Washington, D.C. "W.A. Green, Chief Prohibition Inspector."
Ilargi: As everyone spends their time getting increasingly nervous about the future quality of ouzo and olive oil, Stoneleigh looks ahead and beyond and holds up a mirror that says many of the aspects of modern day Greek society that make it so vulnerable are in fact established features of all countries and communities, features that have merely been dormant for what will look to yet-to-be-born historians as no more than the blink of an eye. When times get tougher, so will we. And although we may like the sound of that at first glance, it doesn't necessarily spell a lot of good, not when it means we get tougher on each other.
People are increasingly collectively horrified at the extent of the fraud and corruption that lies at the heart of our financial and broader governance structures. They seem surprised, as if this were something new, when it has actually been growing in tandem with our credit hyper-expansion for decades. Corruption in complex systems never goes away, it merely waxes and wanes, and goes through phases where it is more or less visible.
During long manic periods, all manner of abuses occur, but no one notices while the party continues, because no one wants to notice. As long as people generally have access to easy credit and the illusory wealth effect it brings, they don't ask hard questions and are largely oblivious to risk. Even if they lied on their own mortgage application, in order to qualify for a larger loan than they could really afford, and know others who did the same, they cannot seem to imagine what the consequences might one day be, both for themselves and for the financial system as a whole. To paraphrase one journalist who commented on the national pyramid bubble in Albania in the mid 1990s, when people feel they are operating within the bounds of properly structured criminality, they feel no personal responsibility and do not fear consequences.
Both the predators and the prey are complicit in the development of a mania. Predators lent money into existence without regard to risk, since they were selling that on to Wall Street investors through securitization. Just like those they preyed upon by actively enticing people into loans they could not afford, they turned a blind eye to the blatant lies on mortgage applications, inflated assessments and other fraudulent aspects of the developing bubble. They made their money through fees anyway, but did not contemplate the creation of systemic risk which would ultimately bring them down as well.
Both sides had an interest in the party continuing because it benefited them personally in the short term. The prey were insisting on being handed the empty bag, which is all that's left at the height of a bubble, while the predators were only too pleased to oblige. Of the two, the predators were certainly in a better position to assess the situation and must be regarded as the more culpable party, but without the greed of the prey, the exploitation would not have been possible.
When times have been both relatively good and stable for a long time, people's time horizons lengthen, and they feel they have the luxury of the longer term view. Economists would say that their discount rates (the extent to which they value the present over the future) have declined. Humans are never collectively very good at taking a long term view, but in stable times, where they don't have to worry about where their next meal is coming from, they are at their best in this regard. It is in times like this that environmental movements arise and humans start collectively valuing other forms of life (many individuals do this anyway, but for it to become a collective movement requires a human herding element that is only present at certain times).
The height of a mania is a very unusual time that combines the best of good times for a majority of people, illusory though it may be, with a rapid rate of change. People begin to manifest mixed messages, for instance environmentalism tinged with fear. As discount rates steepen, people make more and more short-term decisions and ignore the longer term risks. They throw caution to the wind, with predictable consequences, first through euphoria and then in desperate denial. That is how we became the authors of our own present debt predicament.
Eventually, as the mania comes to an end, the rapid rate of change mostly to the upside will be replaced with a rapid rate of change to the downside, combined with a significant contraction in material wealth, as excess claims to it are extinguished. The confluence of circumstances that had led to a longer-term view will reverse sharply. Unfortunately, the result will be a state of crisis management, just when cool heads and rationality would matter most. We who have had the luxury of the long term will find out what it is like to worry about where our next meal is coming from, and just how short our time horizons will become under those circumstances.
In many parts of the world, instability has been a chronic condition for decades. There are huge disparities between haves and have nots, and one's position of fortune or misfortune is often determined in relation to personal connections with those in power, when power itself can be a very ephemeral thing. These are conditions that promote very high discount rates, not just among the have nots who have to worry about feeding themselves, but also among the haves whose benefactors could be out of power tomorrow, ending their privileged position. Under these circumstances, governance is often appalling, because those in or near power have a direct incentive to loot the public coffers while they have the chance. Where power structures are clan-based, the incentive is even stronger, as losing power could easily lead to persecution by the incoming group, and the consequent need to escape with portable wealth.
What this engenders is a culture of endemic corruption, which we would do well to study, as it is likely where we will find ourselves for much of this century. We think we live with corruption now, as we hear about fraud, ponzi schemes, bailouts combined with epic bonuses and a revolving door between Goldman Sachs and the US Treasury. As self-evidently corrupt as this is, it is nothing in terms of the impact on daily life compared with the top-to-bottom corruption other peoples have to live with. We have not had to pay off every public official for the performance of his own job, pay bribes to secure contracts, pay to have legal standards waived, pay protection money to the police or pay a high enough political 'roof' to prevent our property from being claimed by the better connected. We have not had to live where life is cheap, authority figures at all levels are completely unaccountable, abuse of arbitrary power is rampant, the legal system actively undermines the rule of law and casual violence abounds. This is what happens when people feel that they have no long term.
Our media, when it focuses on unluckier parts of the world at all in our infotainment bubble, tends to do so with an air of superiority, as if we were somehow innately better than those who live under corrupt regimes. They fail to note that our position at the centre of a globalized world has allowed us to cream off the surpluses of the periphery, giving us the stability required for the luxury of the long term while actively depriving others of the same. Our boom has been an aggravating factor in the culture of corruption that has taken root in so many places, but our coming bust will see these same tendencies develop in our own countries.
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When a Little Greece Goes a Long Way
Should the woes of a country with fewer people than metropolitan Los Angeles really roil the massive U.S. financial markets? This is a hotly debated question after worries about Greece's debt woes sparked wild swings in the U.S. stock market last week. Signs that the trouble in the Greek bond market was infecting others in Europe helped send the Dow Jones Industrial Average into a spiral Thursday and most of Friday before a late-day rebound turned the market back to positive territory.
