beat J. Guldimann, LLD

Posted in Bankruptcy, Crisis, EU, Economy, Fed Policy, IMF, Sovereign Debt | No Comments »

What’s QE all About Anyways? (or Why it’s too Early to Buy the Banks or Bank Assets)

Yesterday, following an interview on BNN we received quite a bit of email in response to the remarks I made on-screen regarding Mr Bernanke’s policy of Quantitative Easing (QE). There seems to be a great difference of opinion, and we might add, confusion, as to what this program actually entails and why it is being pursued.

The announced aim of QE is to raise asset prices above their market clearing levels in order to add a fillip to growth prospects in the US.  Ben Bernanke, speaking recently contends:  “I think we are underestimating and continue to underestimate how important asset prices, very specifically equity values are, not only for shareholders and the like, but for the economy as a whole.” 

The proposition that Monetary Policy can exert a growth impact on the real economy through an asset channel, AND that it will be significant,  AND that the Fed can predictably control this effect within reasonable tolerances and timeframes as contemplated by Bernanke, is highly speculative at best. One needs only to review the available literature in this area or to do the math on the potential impact of the announced QE program to arrive at this conclusion. Once past the hurdle of needing to treat the Fed Chairman’s pronouncements with a dose of healthy scepticism, and given the size of the intervention, the obvious conclusion one must draw is that the intended effect of QE is perhaps directed at certain other policy objectives that the Fed deems to be at least as important as raising employment and economic growth prospects. Bernanke’s recent admission that unemployment would remain high until at least 2014/15 – essentially saying to the unemployed “There is nothing we can do for you folks beyond issuing dole checks” –  underscores this interpretation.

There are in fact three interlinked goals of QE in combination with ZIRP (Zero Interest Rate Policy). The first has to do with the condition of bank balance sheets; the second with the condition of the Fed’s balance sheet and the last with the funding requirements of the US Government.

 Bank Balance Sheets

The FDIC Claims that it has 860 banks on its watch list, the most since the S&L debacle which occurred almost 30 years ago. As a regulator/policymaker there are three things that you can do in a situation where you have failing banks on your hands:

 (1)     Liquidate the banks – Fire everyone; sell of the good bits and manage down the junk. Prosecute the criminals and fraudsters

(2)     Put into receivership or conservatorship –  Fire management. Restructure Business and off to the races again. Prosecute the criminals and fraudsters

(3)     Subsidize – Give money to fix TEMPORARY Problems. Everything else stays the same. This assumes that the business is basically healthy and there has been no accounting control fraud.

 …..and to execute any one of these strategies you need to ensure the following Best Practice Guidelines are met:

(1)     Transparency. Ensure that the markets understand what is going on i.e. how bad the issues are and what the intended results are

(2)     Assertiveness. Need to act aggressively and with purpose to stem the problems in the early stages

(3)     Accountability. Hold executives etc responsible and measure performance during the restructuring , liquidation or subsidy period.

(4)     Clarity. Explain the markets EXACTLY what forms of assistance that the banks are getting and why

We have written in that past about the fact that the zombie bank problem is much, much larger than what the authorities have been telling the markets. In fact we estimate that the scale of the problem in the US is on the order of USD 500 to 700 billion dollars. Therefore what is being attempted in the US (and in Europe) to cure the zombie bank problem is a stealth subsidization approach complemented by liquidation of only the most rotten of the zombie banks (e.g. in the US those banks, for example, that have a gross asset impairment ratio of over 20%). In pursuing this policy the Fed, the OCC and FDIC have implicitly adopted an approach that assumes that the institutions are basically sound and all they need is a bit of money and some time and the problems will take care of themselves. In fact the chart below shows that the Fed’s usual trick of lowering the Fed Funds rate opening a wide spread against term rates and thereby allowing the zombie banks to re-capitalize themselves by riding the curve is not working at all as well in the present situation as it has in past years. This is why QE, which gives the banks more cash to play with, is being aggressively pursued.

The effort to keep the true condition of banks cloaked also explains why the US authorities suspended (without formal announcement) the application of the “Prompt Corrective Action Law“ and strong armed the FASB into striking down the mark to market rules allowing insolvent institutions to continue to “mark-to-fantasy” and avoid liquidation. These policy actions are all related to maintaining the impression that almost all banks in the US are still healthy. Recall that our view of the Bank Stress Tests in the US (and Europe) is that they were designed to make the banks appear to be sounder than they really are. In the case of US banks, the stress tests did not properly stress real estate risks; and in the case of the European test, it was Sovereign Debt exposures that got the once over lightly treatment. Look at where we are today. How credible do the test procedures seem now in the wake of renewed concerns regarding the European Sovereign Debt situation and persistent weakness in US housing markets and the looming rollovers of commercial real estate loans there?

Hence we can infer that similar objectives have lain behind the refusal of banks and policymakers in Europe to consider debt write downs. This is why the bailout packages being forced onto the peripheral European countries are considered to be very rickety solutions in our opinion. They do not accommodate the needed reckoning and write down of the bad loans made by banks to those economies, pile more debt onto them that is then expected to be funded by taxpayers who, as a consequence of the situation, effectively become tax slaves.  This situation is not socially nor politically stable in the medium term, and certainly will not last long enough for these economies to dig themselves out of the mess by using these means. Refer to our previous comments on the history of fiscal remediation efforts.

(Compare the actual actions of the authorities as described to the Best Practices Guidelines shown above)

As long as the banks remain weak, look for the US authorities to maintain their “extend and pretend” policies; and look for QE to make another encore appearance. (Similar motivations, namely the need for a blanket solution to the Sovereign Debt Crisis in Europe is why the European Central Bank has just re-started its QE program.)

What would we have done? See here.

The Fed and the Treasury

There are two other reasons for running the QE, namely to help the Fed and the Treasury to dig themselves out of the holes that they are in:

The Fed needs to find a way out of the “roach motel” it created for itself when it re-discounted toxic waste from the market at par (instead of market value)  to keep the worst of the insolvent banks afloat, and when it bought back huge MBS inventories from Fannie Mae and Freddie Mac. The “elevator boots” afforded by its ability to massively leverage its footings without regard to capital considerations or credit risk are certainly helping it achieve this objective. Recent disclosures by the Fed regarding its lending operations and counterparties do not tell the entire story. Moreover, the fact that the Fed is not, and never has been, subject to mark-to-market rules or disclosure requirements as to its activities, in theory allows it to play this game until the combination of money printing and yield curve trading covers its internal asset valuation deficit. The fact that the QE undertaken so far is insufficient to cover this shortfall is one more reason why we will likely continue to see additional QE after this round is completed.