For some, the bond-market woes afflicting Greece and other European countries provide real reason for worry. They argue that while the debt problems seem contained now, they can easily spread. Greece is just one of many economies today—including the U.S.—carrying hefty debt loads as a legacy of the financial crisis. Even if sovereign-debt issues among southern European countries, Ireland and the U.K. don't flare up to a full-fledged global contagion, the wary say the result is still likely to be higher borrowing costs in Europe that would slow the economic rebound both on the continent and elsewhere around the world. Greece "is a shot across the bow," says Henry McVey, head of global macro and asset allocation at Morgan Stanley Investment Management. Now that financial institutions have reduced debt, "investors are now focused on which governments are over-leveraged," Mr. McVey says.
Regardless of whether the reaction to Greece was warranted, last week's turmoil reflected the tenuous nature of the stock market's bullish sentiment. Investors came into 2010 generally optimistic based on expectations for a "Goldilocks" global recovery where growth improved but at the kind of slow pace that would allow interest rates to stay low. The first snag was hit in mid-January when China moved faster than expected to restrain bank lending. Now the debt crisis in Europe, although long in the making, suddenly throws another monkey wrench into the works. "What a couple of weeks ago looked like a perfect economic-recovery scenario has been blown out of the water," currency analysts at BNP Paribas wrote Friday.
As a result, investors last week rushed back out of risky assets, which also included commodities and corporate bonds. Meanwhile, the dollar strengthened—a negative for U.S. exporters—as investors bailed out of euros. For many investors, the destination was U.S. Treasurys. The fears run the gamut, from a simple slowing of the economic recovery to more extreme scenarios such as a new credit crunch in Europe as banks contend with losses on big holdings of government debt or a withdrawal of countries such as Greece from the European Union. The overarching fear is contagion, that the woes in troubled economies will spread as investors rush to sell investments in more accessible but otherwise healthy markets to offset losses in places like Greece.
But for some, it is a tempest in a teapot. While not dismissing the challenge facing those countries, some say it is simply not a material problem for the U.S. markets, especially stocks. They say last week's tumult was driven by short-term hysteria about a tiny bond market to which U.S. companies, especially banks and other financials whose stocks were hard hit last week, have very little direct exposure. Investors should instead focus on the improving U.S. economy and another round of better-than-expected corporate profit reports for the fourth quarter. If anything, the U.S. should continue to provide a safe haven for investors. "What we're seeing is noise," says Aaron Gurwitz, head of global investment strategy for Barclays Wealth.
Michael O'Rourke, market strategist at broker dealer BTIG, notes that the Greek stock market's capitalization is only slightly bigger than Citigroup's. Adding together all the troubled economies in Europe, "they will equal the size of one systemic institution in the United States." Mr. O'Rourke writes. Supporting the outlook for U.S. stocks, "most S&P 500 companies have better balance sheets than most sovereigns, including the United States." Against a backdrop of a "V"-shaped recovery in corporate profits, expectations of continued low short-term interest rates and reasonable valuations, Barclays Wealth has been recommending investors overweight stocks. Mr. Gurwitz says the Europe situation doesn't change their strategy.
Mr. Gurwitz puzzled over the fixation on Greece when U.S. investors have an even bigger problem in their own backyard that so far most are ignoring. The California situation is much more important than Greece," he says. Greece comprises about 2% of Europe's gross domestic product, while California—struggling to pay its debts—represents more than 10% of the U.S. economy, he says. "Yet nobody's talking about California," he says. Morgan Stanley's Mr. McVey acknowledges that at some $350 billion, Greece's bond market is tiny, but he says that is missing the point. The turn of events in Europe "is no different than what you saw at the investment banks: the market doesn't want to do business with over-levered entities," he says. The result, he says, is an even more challenging economic recovery. "Investors are going to increase the cost of capital for over-leveraged entities—governments or corporations, particularly financial institutions that do not get their financial houses in order quickly," he says.
John Brynjolfsson, head of investments at hedge fund Armored Wolf, sees two reasons that the Greece situation presents real issues. The first is the degree to which the global economic recovery is still reliant on massive stimulus efforts. "Everyone is depending on sovereign and fiscal authorities to keep the music going," he says. However, because the huge government deficits eventually act to slow economic growth, "people know that eventually the music is going to stop playing." The key unknown is at what point do the bond markets force governments to cut back on the stimulus. The answer, Mr. Brynjolfsson says, "is purely a function of confidence." Greece, he says, may "accelerate what could theoretically happen over a five- to 10-year horizon and instead make it happen within a three- or six-month period."
The other problem is the potential for a meaningful rise in inflation, Mr. Brynjolfsson says. "We know there has to be an end game and one of the outcomes would be this miraculous surge of productivity, profits, income and growth to get us out of these problems—and frankly that's a stretch." More likely is default or inflation, and of the two, inflation is the most palatable. "It's not a question of if but of when," not just in Europe, but in the U.S., Mr. Brynjolfsson says. "As long as [Fed Chairman Ben] Bernanke has ink, paper and printing press, we can assume that the Fed will try to offset any amount of de-leveraging going on."
All this could play out with central banks keeping short-term interest rates low, while intermediate and long-term interest rates rise, he says. At the same time, the "printing press" method of dealing with the budget deficits would erode the value of the dollar, yen, sterling and the euro. That is leading Mr. Brynjolfsson to employ bearish trades on developed country stocks while owning emerging-market stocks. He is also holding commodities and betting on a rise in the VIX, a measure of stock-market volatility. Amid the uncertainty, the VIX surged more than 20% Thursday.
Falling Euro Puts US Recovery Under Threat
by Simon Johnson
Intensified fears over government debt in the eurozone are pushing the euro weaker against the dollar. The G7 achieved nothing over the weekend, the IMF is stuck on the sidelines, and the Europeans are sitting on their hands at least until a summit on Thursday. There is a lot of trading time between now and then – and most of it is likely to be spent weakening the euro further. The UK also faces serious pressure, and there is no telling where this goes next around the world – or how it gets there.
There may be direct effects on the US, as our banking system remains undercapitalized. Or the effect may be through making it harder to export – one of the few bright spots for the American economy over the past 12 months has been trade. But this is unlikely to hold up as a driver of growth if the euro depreciation continues. Some financial market participants cling to the hope that the stronger eurozone countries, particularly Germany, will soon help out the weaker countries in a generous manner. But this view completely misreads the situation.
The German authorities are happy to have the euro depreciate this far, and probably would not mind if it moves another 10-20 percent. They are convinced that they must – in fact, should – export their way back to acceptable growth levels. Competitive depreciation is of course a no-no in international policy circles. But if your dissolute neighbors – with whom you happen to share a credit union – threaten to implode their debt rollovers, and makets react negatively, how can you be held responsible? Germany and France have no objection to euro depreciation – they are confident that the European Central Bank can prevent this from turning into inflation.
It’s the US that should be concerned about the effect on its exports (and imports; goods from the eurozone become cheaper as the euro falls in value) if the euro moves too far and too fast. But the US failed to raise the issue with sufficient force at the G7 finance ministers conclave in Canada and the course is now set – at least until Thursday. The euro depreciates, the dollar strengthens, and our path to recovery starts to run more uphill. And if these European troubles start to be reflected in difficulties for leading global banks over the next few days or weeks, the negative impact will be much greater.
UK economy 'faces crisis' warns former IMF economist
The UK should be seen in the same category of countries as Greece and Spain, who are facing severe debt problems, a leading economist has said. Ex-IMF chief economist Simon Johnson also described the G7 group of leading economies as "fundamentally useless". His comments to the BBC came as G7 finance ministers discussed the growing crisis in some Eurozone nations. Treasury sources said all three major credit-rating agencies had reaffirmed the UK's triple A credit status. One of the major concerns about a country having large budget deficits is that it cannot spend sufficiently to boost its economy.
Although the UK did officially come out of recession in the fourth quarter of 2009 - ending six consecutive quarters of economic decline - the growth was just 0.1%, much less than expected. "It is right that borrowing has been allowed to rise so that the government has been able to protect the economy from the global downturn," a Treasury spokesman said. "But, supporting the economy through to recovery goes hand-in-hand with steps to rebuild fiscal strength once recovery is firmly established. "That is why the government has set out a clear plan to halve the deficit over the next four years, while protecting the frontline services that people depend on."
Last week the Euro hit a seven-month low against the dollar, as traders worried that Greece's government debt problems could spread to other European countries such as Spain and Portugal. Stock markets have seen big falls too, as investors studied the countries' spiralling deficits and questioned their commitment and ability to bring them down. Mr Johnson has said that the UK should be added to those countries, whose government debt ratings have come under serious pressure.
"The financial markets are taking a long hard look at the fiscal accounts of all these countries and they don't like what they see," he said. "Now Greece is an an extreme example - there I think you can see that it's going to get very messy very quickly - but unfortunately the budget situation in these other countries is also weak. "And I have to add the UK to this list. Unless you can persuade the markets that you're really going to bring the budget under control within the foreseeable future and you're going to have some credible actions - and you're going to have to do some persuading - you're going to have big trouble."
Mr Johnson also called the G7 a "fundamentally useless organisation" for not reacting quick enough to the problem and for remaining in an out-of-date mindset. "The G7 countries are completely asleep at the wheel. I looked at the information they put out from their meeting I was absolutely shocked," he said. "They seem to show no awareness at all that much of Europe is facing a serious crisis and it's not limited to Spain, Greece and Portugal, it's also going to include Ireland. I think Italy is also very much in the line of fire. There's a very serious crisis inside the Eurozone."
His damning critique of the G7 came only hours after the very last meeting of its finance ministers at which the Europeans had to reassure their counterparts from the US, Canada and Japan over the deteriorating state of the public finances in some Eurozone countries. At the gathering, it was agreed not to involve the IMF and to leave the matter to the European Union.
UK chancellor Alistair Darling, who was at the meeting in northern Canada, said the world was set for a steady but slow recovery and that governments' stimulus packages should remain in place until the recovery was assured. "The important thing is that we all are absolutely committed to maintaining the support for our economies until we make sure we have recovery established, and than to make sure we can chart a way to ensure that we got sound, long-term growth in the future," he said. "In the last 18 months, we've come through an extremely turbulent period. But I think we can be confident, although we remain cautious, that we are on the right path, provided we see that through."
But his words were brushed aside by the former IMF chief economist, who said that he had not seen any strong EU leaders stepping up and acting on the issue. He said that many of them were still in the mindset of a few months ago - and that they hadn't realised that sentiment in financial markets had changed. The pressure on the EU to act will be brought into sharp focus this week when the new President of the European Council Herman von Rompuy chairs a special economic summit in Brussels at which the public finances of Greece, Spain and Portugal will be discussed.
This Crisis Won’t Stop Moving
by Gretchen Morgenson
You know we’re in trouble when we’re told that the economic problems in Greece, Portugal and Spain, the most indebted countries in the euro zone, are likely to remain safely contained in those nations. After all, we heard the same nonsense in 2007 from United States financial leaders talking about the subprime mortgage mess. Both Ben S. Bernanke, the chairman of the Federal Reserve Board, and Henry M. Paulson Jr., then the Treasury secretary, rolled out to reassure concerned investors that troubles in mortgage land wouldn’t permeate the rest of the economy.
As we all now know, mortgage woes were contained — to planet Earth.And so it may be with overleveraged nations in Europe. Simply put, contagion is a fact of life in our interconnected global economy and financial markets. And that means investors must strap in for more gyrations in the stock and bond markets as the great and painful deleveraging that began in 2007 continues around the world. Sure, there are rays of light amid the gloom. The slightly upbeat jobs report on Friday, for example, is an example. But it is only one data point and not enough to move the needle on much larger issues that remain, including investor fears that Greece, Portugal and Spain will default on their debts.
"This is a reminder that every country has its limit," said David A. Rosenberg, chief economist and strategist at Gluskin Sheff & Associates in Toronto, one of Canada’s top wealth management firms. "And our heightened concerns over sovereign credit quality are not going to abate anytime soon." During his years as chief economist at Merrill Lynch in New York, Mr. Rosenberg was perspicacious indeed. So his take on the potential fallout from financially stressed countries is a valued one. First, Mr. Rosenberg reckons that the flight to the dollar will continue. Even though the United States has plenty of its own economic challenges — enormous public debt weighing on a struggling economy, for example — our lot is far better than others’, he maintains. "In the land of the blind, the one-eyed man is king," he said. "The U.S. dollar is that one-eyed man."