At 14.5 % of GDP, US Federal Tax revenues are off sharply from the usual 18-19% run rate. In combination with the various stimulus measures and entitlements ramp up, this has opened up a huge funding requirement. The Treasury needs a helping hand to fund its deficit as it is becoming clear that there is significant congestion in US bond markets as evidenced by recent price action and the withdrawal of foreign players from the buy side. There is in fact more than some reason to believe that the Treasury does not want to expose itself to funding risks because they want to maintain the fiction that they have no problem closing the deficit. Recent results of the coupon passes show that on-the-run bonds are being submitted back to the Fed, and thus even the pretence that these operations are not designed to monetise the deficit has evaporated. The Chinese for their part laid down the gauntlet a month ago when Dagong Credit Rating Agency downgraded the US to A+ with a negative outlook. “Who listens to Dagong?” one might ask. The answer is that they only need one client – the Chinese Government – and if the ratings threaten to fall below single “A” (the typical investment cut-off for central banks and Governments); what that client does or what it tells the market in intends to do with its holdings of US dollars and US Treasury debt is of vast significance. By way of this indirect method, the Chinese are showing the US that they are in possession of some pretty big political and economic levers. We know the Chinese are upset with the QE and the “meddling” by the US as regards the yuan/US exchange rate. How this policy tussle shakes out is something that we will be watching with interest. Finally, the fact that there is at present almost no recognition among the US leadership that the US needs to get its fiscal house in order is a third reason that adds to the probability that the continuation of QE beyond the current program is very likely.

 Risky Business

Note that the dangers of the QE and ZIRP stance are substantial and numerous. These include growing geopolitical tensions, social unrest, the intensification of imbalances and fiscal stresses in emerging and other economies, rising inflation and a loss of credibility for the Fed. Moreover, far from being a set of policies solely designed to re-start the economy, the discussion above suggests that the financial underpinnings of the US are on a very precarious footing, that the Fed knows this, and that this is why it has chosen this untested and risky policy path involving QE and ZIRP.

As measured against Bernanke’s announced intentions of lowering the dollar, lowering bond yields, raising stock and property prices, and boosting the economy the QE program must be judged a failure. However, the jury is still out as to whether the Fed will be successful in achieving its unannounced goals as described above, and if in fact QE and ZIRP are the appropriate tools for all of these jobs or just a perilous policy patchwork assembled and implemented in haste.

Posted in Banks, Bond Market, Fed Policy, Loan Losses, Sovereign Debt | No Comments »

Bernanke in the Hot Seat

 “With all due respect, U.S. policy is clueless….(the problem) is not a shortage of liquidity. It’s not that the Americans haven’t pumped enough liquidity into the market.”

  Wolfgang Schauble, German Finance Minister reacting to QE2

As we saw in the lead up to the G20 meetings in Seoul this past weekend and at the meetings themselves, there is a growing chorus of discontent regarding US economic policies. Direct attacks on the Fed and its Chairman would have been unthinkable at any time in the past 30 years. Thus, while  his predecessors received the utmost in the way of deferential treatment at all times, Ben Bernanke is rapidly becoming the sad-faced “no respect” poster child for economic policies that have so far failed to live up to their advance billing and for the associated growing global economic tensions.

Just ahead of the G20 meetings, Chairman Bernanke penned an article in which he attempted to deliver an overview of the situation and the Fed’s plans for reinvigorating economic activity.  The letter is astonishing in a number of dimensions:

According to Chairman Bernanke, it seems that in spelling out Fed policy and the need for additional stimulus that the Fed intends to get the economy growing by creating false markets (ie higher prices) in the stock bond, and real estate sectors. This is short-sighted, arrogant and ill-considered even before one takes into account the fact that the man was announcing his intentions to the markets with the apparent conviction that the investment professionals who operate within them would heed his financial advice, rather than consider the logical implications of it.

Chairman Bernanke’s piece waxes eloquent, saying that the risk of deflation warrants further strong doses of liquidity: ”……… the need to achieve certain outcomes, low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating. The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed.” These are all laudable policy objectives, but the point is that nowhere in this article is there any mention of what the risks are of these proposals. For example, some of the second order effects of QE  and ZIRP that we know about today include:

• Liquidity leakage and consequent pressures on markets in other countries, particularly emerging economies;
• Contribution to economic imbalances and unwelcome swings in FX parities;
• Disruption of trading relationships;
• Rapid inflation of input prices and foodstuffs which falls disproportionately on low income population groups and countries and those on fixed incomes;
• Intensification of the Sovereign debt crises in other economies;
• A reverse wealth effect on consumption from the Zero Interest Rate Policy stance that hits retirees and savers.

Chairman Bernanke`s letter fails to mention other key risks of his policies including the possibility of significantly elevated inflation numbers down the road, dangers for the financability of the yawning US fiscal deficit, and a potentially unmanageable downgrading of the United States as guardian of the global reserve currency. Predictably, his explanations also fail to acknowledge the vast solvency problem in the US financial sector that needs to be urgently addressed (in ways that are markedly different from the Fed’s and the FDIC’s  “extend and pretend” approach). Not surprisingly many commentators and observers are starting to mock Bernanke and his policies.

Given the fact that there is general agreement that QE1 has been a failure; these are issues that should make the Fed and Mr Bernanke sit up and take note. As for QE2 it is hard not to observe that since the launch of this policy the stock market has lost 4% of value; bond rates in the Fed’s announced “buying zone” have backed up 40-50 basis points and the economic numbers are still expected to remain soft by the mainstream economists.

On this latter point it also helps to do the math. Even if this round of QE works and raises prices in various asset markets, then the addition to GDP through the wealth effects that Bernanke is staking everyone’s future on, will, under the best of circumstances, only translate into about an extra 0.3 to  0.7 percent of growth. This is peanuts, and certainly not an objective worthy of risking significant disruptions to achieve.

For this and other reasons best dealt with under separate cover, there is now significant opposition being mounted against the Bernanke policies. Not only did Obama and the US delegation get a bollocking from their G20 colleagues over US economic policy last weekend, several prominent FOMC members, including Plosser,  Hoenig and Warsh have spoken out against additional QE, others in the US have cautioned on Fed policy, and this week an number of prominent economists, investors and commentators issued a public letter to the Fed asking it to cease and desist on QE.