But that does not mean we are finished with our own debt purge. "Watching the situation in Europe, it’s not even clear that the root cause of problems here at home has been solved," Mr. Rosenberg said. "We still have a very fragile situation: household balance sheets, and delinquencies, defaults and home prices are still vulnerable to another down leg. People think because you finish one chapter in this post-bubble credit collapse that the book is done." As for housing prices, Mr. Rosenberg expects further declines of 10 to 15 percent over the next few years. He pointed to the roughly nine million residential housing units available for sale across the country, a very high vacancy rate when judged against a total housing stock of 130 million units.
If his forecast is accurate, the numbers of borrowers who owe more than their homes are worth will rise significantly. Mr. Rosenberg estimates that fully half of the mortgage-holding population in the country could be underwater by 2011. For now, these borrowers are getting little to no help from lenders — no surprise — or from the government. Indeed, the Obama administration’s loan modification program has more or less allowed banks that own second mortgages on troubled borrowers’ homes to continue to press for full repayment of these obligations. When it comes to writing down principal amounts on mortgages, the government has pressured those holding the first mortgages more than the institutions holding the seconds. Never mind that the second liens are worthless and should be written down to zero.
This see-no-evil approach to second mortgages is part of an overall denial on the part of policy makers, politicians, bankers and regulators that has prolonged the agony of this crisis. Owning up to reality about what loans are worth is rough medicine to take, but denying that problems exist only puts off the inevitable. "We are much further along the road to price discovery and full disclosure than Japan was at this same stage of their credit contraction," Mr. Rosenberg said. "There are still some very significant credit problems in the U.S. and as they pertain to commercial real estate are still extremely problematic. Some banks will likely be whipped very hard." The challenge for Mr. Obama is that he has thrown oodles of taxpayer money at these problems and still the unemployment rate stands at 9.7 percent.
"We came off a year when you could not have asked for more government stimulus and we lost five million jobs," Mr. Rosenberg pointed out. "What do you do for an encore? The deleveraging is ongoing and yet the government stimulus is largely behind us. That is problematic for an economic forecaster." The fact is, to save the world from economic collapse we have transferred the liabilities of the private sector to the public. And not every country has the money to service or repay that debt. "We are in a post-bubble credit collapse and there are going to be periods of calm and stormy weather. Investors will have to navigate through the volatility," Mr. Rosenberg said. "Unfortunately, I think we are still in the early stages. The next recession will happen more quickly than people think."
What Goes Around Comes Around
by David Rosenberg
First the governments bail out the banks who were (are) basically insolvent. Then these governments, especially in Europe, see their balance sheets explode and face escalating concerns over sovereign default. The IMF now predicts that the government debt-to-GDP ratio in the G20 nations will explode to 118% by 2014 from pre-crisis levels of around 80%.
Now, the ball is put back onto the banks because many have exposure to the areas of Europe that are facing substantial fiscal problems right now. According to the Wall Street Journal, U.K. banks have $193 billion of exposure to Ireland. German banks have the same amount of exposure and an additional $240 billion to Spain. Many international bond mutual funds also have sizeable exposure to sovereign debt of Portugal, Ireland, Greece and Spain as well. Contagion risks are back. Stay defensive and expect to see heightened volatility.
In a nutshell, toxic assets have basically been swept under the rug in the hopes that we will outgrow the problem. Leverage ratios across every level of society are still reaching unprecedented levels as the public sector sacrifices the sanctity of its balance sheet in its quest to stabilize the dubious financial position of the household and banking sectors in many parts of the world.
Whatever bad assets have been resolved have almost entirely been placed on the books of governments and central banks, which now have their own particular set of risks, as we have witnessed very recently in places like Dubai, Mexico, and Greece, not to mention at the state and local government level in the United States. We simply have not seen a reduction in the percentage of properties with mortgages that are "under water", hence the FDIC has identified 7% of banking sector assets ($850 billion) that are in "trouble", so how can it possibly be that the financial system is anywhere close to some stable equilibrium?
When accurately measured, including the shadow inventory from bank foreclosures, there is still nearly two year’s worth of unsold housing inventory in the United States, and commercial vacancy rates are poised to reach unprecedented highs, and this excess supply is bound to unleash another round of price deflation and debt defaults this year. The balance sheets of governments are rapidly in decline across a broad continuum, and it is particularly questionable as to whether Europe is in sound enough financial shape to weather another banking-related storm.
The global economy is set to cool off. Not only is China and India warding off inflation with credit tightening measures but most of the fiscal and monetary stimulus thrust in the U.S.A. and Canada is behind us as well. And, the fiscal tourniquet is about to be applied in many parts of Europe, especially the PIIGS (referring to Portugal, Ireland, Italy, Greece and Spain — these countries account for a nontrivial 37% of Eurozone GDP). Greece’s GDP has already contracted by 3.0% YoY, as of Q4, and is expected to contract 1.1% in 2010 and 0.3% in 2011 as a 13% deficit-to-GDP ratio is sliced from 13% to 3% (assuming this fiscal goal can be achieved politically). Portugal has a 9.2% deficit-to-GDP ratio that is in need of repair and Spain has a deficit ratio that is even worse, at 11.4% of GDP.
The bottom line is that even if the fiscally-challenged countries of Europe do not end up defaulting, or leaving the Union, the reality is that they will have to take draconian measures to meet their financial obligations. Devaluation was the answer in the past in Greece but it cannot rely on that quick fix this time around without leaving EMU and if it did, then that could make it even harder to service its Euro-denominated debts — at least not without a restructuring. And, if Greece did attempt at a debt restructuring, rest assured that Italy, Spain, Portugal and Ireland would be next — we are talking about a combined $2 trillion of potential sovereign debt restructuring that would more than triple the $600 billion direct cost of the Lehman bankruptcy.
This poses a hurdle over global growth prospects at a time when Asia will feel the pinch from the credit-tightening moves in China and India. And heightened risk premia will also exert a dampening global dynamic of their own in terms of economic decision-making by businesses and households alike. The intense sovereign risk concerns are not limited to Europe either. In the U.S.A. we saw CDS spreads widen out to their highest levels since the equity markets were coming off their lows last April. According to the FT, the Markit iTrax SivX index of CDS on 15 western European sovereign credits rose above 100bps on Friday for the first time ever.