The open dissent on the FOMC and the fact that this has been taken into the public domain is extremely noteworthy. Tensions has been building between those in the Fed that regard these policies as the only way out of the Roach Motel and those who want to chart a different course and restore some measure of transparency and sanity to US monetary policy. One immediate outcome of the second alternative, provided that the policies are well thought out and capably executed is that it would defuse the systemic risks and spill-over effects that have been accumulating in the global economy and in international relations as a consequence of ZIRP and QE.

In the present scenario Chairman Bernanke is therefore in an unenviable and weak position: There is growing conflict regarding the path he has charted and what remains of the Fed’s credibility is at serious risk. There are obvious questions to be asked regarding his competencies. His communications style shows that he has little appreciation or understanding of risk and market behaviour. He failed to spot the crisis in its early stages, saying on numerous occasions that it was limited in scope and containable. His policies have not worked and considerable international tension and opposition to his policies and their intent has been building. Not to be overlooked, prior to QE1 he also mislead lawmakers and the markets repeatedly as regards the likelihood of debt monetization by the Fed – ie the willingness of the Fed to run a QE.

In the meantime, there is scant hope of a major near term bounce in the US economy. Five million jobless on the US unemployment rolls will see their benefits run out in the next couple of months. Commodity markets continue red hot. Debt crises in a number of economies are worsening. If the Fed continues to plough on as per its policy announcement we can only expect the geopolitical picture to become even more fraught

 “Honourable Committee Members…….the dog ate my homework”

With this and other depressing information painting the backdrop for his testimony, there is very little good news that Chairman Bernanke will be able to serve up to US lawmakers in February when he is obliged to deliver his semi-annual Humphrey Hawkins testimony regarding Fed Policy. He is presiding over a giant mess that he himself helped create and now cannot get out of.

The Bottom LIne: Barring a major failure of courage and leadership within the FOMC and US Government, and from the Obama Administration  (not exactly a zero probability outcome given the personalities involved)  it is likely, but far from certain, that we could see Ben Bernanke sacrificed on the altar of political expediency or resign. In the meantime the political and economic ructions resulting from QE will continue.

Posted in Banks, Bond Market, Fed Policy, Restructuring, Sovereign Debt | No Comments »

Recovery Partners Turnaround Clinic – Leaders under Stress

This week we heard from the IMF that the total borrowing requirements of key governments in 2011 will amount to around  $10.2 trillion. The estimate represents a rise of 7% from 2010 and over 27% of the annual GDP of the developed economies. This rollover profile exposes the vulnerabilities in the maturity composition of Sovereign liability portfolios and the likelihood that most Sovereigns will find it impossible to appropriately de-risk their financial exposures by extending term or otherwise executing an imunization strategy. The bottom line is that unless deficit control and the establishment of debt management perfomance benchmarks is adopted as a matter of urgency in many economies,  it becomes very easy to envision the near term onset of another round of severe financial turbulence.

The risk of another shake-up also relates to what is often ignored in these situations: the human dimension. Economists are very good at quoting statistics but notoriously bad at interpreting the emotions, motivations and fears that always lie behind the raw data, and what these might mean in terms of the probable outcomes in a given situation. Recently, we were fortunate to sit down with Dr Jack Muskat, one of the members of our Advisory Board, and interview him on his experience in this area.

Q: Dr Muskat can you tell us a bit about your experience in dealing with organisations and leaders under stress?

JM: Well usually I only like to get involved in situations where there is a high probability of a successful restructuring or exit from crisis. The key indicators for a successful exit from distress are usually all or a combination of the following factors: it is a situation that matters in terms of the dollar amounts; it is politically and economically sensitive; there may be international implications; it might also feature multiple investment parties and in all cases there is a significant debt load. You also have to have the right leadership team in place.

Q: So you are saying if all of these factors are present the odds of turning things around are good?

JM: Not exactly, what I mean is that when all of the factors are present that the odds for a successful crisis management outcome should be good. What I find frequently is that psychological factors erode the odds of turning a situation around. Whether the cause of distress is management weakness, inadequate financial controls, fraud, weak strategy or execution or some external factors; what we usually see in most stress situations is that is that leaders are frequently first caught is a cycle of denial that is  then followed by a cycle of blaming others for the problems. If this goes on for too long the opportunity to successfully turn things around will disappear and failure becomes the only “option”.  I can tell you that the foregoing sequence of events is already in motion in a number of Sovereigns who find themselves under financial pressure.

Q: How so?

JM: It all comes down to the personalities involved. What I have found is that when leaders are under stress it is very common for them to slip into behaviour patterns that are extremely counterproductive. I say this because we use a variety of tools to diagnose the issues and to determine whether the incumbent leadership in a crisis situation is psychologically suited to managing the crisis, stabilizing matters and capable of executing a credible recovery plan.

Q: Can you provide some examples please?

JM: Well you have start from the reality that the leaders in a crisis situation are usually new to these type of events. Typically you don’t find crisis managers working full time leading a company or in a Government waiting for the day when something blows up. The leadership is a crisis is more typically untested and new to the situation. This means three things: (1) there may be feeling of guilt or anger associated with the crisis as they find it difficult to distance themselves emotionally from the situation; (2) there may very well be a competency problem amongst the leadership in that they are incapable of dealing with the issues; and (3) there may be a bandwidth or capacity problem within the organisation as the leadership becomes engulfed in problems that are increasing at a rate faster than its ability to solve them. Alternatively you may find that the peson selected because of relevant credentials has not bothered to properly analyze the crisis and evaluate his prescriptions in the context of what the situation really might require.

Q: What happens then?

JM: This is where the trouble really starts. If you have a leadership in a predicament like that they may react in a variety of ways, all of them counterproductive: (1) they could bury their heads in the sand and refuse to acknowledge the problems or that their preferred way of dealing with them won’t work; (2) they become defensive and attack anyone who looks into how the issues are being  handled with the intention of offering sound advice; (3) they might engage in “magical thinking”, that is, believing that a painless solution is available to them if only they do one simple thing; (4) they might engage in nihilistic thinking, believing that the situation is so bad that it doesn’t matter if it gets worse; (5) they may panic and opt for a destructive course of action; or finally (6) the leadership may engage in all of these behaviours.

Q: Wow, that sounds like it would be impossible to deal with.

JM: It gets worse. If these types of behaviours are present it might also be accompanied by physical symptoms that further detract from the ability of these leaders to make the correct decisions – lack of self esteem, feelings of failure, sleeplessness, poor eating habits, lethargy, withdrawal from social interactions. All of these conditions lead to inertia, poor decision making and a tendency to always be in a reactive mental state. Frequently valuable time and energy is wasted by these type of leaders in diverting scarce resources and attention to issues that are not germane to resolving the actual causes of the crisis. This is usually known as “rearranging the deck chairs on the Titanic”.  We all know how that situation turned out

Q: So how do you handle this and recover the situation?

JM: You have to get the right leadership installed. Our screening techniques allow us to determine if any of these destructive behaviours are present within a leadership group and whether the leadership group has the right aptitudes to deal with the crisis and apply solutions. In a crisis situation the best leader is one that knows how to admit to and correctly prioritize the actual problems, knows that they must urgently identify the best possible advisors, and then is prepared to receive and process advice in order to create a plan to lead the way out of the mess. On top of them being able to then stick to and execute a credible plan, you also want leaders who can frame the situation in such a way as to inspire others to support the crisis management plan. This is important because you want to maximize the likelihood of emerging from the problem. A good example of this is the current leadership in Great Britain. They have a debt crisis there and the new Government has just delivered an austerity budget. However by evoking nostalgic memories of the post-WWII rationing period and the British “stiff upper lip” they have got the British public behind them and that has measurably increased the odds that the debt management plan will work there. The same cannot be said for many other crisis-hit economies, a number of which we at Recovery Partners expect will hit the proverbial “wall” in the near term, barring a change in course.

Q: Thank you for these valuable insights Dr Muskat. It is clear that from what you have said, that the probability of a policy mis-step or other dangerous miscalculation is relativley high in the current environment as it relates to Sovereign Debt in a number of countries.

JM: It certainly does seem so.

Dr Jack Muskat is a management psychologist with over twenty years consulting and business experience with individuals and organizations. He is an acknowledged expert on issues relating to organizational culture and leadership, succession planning, strategic management and corporate distress. Dr. Muskat received his Ph.D. in Applied Psychology from the University of Toronto. He is a member of the Canadian and American Psychological Associations and is a recognized speaker and published author.

Posted in Bond Market, Restructuring, Sovereign Debt | No Comments »

A is for Austerity

 ‘Advocates of austerity believe that mystically, as deficits come down, confidence in the economy will be restored and investment will boom”            Joseph Stiglitz writing in the Guardian newspaper recently 

 No Professor, we don’t believe in Magic. You do.

A couple of days ago, I together with Martin Wolf of the Financial Times was interviewed by Howard Green of BNN on the recent austerity budget passed by the UK Government. The entire interview is viewable by hitting  this link or by going direct to our Newsroom page.

For those of you who do not want to watch the entire 21 minute clip; this short note will identify some of the key points that were raised. I was quite glad to participate in this discussion because it exposed a number of deficiencies in the thinking behind opposition to getting government finances under control and implementing sound debt management policies in the UK and elsewhere.

“Cuts could mean contraction of GDP of 1-2% per year” Wolf

Mr Wolf cites a recent IMF study that estimated the impact of fiscal tightening on GDP growth in countries that are running ZIRP. According to the boffins on 19^th Street, this could shave growth in those economies by a small amount. And according to the Krugman crowd, this must be avoided at all costs by maintaining Government spending.

We say “So what”. This is not a choice between “Jam today, or Jam tomorrow”. There is no more jam. Western economies in many cases need to face up to their fiscal situation by making hard choices on expenditure reduction and debt control. Expenditures need to be managed better and in many cases the size of governments need to shrink in order to “right size” to a situation where there are more and longer lived retirees draining pension and medical expenditure coffers while fewer taxpayers as a proportion of the population are around to fund these requirements. The UK (and the US and others) is in this boat. The focus on the next few quarters or a couple of years of GDP growth misses the imperative of recalibrating public finances to the reality of the next FIFTY years.

The social contract needs to be re-engineered and there is no time to waste. Mr Wolf’s line of thinking also seems to hold that only if the recovery was well in hand then austerity would be a risk that Britain could afford to take. On the basis of our understanding of history and the proclivities of Postwar developed country governments, the chances are that if Britain was well into recovery there wouldn’t be any debate about cuts at all. There would be none and the orgy of spending would continue until financial collapse became an unavoidable consequence (as is rapidly becoming the case in the US). Austerity now and a re-engineering of the entire basis of Government tax and expenditure policy is a risk that Britain and other developed country Governments cannot afford NOT to take. So far the only large economies that are tilting against this thinking are Japan, which is drowning in debt; and the US which is blindly hoping that it massive monetray and fiscal experiment can turn things around without the need for any real sacrifice or reckoning.

“The government needs to maintain or expand its deficit as long as the private sector is running huge surpluses”  Wolf

There was broad agreement that we are in a state of affairs where the Western economies will be in a vulnerable, slow-growth mode as they de-leverage from the credit boom. Mr Wolf seems to believe that this obliges the Government to maintain or expand its deficit – for as long as it takes to get out of the slow growth mode. This ignores the history. Expanding your deficit is exactly the wrong policy. Japan is proof enough that all you get from Keynesian deficit spending is more debt. Japan has squandered decades of trade surpluses by paving its countryside and building roads and bridges to nowhere.  The country’s debt to GDP ratio now stands at over 200% after two decades of following failed policies that are still being peddled in the face of this experience by the likes of Stiglitz, Krugman and Wolf. If interest rates don’t rise first and choke off Japan’s debt servicing capacity, Japan’s fast shrinking working age population guarantees its ultimate demise as a financial power within the next couple of decades.  (As a sidebar, in all of these debates about deficit spending their proponents never hint at establishing deficit limits, debt to GDP limits or performance metrics being applied to these programs. Their thinking seems to be that Governments can keep writing blank checks and printing money without limit. Why has no one, for example, referenced the Stability Pact limits adopted by the EU – namely the obligation to keep government deficits under 3% and Debt to GDP under 60%. This seemed to make sense in determining admission criteria to the EU – before the Crash.)