The Fed's "Exit Plan" Is Just Another Secret Gift To Wall Street
by Henry Blodget
The Fed is planning to detail its "exit plan" this week, the WSJ says. This exit plan is the means by which the Fed will gradually reverse the tremendous stimulus it is still pumping into the economy and financial system.
As we've noted often over the past year, the Fed is in a bind. During the financial crisis, it bought hundreds of billions of dollars of real-estate loans and securities from banks to reduce mortgage rates and ease the pressure on bank balance sheets. This, in turn, pumped hundreds of billions of new dollars into the economy, which has helped the banks--and bankers--to make a killing over the past year. The question--the bind--is how the Fed can reverse this stimulus without killing the economy.
And the initial answer seems to be...By giving the banks yet another gift at taxpayer expense.
The idea behind giving the banks cheap money was that the banks would lend it to consumers and businesses. Unfortunately, that hasn't happened: Since the start of the crisis, bank lending has fallen off a cliff (see chart at right).
The banks are, however, lending to the Federal government, which needs to fund record deficits by borrowing more than $1 trillion a year. Banks are also collecting interest--currently 0.25% a year--on the $1 trillion or so of "excess reserves" (see below) that they aren't lending to anyone.
The combination of the Fed's desire to stimulate lending via cheap money and the government's desire to stimulate the economy by running a huge deficit has made it a great time to be a bank: Banks can borrow from the government at artificially cheap rates and then lend the money back to the Federal government at higher rates, pocketing the difference. Or they can just keep the excess reserves at the Fed and get paid to do that.
And now it's going to get even better to be a bank.
Because the first part of the Fed's exit plan will reportedly be to increase the amount of interest the Fed pays on "excess reserves."
Banks are required to keep a certain percentage of their assets in cash at the Federal Reserve. Any cash above this required amount is "excess reserves," and the Fed is currently paying 0.25% interest on it. The Fed's exit plan will call for increasing this interest rate, to encourage the banks to keep more money in excess reserves instead of lending it into the economy and thus expanding the money supply.
The idea here is that, by encouraging banks to increase the amount of money they keep on account at the Fed, the Fed will reduce the amount of money that gets loaned out to businesses and consumers, thus forestalling inflation. Increasing interest paid on excess reserves will also put off the day that the Fed has to start selling its real-estate assets back to banks, a process that might create taxpayer losses and raise mortgage rates, which the Fed is loathe to do.
Of course, in the process of increasing interest paid on reserves, the Fed will be paying banks even more not to lend. In the process, it will be giving banks yet another way to take nearly free money from the taxpayer and give it back to the government at a higher rate--and then pocket the difference.
All of this underscores the main message of the government's bailout policies, which has been so glaringly evident over the past year: It's a great time to be a banker.
Europe Risks Another Global Depression
by Simon Johnson
The entirely pointless G7 meeting this weekend only served to underline the fact that Europe is again entering a serious economic crisis. At the end of the meeting yesterday, Treasury Secretary Tim Geithner told reporters, "I just want to underscore they made it clear to us, they the European authorities, that they will manage this [the Greek debt crisis] with great care." But the Europeans are not being careful – and it’s not just about Greece any more. Worries about government debt and associated public sector liabilities (e.g., because banking systems are in deep trouble) have spread through the eurozone to Spain and Portugal. Ireland and Italy are next up for hostile reconsideration by the markets, and the UK may not be far behind.
What are the stronger European countries, specifically Germany and France, doing to contain the self-fulfilling fear that weaker eurozone countries may not be able to pay their debt – this panic that pushes up interest rates and makes it harder for beleaguered governments to actually pay? The Europeans with deep-pockets are doing nothing – except insist that all countries under pressure cut their budgets quickly and in ways that are probably politically infeasible. This kind of precipitate fiscal austerity contributed directly to the onset of the Great Depression in the 1930s.
The International Monetary Fund was created after World War II specifically to prevent such a situation from recurring. The Fund is supposed to lend to countries in trouble, to cushion the blow of crisis. The idea is not to prevent necessary adjustments – for example, in the form of budget deficit reduction – but to spread those out over time, to restore confidence, and to serve as an external seal of approval on a government’s credibility. Dominique Strauss-Khan, the Managing Director of the IMF, said Thursday on French radio that the Fund stands ready to help Greece. But he knows this is wishful thinking.
- "Going to the IMF" brings with it a great deal of stigma. European governments are unwilling to take such a step as it could well be their last.
- The IMF is supposed to provide only "balance of payments" lending. That doesn’t fit well when a country is in a currency union such as the euro, which floats freely and does not have a current account issue, and the main problem is just the budget.
- Greece and the other weak eurozone countries need euro loans, not any other currency. If the IMF lent euros, that would be distinctly awkward – as this is what the European Central Bank (ECB) is supposed to control.
- Sending Greece to the IMF would result in some international "burden sharing," as it would be IMF resources – from all its member countries around the world – on the line, rather than just European Union funds. But is the US really willing to burden share through the IMF? After all, Europe has long refused to confront the trouble in its weaker countries, now known as PIIGS (Portugal, Ireland, Italy, Greece, and Spain)? How would the Chinese react if such a proposition came to the IMF?
- Would the Europeans really want the IMF and its somewhat cumbersome rules to get involved – this would be a huge loss of prestige. It could also lead to some perverse outcomes – you never know what the IMF and the US Treasury (and Larry Summers) will come up with in terms of needed policies (ask Korea about 1997-98; not a good experience). The European Union (EU) has handled IMF recent engagement well in eastern Europe (from the EU perspective), but that was seen as the EU’s backyard. If the eurozone is in trouble, everyone will be paying much more attention – no more sweetheart deals.
- The IMF gave eastern Europe amazingly good deals over the past 2 years (by IMF standards). Would this fly with financial markets in the sense of restoring confidence in the PIIGS and their medium-term fiscal futures?
- Does the IMF really have enough resources to backstop all the PIIGS? The IMF’s notional capital was increased substantially last year, but just based on what we see now, the Fund would need even more ready money to tackle the eurozone – all the weaker countries would need at least preventive lending programs and these would need to be large. If that is where this goes, the EU looks simply awful and has failed at a deep level.
- The IMF could play a constructive "technical assistance role" alongside the European Commission, but everyone would want to keep this pretty low profile. Anything that goes to the IMF executive board would result in a lot of cheering and jeering from emerging markets. This would break the power of Europe on the international stage – perhaps a good thing, but not at all what the European policy elite is looking for.
The IMF cannot help in any meaningful way. And the stronger EU countries are not willing to help – in part because they want to be tough, but also because they do not have effective mechanisms for providing assistance-with-strings. Unconditional bailouts are simple – just send a check. Structuring a rescue package that will garner support among the German electorate – whose current and future taxes will be on the line – is considerably more complicated.
The financial markets know all this and last week sharpened their swords. As we move into this week, expect more selling pressure across a wide range of European assets. As this pressure mounts, we’ll see cracks appear also in the private sector. Significant banks and large hedge funds have been selling insurance against default by European sovereigns. As countries lose creditworthiness – and, under sufficient pressure, very few government credit ratings will hold up – these financial institutions will need to come up with cash to post increasing amounts of collateral against their derivative obligations (yes, the same credit default swaps that triggered the collapse last time).
Remember that none of the opaqueness of the credit default swap market has been addressed since the crisis of September 2008. And generalized counter-party risk – the fear that your insurer will fail and this will bring down all connected banks – raises its ugly head again. In such a situation, investors scramble for the safest assets available – "cash", which actually (and ironically, given our budget woes) means short-term US government securities. It’s not that the US is in good shape or even has anything approaching a credible medium-term fiscal framework, it’s just that everyone else is in much worse shape.
Another Lehman/AIG-type situation lurks somewhere on the European continent, and again our purported G7 (or even G20) leaders are slow to see the risk. And this time, given that they already used almost all their fiscal bullets, it will be considerably more difficult for governments to respond effectively when they do wake up.
Speculators build record bets against euro
Currency speculators have increased their bets against the euro to the highest level since the creation of the single currency. Figures from the Chicago Mercantile Exchange, often used as a proxy of hedge fund activity, showed investors increased their bets against the single currency to record levels in the week to February 2. Data showed net short positions against the euro rose from 39,500 contracts to 43,700 contracts, equivalent to $7.6bn. This surpassed the levels of bets against the euro seen in September 2008, when investors abandoned the single currency as haven demand for the dollar surged in the wake of the collapse of Lehman Brothers.
The news came as the euro dropped to a series of multi-month lows against the dollar, culminating last Friday when the single currency fell to an eight-month trough of $1.3583. Analysts said sentiment towards the euro had soured amid increasing concerns over the fiscal problems in Greece, which had spread to encompass worries over other countries on the periphery of the eurozone sporting large fiscal deficits and high labour costs, and even the very existence of the single currency.
Thomas Stolper at Goldman Sachs said the drop in sentiment towards the euro reflected not merely worries over Greece, but were symptomatic of broader concerns over European sovereign debt sustainability and European monetary union. He said the small size of the Greek economy, which represents about 3 per cent of eurozone gross domestic product, meant that its direct significance was not the real issue. "We think it is rather more likely than not that Greece will obtain some form of fiscal support from the rest of the eurozone or otherwise risk default," said Mr Stolper. "But behind this intense focus on Greece obviously is the long-standing unresolved issue of how to enforce fiscal discipline in a currency union of sovereign states."
Greece's financial crisis puts the future of the euro in question
Leave Greece to us. It's a family affair. That was the message from Brussels as shares plunged in Athens, customs officials walked off the job in protest at swingeing budget cuts, the financial contagion spread westwards across the Mediterranean and the International Monetary Fund started to cast a long shadow across the soft underbelly of the eurozone. As far as the European commission was concerned, matters were simple. By a mixture of incompetence and deceit, the Greeks had allowed their deficit to balloon out of control, putting the credibility of monetary union at risk. They now had to put their own house in order, which they could do with the help of some tough love from the rest of Europe – likewise, the financially incontinent governments of Spain and Portugal.
European Central Bank president Jean-Claude Trichet said last week it was vital that Greece met its stated goals for cutting its budget deficit and that the steps announced by the government were encouraging. "The ECB governing council approves the medium-term goal ... we expect and are confident that the government will take all the decisions that will permit it to reach that goal," he added. "The measures taken last Tuesday – tax rises, the freezing of wages in the public sector, and the pension reform – are steps in the right direction."
But the reality is more complex. A crisis that began with the previous government in Athens cooking the books developed into three interlocking themes – the reluctance of the Greeks to swallow the nasty budgetary medicine prescribed for them, the medium-term outlook for the single currency and Europe's long-term role in a rapidly changing global economy. Despite the hands-off warning from Brussels, the IMF has been itching to send a hit squad across the Atlantic to help sort out Greece's acute budgetary crisis. "We are there to help," says the managing director of the IMF, Dominique Strauss-Kahn. "I have a mission on the ground to provide technical advice requested by the Greek government. And if we're asked to intervene, we will." But he adds: "I understand that the Europeans don't want this for the moment."
They certainly don't, but a mission may still be sent, if only to prevent the contagion spreading. Nouriel Roubini, economics professor at the Stern School of Business at New York university, said in Davos last month: "If Greece goes under, that's a problem for the eurozone. If Spain goes under, it's a disaster." He has been strongly advising the beleaguered socialist government of George Papandreou to seek help from Washington, a view shared by Harvard professor Kenneth Rogoff, former chief economist at the fund: "Greece is going to end up with an IMF programme of some sort in order to get credibility."
Rogoff, who has just published a book on eight centuries of financial crises, said that Greece was "a serial defaulter". Since the modern Greek state was founded in 1830, the country has, on average, been in sovereign default every other year and had been through five big defaults in less than 200 years. "Greece has been worse than any Latin American country," he adds. The risk of another default or – the doomsday scenario – of Greece deciding to leave the single currency has spooked investors, who are demanding a high price for holding risky Greek debt. The gap between the interest rates on rock-solid German bunds and Greek bonds has widened sharply.
The IMF would probably already be involved were Greece outside the eurozone. But according to Charles Grant, director of the Centre for European Reform, the commission wants to keep the fund at arm's length because it would give the Americans a say in single currency affairs, a blow to European pride. Grant says this is regrettable: "The IMF is very experienced in these matters; it is professional and is not subject to political pressure. There is a political point as well. If the commission sets conditions that lead to hospitals being closed, there will be demos against Brussels. If the IMF does it, the demos will be against the fund."