“Developed Countries Have no Difficulty Funding Themselves. There is no risk to the US.” Wolf

The observation that because Governments are able to fund today does not mean that they will be able to fund tomorrow.  Does Mr Wolf seriously believe that if his no-cut policies were followed that in three or four years that the UK would be able to raise funds cheaply in Sterling? Or at all? This view is coming from people like Messrs Wolf, Krugman and Stiglitz who have never sat on a desk and had to fund anything, let alone run a process in unsettled markets. It ignores the reality that debt portfolio management is a game of risk minimization. The debt portfolio manager must always be prepared for the “storm” and never become complacent. ZIRP can’t last forever and countries with high debt loads, unwieldy and poorly specified portfolios, badly specified debt policies, or other holes in their game plan and ability to execute will suffer reduced fiscal flexibility up to and including default in the next few years. There is in fact significant risk to the US at the present time precisely because they have engaged in massive debt creation with QE1,  are now about to unleash QE2; and are on an unsustainable fiscal track with no exit strategy having been communicated to the market. (At the time of writing it appears that Mr Bernanke and the Fed Governors are dithering over the size of the next round of QE.)

“If there are no buyers for the bonds its because you have a wonderful recovery” Wolf

Actually if you have no buyers for your bonds it could be because you have upset your traditional investors by acting against their interests; if you have a history of issuing too much debt and have run out of headroom; or if the market loses confidence in your ability to manage your financial risks in a prudent way. These are all situations that can befall countries who wear out their welcome in the New Issues Beauty Parade. As this slow growth period wears on, which everyone agrees it will, the markets will undertake a triage of the most financially weak and mismanaged economies . It will pay dividends to those economies who can stay out of this group and contain their vulnerabilities to an adverse financial shock. Constraining deficits and implementing prudent debt management and financial risk management policies and communicating these to the markets as the UK authorities have done is a huge step in the right direction

”China isn’t Selling Bonds. There is nothing to buy there” Wolf

Mr Wolf is dead wrong. China has issued sovereign debt on a number of occasions and several Chinese banks and SOE’s also have outstanding yuan-denominated debt issues as do foreign multinationals such as McDonalds. They are not issuing the bonds for financing purposes because they don’t need to. Rather, the opening of this market is a part of China’s attempt to internationalise its currency develop the market for financial products based on the yuan, and develop a doemstic capital market. There are billions and billions of yuan bonds available for purchase. No debt manager with a heavy borrowing calendar (like the US Treasury) nor any fixed income asset manager, should ignore China’s rapid move up the learning curve in this area, nor China’s growing atrractiveness as an investment destination.

“The fundamental assumptions are Neanderthal and Pre-Keynesian”  Wolf

Mr Wolf’s contention is that the austerity budget is the wrong policy because it risks throwing the economy back into recession or even into a Depression. How can this be argued when at first one trots out the IMF forecast and hangs one’s hat on it? It shows a potential hit of 1-1.5% of GDP. This is small beer, and certainly not a Depression!

The real risk in this scenario is something that we have said for some time now: The record of governments implementing and maintaining fiscal consolidation initiatives to their proper conclusion is not very good. Out of 140 attempts in the last 30-40 years there have been only a handful of success stories. The real risk therefore is that the UK Coalition Government loses popularity and the stomach to see the plan through, it is then abandoned and Britain again becomes more vulnerable to financial stresses. Failure to act forcefully now on these matters in the US and elsewhere virtually gurantees another round of turbulence in the not to distant future. Acting now, as Britain has done assures some insulation from the finacial shocks that are most probably yet to come.

Although, Mr Wolf expresses hope for its success, he could do much more than hope through his position of influence on the FT pages by actively supporting the Government in this important and right-minded enterprise to get the country’s finances under control.

Posted in Bank Loans, Bankruptcy, Banks, Bond Market, Crisis, Fed Policy, IMF, Restructuring, Sovereign Debt, Sub-Prime | No Comments »

The Bernanke Cult

“Insanity: Doing the same thing over and over again and expecting different results.”            Albert Einstein

 The release of the September Fed minutes out yesterday put the final nail in the coffin of those who believe that Ben Bernanke is not a man determined to make financial history. For some time we have been predicting that the Fed’s approach to the crisis will continue and that further doses of expansionary monetary action are in store. As recently as this past Friday Alex Jurshevski reaffirmed Recovery Partners’ view that QE2 was a “done deal” on BNN (see segment 1 and segment 2).

 Indeed, it appears that unless Mr. Bernanke is impeached, suffers a sudden attack of a weird virus or falls under the wheels of a moving bus, that his high wire monetary experiment will continue. Hence our added expectation that there may be additional rounds of QE if this one fails as Round One has. We expect implementation of QE2 and possibly further kicks at the can despite the fact that there is no evidence that these policies have ever worked in a positive fashion to rehabilitate an economy overdosed on credit and suffering from solvency and debt problems on an immense scale.

 David Rosenberg discusses most eloquently the various concerns regarding the present policy course and the confidence we should be placing in Bernanke’s Fed and the Treasury in a recent client communication. We would add the following three points to his most erudite commentary:

 (1)     Donning our trading hats, we note that the concept of “risk limits” is completely absent from the policy course established by Bernanke. The rapid expansion of the Fed’s balance sheet in relation to GDP has no historical comparator save in situations where the central monetary authority lost control of the printing press and hyperinflation was the result.  Moreover the only private sector examples of rapid, massive and intentional balance sheet expansion that we can think of are limited to situations of accounting control fraud and eventual bankruptcy. Where this will all end up one can only guess.

 (2)     Bernanke has demonstrated that he only has a very limited understanding of credit risk and its implications for the cost and risks of his chosen policies. In testimony to Congress he boasts that the Fed “has never lost a penny” in its repo operations. The Fed bailed out banks by repo’ing toxic waste for term and giving back cash which the banks could use to buy risk-free (for the time being) Treasurys and earn a spread in order to re-capitalize their balance sheets. What he does not mention is that this operation could only have been made possible by valuing the repo’ed toxic waste at above-market prices and by the fact that the Fed (a) does not presently have to disclose the detail of these trades; and (b) that it has never been bound by mark-to-market requirements on its portfolio holdings. The hope appears to have been that QE1 would work, asset prices would rise and the trades would be reversed. Since the bulk of the toxic assets are housing-market-related, this seems to have been a “Hail Mary” strategy from the outset.