For the Greek public last week, it barely mattered whether the harsh measures were coming from their own government, the commission, the fund or a mixture of all three. All they knew was that they did not fancy higher taxes on fuel, working longer to get their pensions and, if they were civil servants, taking a 10% pay cut.
Similarly, trade unions in Spain bridled at plans announced by Prime Minister José Luis Rodriguez Zapatero to increase the number of years workers would have to make contributions before receiving state pensions. Still reeling from the effects of the global recession of the past two years, Greece, Spain and Portugal now face a prolonged period of weak growth and high unemployment. Some argue that the cuts being inflicted on the eurozone's weaker economies highlight a fundamental weakness in the single currency – its lack of a centralised budgetary mechanism, such as exists in the US, to move resources from rich parts of the union to poor parts.
Gerard Lyons, chief economist at Standard Chartered, says there have been several examples of monetary unions that have collapsed because they were not accompanied by fiscal union: "For monetary union to survive, it has to become a political union. If it doesn't there is likely to be some sort of implosion and a move towards a two-speed Europe." Roubini agrees: "The eurozone could drift … with a strong centre and a weaker periphery, and eventually some countries might exit the monetary union."
Mats Persson, research director of the Open Europe thinktank, believes Greece should not have been allowed to join the euro in the first place, and that there comes a point during an extreme crisis when countries can see the desirability of having their own currencies, so that they can adjust through devaluation: "The question is whether Greece can ever compete as a middle-rank eurozone country without some proper structural reform, and whether that is possible without its own monetary policy."
In the short term, leaving the single currency is not on the policy agenda in Greece, Spain or Portugal. Nick Parsons, head of markets strategy for NAB Capital, the wholesale markets division of National Australia Bank, says: "Has the euro been a disaster for Greece? No. You have to think about where they would have been without it. Arguably, the financial crisis would have been greater outside the eurozone." Grant at the Centre for European Reform notes that Portugal, Spain and Greece had all been dictatorships until the final third of the 20th century and saw membership of the EU and the single currency as a sign of growing up politically: "That's why Europe is very popular in these countries."
But even the most ardent europhiles admit that the chances of constructing a fully fledged political union in order to make monetary union work better are remote. Instead, they say, countries will have to make themselves leaner and fitter through structural reforms of their economies and accept some centralised control over their budgets from the eurozone's big two, Germany and France. Parsons says: "What will happen is that there will be the emergence of a strong bloc which will ensure that never again will countries be allowed to go off and do what they want. Instead, they will have to do as they are told. There will be a stripping-away of fiscal powers from those that don't behave."
Determination to make the single currency work has been driven by two seemingly contradictory forces. On the one hand there is a sense that the financial crisis has been a failure of the Anglo-Saxon model, and hence a shot in the arm for European social democracy; Nicolas Sarkozy used his keynote speech in Davos to call for a different form of capitalism. On the other hand, there is a sense that economic and political power is shifting inexorably to Asia.
It is accepted that the structural reform to meet the challenge of China will be long and arduous. The Germans have shown a willingness to grind out productivity gains by accepting cuts in real wages, and the Irish are currently doing the same. But the hopes of the Lisbon agenda – agreed a decade ago with the aim of making Europe "the most dynamic and competitive knowledge-based economy in the world … by 2010" – remain unfulfilled.
Countries such as Spain and Greece are emblematic of the problem. They lack both the physical and human infrastructure needed to make themselves more competitive, yet it is in those areas – spending on roads, universities and skills – that the axe will fall. This presents a problem not just now but for the future, as the ageing baby boomer generation presents Europe with a steady decline in its working-age population.
Writing in the current edition of Foreign Affairs magazine, Jack Goldstone, professor at George Mason University's school of public policy in the US, says that Europe is expected to lose 24% of its prime working-age population (about 120 million workers) by 2050, while those aged 60-plus will increase by 47%: "It is essential, despite European concerns about the potential effects on immigration, to take steps such as admitting Turkey into the European Union," he writes. "This would add youth and dynamism to the EU – and prove that Muslims are welcome to join Europeans as equals in shaping a free and prosperous future."
Russell Jones at RBC Capital Markets says: "Within 10 years, European populations will be in decline and dependency ratios [the ratio of the population aged 0-16 and 65-plus to those aged between 16 and 65] will really start to take off." Between now and 2050, the OECD estimates that the cost of healthcare and pensions will rise by 7.5 percentage points of GDP in Germany, 7.3 points in France, 13.5 points in Spain and 16.8 points in Greece. "In such circumstances, the willingness of those populations at the core of Europe to subsidise those in the periphery is likely to be a lot less than it is now – and it is already in short supply," says Jones. "Governments will have their hands more than full at home."
Greek unions threaten austerity moves
Greek unions said today that they would fight government austerity measures as they prepared for a 24-hour strike on Wednesday, a rebuke to the efforts of Prime Minister Papandreou to rally support for his budget-cutting reforms. The walk-out by Greek public sector workers, who are protesting against government plans for wage freezes, tax rises and an increase to the retirement age, will overshadow an EU summit meeting in Brussels on Thursday, when Europe's leaders will discuss the plight of Greece and other financially challenged states on the periphery of the eurozone, including Spain and Portugal.
The threatened civil service strike drove up the yield on Greek government bonds and depressed the value of the euro. The single currency has lost about 10 per cent of its value since November as concern mounts about the fiscal challenge from the Mediterranean states. Greek labour unrest is rattling investors, who fear that Prime Minister Papandreou will struggle to cut Greek government spending. Greece is forced to pay a huge premium to borrow money compared with fellow eurozone governments and the difference between Greek bond yields and the benchmark German Bund yield widened by a further 15 basis points today to 3.65 percentage points. The cost of insuring Greek government debt has also risen, settling today at €407,000 (£357,000) for each €10 million exposure.