 (3)     Every first year economics student understands that in economics there “is no free lunch”.  Hiowever, Mr. Bernanke’s entire bag of policy tricks is based entirely on the premise that it is possible to have a free lunch – by paying for it with scrip. Conversely, the US population are beginning to rapidly see through the subterfuge and understand that the intended re-capitalization of the banks was and is intended to be largely taxpayer and scrip funded. Moreover the public backlash against additional pump priming has already been noted in Washington, thankfully reducing the propensity of the Obama Administration to further jack up deficits and the need for Bernanke to issue even more scrip. Even the MSM is now finally beginning to understand this reality and  that the second order effects of the Fed’s policy stance include, in part,  fomenting a full blown currency war. Although this latter realization is only now making headlines, the currency war has been in progress in earnest since QE1 was first announced.

 The bottom line is that while there may have been some basic understanding of the risks of policy failure at the Fed and Treasury there appears to have been, and there continues to be, no appreciation of the consequences of these risks beyond their potential impact on one-dimensional economic variables.

This is because Bernanke seems a technocrat of the highest order who has forgotten that the study of economics is more formally known as “Political Economy”. The potential consequences of Bernanke’s policies include: the utter debasement of the US dollar; an economy that remains mired in slowdown through an extremely protracted adjustment period; widespread bankruptcy, social unrest, the bankrupting of smaller countries and populations, geo-political trade and military friction and the erosion and possible destruction of the Postwar Pax Americana from which the entire World has benefited enormously for over a half century.

 Believing that these policies will work is rapidly becoming an article of faith.

 Welcome to the Bernanke Cult.

Posted in Bankruptcy, Bond Market, Fed Policy, Loan Losses, Stock Market | No Comments »

Destination Canada

“It is a serious question. We are no longer talking about a single country having a big Depression but the entire world.”      Paul Volcker

Where to turn? Each day we are bombarded by stories of bombings, plagues, genocide, civil war, famine and hardship. On the economic front the available information is increasingly evoking memories of the disaster that is now known as the Great Depression.

Countries that were once regarded as the bulwark of the Postwar Monetary System now seem to be engaging in a high stakes game of chicken: the Fed is actively debasing the dollar; the Bank of England is talking sterling down; the European Central Bank is buying the bonds of Zombie EMU Sovereigns to stave off the collapse of European Banks and destruction of the Euro; and on September 15^th the BoJ carried out one trillion yen worth of FX sales and has threatened a follow on operation. Russia, Brazil, China and other South East Asian Nations are also actively playing the debasement game; even staid old Switzerland has been accumulating FX reserves at a torrid pace.      

There is little confusion over the reasons for this tilt into head-over-heels competitive devaluation. Global demand has shrunk, and all countries are now vying for a slice of a shrinking export pie in order to maintain domestic income, employment and taxation levels. Hence, this outbreak of currency exchange conflicts is bound up with mounting signs that the global economic crisis is systemic, rather than merely cyclical, and a growing pessimism that a genuine recovery is not in the offing.

In addition to general economic malaise many developed countries are experiencing a demographic crisis. Coupled with the fact that of many of these countries have been simply living beyond their means and are now facing debt crises, an adjustment to reality seems inevitable.

In today`s market environment the key question for investors may be rapidly becoming one of capital preservation rather than return maximization. Where do you go when everything seems to becoming apart at the seams?

The Great White North Beckons

Private Investors and risk aware investing institutions could do worse than consider Canada as a destination for their portfolio assets.

Canada’s Financial Institutions are well-capitalized, well managed and well regulated. The economic management being delivered out of Ottawa is very responsible with Mark Carney at the helm of the Bank of Canada and Jim Flaherty as Minister of Finance. Indeed, the Bank of Canada stands out in recent monetary history as one of the few central banks that did not succumb to the blandishments of Helicopter Ben and engage in Quantitative Easing, thus it has avoided the inevitable pollution of its balance sheet with non-traditional assets, and the loss of policy flexibility that the Fed and many other central banks are now facing. 

Canada did experience a form of sub-prime mortgage crisis in 2007 and all of the sub-prime lenders and securitizers went bust and investors lost about $20 billion. But this has already blown over, and at the time it barely registered in terms of impact on GDP.

Public Finances are in great shape. Despite CAD 55 billion of stimulus measures implemented to kick-start the economy, Ottawa’s budget deficit is temporary and therefore the country has no structural deficit. From a government debt management standpoint  the only trouble spots are the finances of Ontario and Quebec, but these are issues of a manageable dimension.

We have the most energy resources of any country in the world, a hugely productive agricultural sector; mining; humungous fresh water resources, leading edge high tech industries, low crime rates and we score very low on the corruption index. We have all the wood, concrete, copper and steel that we could ever possibly need to build homes, factories and skyscrapers. All of the 2008-2009 job losses have been recovered up here. Thus our unemployment rate at just a shade over 7.0% compares most favourably with that of our southern neighbour which on the kindest basis is brushing close to 10%.

Politically we punch above our weight on the international scene, being a long time member of the G-8; the G-20 and about to take up a seat on the UN Security Council. Our men and women of the Armed Forces are extremely highly regarded as probably the best Peacekeeping Forces in the world by both friend and foe alike.

Certainly there are some clouds on the horizon. Household finances are somewhat stretched in sense that the private sector has accumulated a large debt load that will need to be reduced in relation to income. Health care costs continue to weigh on public finances and some reform or user pay option will likely need to be introduced in order to restore sustainability. Another medium term challenge is to re-direct our trade relationships away from the US because that economy is going to be in slow growth mode for the foreseeable future and we don’t want our wagon tied to a sputtering locomotive.

At present the economic numbers are starting to soften in Canada and it looks like the housing market is going for a dump in the near term. No matter, a downbeat economic picture describes the outlook  for pretty much most developed economies at present. On a relative basis, as noted above Canada can be expected to outperform because of our strong fundamentals, robust finances and exemplary economic stewardship. All countries will have to weather the coming economic challenges and uncertainties, including having to cope with the consequences of the monetary policy experiment being run by Helicopter Ben. Some countries will fail to manage their affiars and possibly lose a measure of independance as a result,  most countries  will suffer additional great hardships and privations. Canada, for its part promises to continue as an island of relative stability in an increasingly hostile and uncertain global economy.

Posted in Bankruptcy, Banks, Bond Market, Canada, Crisis, Fed Policy, Restructuring, Sovereign Debt | No Comments »

Hubris Meets Nemesis

“…….a central bank should always be able to generate inflation, even when the short-term nominal interest rate is zero …[this] more direct method, which I personally prefer, would be for the Fed to announce ceilings for yields on all longer-maturity Treasury Debt.   Ben Bernanke 2002

Last week Moody’s Investors Service said that the top Aaa ratings of key Western nations face new challenges that increase the possibility of a downgrade. Not one of the big countries was spared – the USA, the UK, France and Germany all came under the microscope for evaluation as to possible future downgrades. Specifically, the  ”distance to downgrade” for these four sovereigns has been reduced, the credit rating agency said in a statement, meaning their credit quality within that top category is declining. In addition a contrast was drawn between the key European states, who are pursuing deficit reduction strategies and the USA which for the time being is not.

By now the events in the US have revealed glimmers of the true picture previously hidden behind the avalanche of economic disinformation that has enveloped the country since the onset of the GFC. The average American is now very aware of the hardships of living in a nation being driven by policies that do not substantively address the very real weaknesses in the economy, and which have been obscured or soft-pedaled by the Government as well as the apologist economists associated with it. The population is also becoming increasingly aware of the dangers of not facing up to the issues that need to be addressed urgently in order to avoid  a slide into an even worse predicament.

However, the Obama Administration, for its part seems to disregard the fact that the economy continues to bleed cash and jobs. It professes to have saved the country by adding Trillions to the National Debt, by allowing many US banks to pretend that they are solvent, and that by following the “diktat” of its ultra-Keynesian advisors that taking on even more debt is the road to salvation. Ordinary Americans are being forced to pick up the tab for the bank failures, pick up the tab for the policy failures, fund insolvent institutions through the payment of net interest margins associated with “carry” trades and are being forced pick up the tab for ill-advised borrowing policies.

Whilst we agree with pretty much all of what the Moody’s reports have to say about the general picture regarding Sovereign default in the countries mentioned as well as elsewhere; we completely disagree with the focus of these reports as being on the “distance to downgrade”. As students of Sovereign Debt we observe that default is not a gradual process, much less one that can be accurately measured using “black box” algorithms or the like. The default process is one that moves akin to a step function: when one or more factors exert too much strain on the underlying structure of debt finance, the whole edifice comes tumbling down very quickly.

 It takes knowledge, experience and judgement to identify the unique factors in each situation that are material to avoidance of the disaster scenario.  In the present case we can identify numerous risk factors that if they continue to be left un-managed or mis-managed could see the United States enter a default scenario or if not outright default, then a situation where a further, and more substantial, loss of geo-political and economic clout  becomes a reality. What follows is a partial list of these myriad danger signals:

Policy Misalignment

Judging by the comments of Bernanke, Paulson and others in the lead-up to the crisis, it is clear that the US authorities completely underestimated the extent of the economic crisis, failed to identify its causes and failed to devise and put forward appropriate solutions. Apart from not allowing the stimulus alternatives and other pieces of economic legislation to be debated by Congress, the Obama Administration has compounded the mis-diagnosis by clinging to the notion that the GFC triggered a cyclical /liquidity problem (which it is not) rather than a structural/ solvency problem (which is what it is).

 As another example of the implications of this error, according to a recent Flow of Funds Report, Washington has been piling on debt at an 18.5% annual rate since the beginning of the year while households have been reducing debt by around 2.5%. Since every dollar of government debt is a promise to tax the private sector in the future with interest, this orgy of public spending has swamped the rational and strenuous efforts of the private sector to return to a sustainable expenditure track and income/savings balance.

Tax Receipts Crashing

Government Tax revenues are slowing. According the Heritage Foundation the problem has some scale: US federal tax receipts are tracking at around 14.8% of GDP, compared to 20.6% in 2000 and a 30 year average of slightly over 18% of GDP.  The US Government is being squeezed between too slow a rebound in tax revenues and the limitations on how quickly it can realistically take its funding requirements to the US Treasury auctions. This cash management information is signalling trouble ahead simply because the economy is recovering much more slowly that what was assumed in Administration fiscal forecasts.

How can we credibly expect a rebound in tax receipts when employment patterns are so weak? The U-3 numbers are tracking just shy of 10% and the U-6 series is at 16.6%. No jobs means that taxes aren’t getting paid.

State and Local Governments are Bankrupt or Going Bankrupt

Slowing revenues at the Federal level are also reflected at lower levels of government. Moreover, Investment in State and Local issuance has completely dried up. As a consequence States and cities across America are amassing scary, yet non-market fundable, budget shortfalls in record time. California as a whole is best known for being on the verge of debt default, but California is not the only State with a Government and its cities on the brink. Moreover, according to the Economic Policy Journal, 32 states are now technically bankrupt, and are borrowing money from the Federal Treasury (read “printed money”) just to keep up with unemployment benefits. The National League of Cities has reported that U.S. municipalities will come up short on debts to the tune of up to $80 billion this year.

Readers, please note that the recent $26 Billion “State Aid Plan” passed by Congress a couple of weeks ago does not actually give the States the money. It merely mandates that they have to match-fund any federal transfers in order to receive them in the first place. In other words the “rescue package” adds to the States’ fiscal burden, it does not reduce it (See “Policy Misalignment”)

 Insolvent Banking System

Readers of this blog know that we have estimated the number of insolvent and/or severely impaired banks in the US to be well over 2000 institutions, far higher than the 800 or so that were supposedly on the FDIC watchlist earlier this year. April 2^nd, 2010 marked the first anniversary of the date when FASB 157 was suspended and with it came the abolition of “mark-to market” accounting. The Administration left FASB no choice but to change their guidelines using the notion that this move was a temporary deferral of the rules, instituted in order to allow time for the banks to adjust to the toxic assets on their books. What progress have banks made in moving assets off of their books in the “Extend and Pretend” environment?  How much closer are these banks to regaining financial health? The answer is: “No one knows for sure”, because the problems have been swept out of view as a consequence of the removal of the `mark-to-market` rules.

The bottom line here is not only that the entire response to the banking debacle in the US wrongheaded, it is also a violation of the Prompt Corrective Action Law which mandates that the regulatory response to financial institution failure must be decisive, transparent, economically rational and that it be implemented in the early stages of a problem situation.

Housing Market  Near Death

The US housing market, a key driver of domestic consumption and wealth accumulation in the Post WWII period is all but dead and is not showing any signs of imminent re-animation. The full force of the plunge in US housing activity after the expiry of the homebuyer tax credit was revealed today in the form of a massive 27.2% decline in existing home sales in July. Sales are now 34% below April’s tax credit-induced peak, well below the previous cycle low back in November 2008 and at a level not seen since June 1993. At the current pace of sales it would now take 12.5 months to erase the inventory overhang, well above the 7 months that has historically been consistent with stable prices. Mortgage applications for home purchase remain close to their recent 14-year low. All of this is happening despite record low mortgage rates. Most observers now concede that weak housing activity is constraining the already fragile and tenuous growth prospects for the general economy.

Debt Issuance  Patterns

 Usually, a Sovereign debt management strategy features limits on issuance of short term debt in order that the debt portfolio not become too sensitive to rate resets and liquidity conditions in the funding markets. Thus, a typical issuance strategy for Sovereigns would be to seek 80% fixed rate term debt, perhaps 20% in floating maturities and perhaps a small portion in inflation indexed stock. In addition, debt managers try to aim for an average maturity of the overall portfolio that will shield it from interest rate volatility usually by aiming for a duration range of 4-6 years. Stable borrowing strategies also feature a diversification of funding sources.

The current situation in the US reflects anything but this. The Chinese and Japanese who together own about 40% of the Treasury stock held offshore are limiting their purchases of Treasuries. China has in fact sold down some of its holdings recently. Britain another large holder is in no position to support the Treasury’s borrowing program. It is not probable that this behavior will change in the future.

The upshot of this is that in the recent US Government fiscal year over 70% of issuance has been in the one year and under (i.e. short dated and floating) portion of the maturity spectrum. Issuance in the 10 year and over maturities has so far constituted less than 7% of the funding requirements. As the deficits projected for the next few years are very large, this disproportionate short-dated issuance will vastly increase the vulnerability of the US Government Budget to rising rates and market funding conditions, placing pressure on the Fed to maintain low rates and possibly imperiling the Dollar as reserve currency should it come under speculative attack. The focus on short-dated issuance in a situation where gargantuan deficits are in store is a very significant risk factor. Ironically, a key risk factor affecting the US dollar is precisely the debt managment connundrum described above.

Off Balance Sheet Federal Government Liabilities

At last count these amounted to around USD 52 Trillion or around 4 times larger than annual GDP. There is no further comment needed here.

Hanging by a Thread

The situation in the United States is reaching a critical point. Key economic indicators are signalling a weak activity profile, Fed and Treasury  policies have not worked and more of the same tonic might in fact prove very dangerous, and offshore investors and trading partners are growing increasingly nervous and unsure of the economic stewardship of the World’s still-largest economy and that whose currency is the principal reserve asset for the Global Financial System.

Given the foregoing it is not be surprising that there are reports of significant stress between members of the FOMC coming out of the Beltway and the growing difficulties that Bernanke is having riding herd on this increasingly restive group of Senior US Central Bankers. However much stress and nervousness there might be at present, to us it seems that, given the results so far, the real difficulties, dangers, and hard choices unfortunately still lie ahead.

Posted in Banks, Bond Market, Canada, Crisis, Economy, Fed Policy, Restructuring | No Comments »

Stress Tests Fail to Impress

Last week European regulators released the much awaited results for bank stress tests that were conducted recently. The tests encompassed 91 key banks representing approximately two-thirds of banking assets in the EU. 

Headline results showed that only 7 banks failed the tests and require in aggregate EUR 3.5 billion of capital to shore up their balance sheets. On the surface this looks a good result. Recovery Partners was interviewed last Friday on this issue just as the results were being officially released to the markets.  The televised discussion can be accessed by clicking on the following links for Part 1 of the interview as well as Part 2. An abbreviated version can be accessed on the Recovery Partners website by clicking on this link.  

This exercise was designed to allay market fears of a banking crisis in Europe stemming from potentially large cross border exposures to governments and banks in the PIIGS and elsewhere. As a  rationale for this very expensive and complicated survey, this explanation alone should give some pause. The authorities are clearly fearful of contagion, banking markets in the EU remain non-functional in a number of important ways and liquidity and trading volumes in the inter-bank markets has slumped and continues at a low ebb due to counterparty credit risk concerns.

Since this exercise was largely conducted to allay fears, our opinion is that the rigor and thoroughness required to bottom out any risk issues was not applied in sufficient measure to give the markets any kind of real comfort at all.

Here is a summary of our concerns:

• The economic scenarios were extremely benign and did not “stress” obligor credit risk sufficiently;
• There was no explicit modeling of sovereign default risk;
• There was no credit modeling of the ECB portfolio which has been significantly degraded in terms of credit risk since the EU Sovereign debt crisis began;
• The Loss Given Default modeling for specific country debt was only applied to bank “front book” (ie trading room) exposures and not to the typically much larger “back book” (buy and hold) positions. This does not make any sense from a credit risk and capital adequacy standpoint which is what this exercise was presumably intended to investigate and measure;
• There was no explicit modelling of liquidity risk and rollover risk which is what the authorities in Europe are very worried about. Over $5 Trn. of bank debt matures in the next 36 months and must be rolled over in the markets in order that the banks can maintain activity. This heavy re-financing calendar is in addition to any fresh capital raises planned by the banks.

Our view on this is that the design of the exercise and transparency of the results and admissions suggest to us very strongly that this was largely a PR exercise rather than a vigorous effort to separate the wheat from the chaff. Therefore trying to assess credit risk and market vulnerabilities amongst European banks using this stress test as a guideline still leaves the markets with considerable uncertainty. The following table which details a portion of the cross border exposures gives an indication of the scale of the potential problem. 

At Recovery Partners it is our belief that this situation will require several more months to play out before market confidence either is re-built and markets stabilize, or the weak sisters begin to drop by the wayside as a function of the, by then ongoing, unsettled funding conditions. The latter scenario might of course be accompanied by renewed and heightened fears of Sovereign defaults. As a final observation, we are unsure as to whether additional confidence boosting measures are planned by the authorities in Europe. If there are some in the works, then a lesson to be taken away from this exercise is for them to be a bit more open and rigorous, lest the market feel that it is being “played” a second time. In that case the market reaction would likely not be as muted and could well feature significant blowback to the detriment of the European banks and the markets there in general.

“There are still inherent funding problems within the interbank market. If the stress tests were designed to basically solve those problems, I think they’ve failed,”  Micheal Hewson, CMC Markets

Posted in Bank Loans, Bankruptcy, Banks, EU, IMF, Loan Losses, Restructuring, Sovereign Debt | No Comments »