Fears are growing that the debt problems of the periphery states will infect the euro, forcing the core member states of France and Germany to arrange financial bailouts of weaker countries. The prospect of intervention was dismissed over the weekend by Wolfgang Schãuble, the German finance minister, at a meeting in Canada of G7 finance ministers, who also ruled out a rescue of Greece by the International Monetary Fund. Greece is saddled with huge public sector debts, equal to 125 per cent of the country's GDP. Prime Minister Papandreou has promised to reduce the gap between public spending and income, currently almost 13 per cent of GDP, to within the EU limit of 3 per cent by 2012 with tough budgetary medicine.
Greek unions were defiant today in the face of insistence by European governments that the Mediterranean state had no choice but to cut its cloth to an austere fashion. "We are fighting so that the working people don’t get to pay for the crisis," said a spokesman from ADEDY, the public sector union. "We demand a pay increase ... a fair tax system."
The wider financial impact of southern Europe's Pigs
Financial markets like to bet against countries and punish those who have policies or deficits that look unmanageable. Back in 1992 the pound came under brutal attack from speculators led by George Soros who were prepared to gamble that the Tory government of the day would not be able to maintain its peg to the Deutschmark in a bid to finally rid the country of inflation. By the time Black Wednesday was over in September 1992, Soros had reputedly pocketed £1bn and the reputation of the government of John Major for economic competence was in tatters.
In a similar way, the governments of Greece and Portugal, and also Spain and Italy, are under attack from the bond markets. That may not sound like a national emergency for the countries concerned but the financial impact is real. Greece started the rot late last year when it revealed that its budget deficit would be twice as big as it thought. Markets hate uncertainty, and being lied to. So they sold Greek government bonds with a vengeance. That matters because governments that run big deficits need to finance them by selling new bonds to financial markets. If people don't want to buy them, they have to offer a higher coupon, or interest rate, to investors.
By selling off existing Greek bonds, dealers pushed up the yields on those bonds because yields move inversely to price. In normal times you would expect any sovereign debt of a member country of the euro zone to trade at similar yields to those of the bloc's heavyweight – Germany. But no longer. The so-called "spread", or difference, between Greek bond yields and bunds (German bonds) widened to nearly 400 basis points late last month. That means if bunds are yielding 3%, Greek bond yields are more like 7%. When Greece recently made a new bond issue, it had to put a coupon on the gilt of a hefty 6.2%. This "risk premium" that investors demand in exchange for holding Greek bonds has shot up because the risk of default has surged with the budget deficit.
That means that the Greeks have to pay twice as much to borrow money to finance their deficit as the Germans. And that is bad news for a country already running a deficit of nearly 13% of national income. The spread of Greek bonds over bunds fell back a bit last week after the European Commission accepted Greek government assurances that it would slash its budget deficit this year. But the problems are no longer confined to Greece. Attention swung last week to the other southern Europe economies, known rather unkindly as the "Pigs" (Portugal, Italy, Greece and Spain).
The spread of Portuguese debt shot up to around 175 basis points over bunds, but remained well below that of Greece. "The state of Portugal's public finances is challenging. Gross government debt reached 77% of GDP in 2009 and, with an expected deficit of over 8% this year, it should rise further. We expect the debt ratio to reach 95% of GDP in 2014," said Christel Aranda-Hassel, economist at Credit Suisse. "Portugal's relatively weak economic performance poses one of the main medium-term risks."
And all the uncertainty surrounding sovereign debt worries spread late last week into many other markets, spreading renewed fears about the strength of the recovery in the global economy. If all main economies have to struggle to pay off the huge deficits run up as a result of their recessions, they could be squeezed by rising taxes and spending cuts for years to come. Suddenly, the robust global recovery world stock markets were pricing in looks a bit overoptimistic. Ole Hansen, a senior manager at Saxo Bank, put it like this: "On Thursday Portuguese and Spanish stocks suffered their biggest daily fall since 2008 as the worries surrounding Greece spread to other weak economies within the Euro zone.
"This fear led to sharp falls in shares across continents and a worldwide flight to the safety of US dollar and treasuries. The euro traded down to a seven month low and all projections about a year of continued dollar weakness has all but disappeared, for now at least." Finally, though, a note about Ireland. The Irish economy tanked in the global recession, losing more than 10% of its national output. The accompanying graph, though, shows that markets were convinced by the Irish government's emergency, austerity budget last year. The spread of Irish debt over bunds has fallen back somewhat. Ireland has decided to take the whole thing on the chin and make the painful budget adjustments straight away. The markets believe them, but they don't yet believe Greece and the other Pigs.
Greek Ouzo crisis escalates into global margin call as confidence ebbs
by Ambrose Evans-Pritchard
For the third time in 18 months the global financial system risks spinning out of control unless political leaders take immediate and radical action. Flow data shows an abrupt withdrawal of German and Asian capital from Club Med debt markets. The EU's refusal to offer Greece anything beyond stern words and a one-month deadline for harsher austerity – while admirable in one sense – is to misjudge how fast confidence is ebbing. Greece's drama has already metastasised into a wider systemic crisis. The world risks a replay of the Lehman collapse if this runs unchecked, this time involving sovereign dominoes.
Barclays Capital says the net external liabilities of Greece are 87pc of GDP, or €208bn (£182bn). Spain is worse at 91pc (€950bn), and Portugal worse yet at 108pc (€177bn); Ireland is 68pc (€123bn), Italy is 23pc, (€347bn). Add East Europe's bubble and foreign debts top €2 trillion. The scale matches America's sub-prime/Alt-A adventure and assorted CDOs and SIVS of the Greenspan fling. The parallels are closer than Europe cares to admit. Just as Benelux funds and German Landesbanken bought subprime debt for high yield with AAA gloss, they bought Spanish Cedulas because these too had a safe gloss – even though Spain's property boom broke world records. They thought EMU had eliminated risk: it merely switched exchange risk into credit risk.
A fat chunk of Club Med debt has to be rolled over soon. Capital Economics said the share of state debt maturing this year is even higher in Spain (17pc) than in Greece (12pc), though Spain's Achilles' Heel is mortgage debt. The risk is the EMU version of Mexico's Tequila crisis or Asia's crisis in 1998. This Ouzo crisis is coming to a head just as tougher bank rules cause German lenders to restrict loans, and it touches on the most neuralgic issue of our day: that governments themselves are running low. Britain, France, Japan, and the US are all vulnerable. All must retrench. The great "reflation trade" of 2009 is over.
Far from containing the crisis, Europe's response recalls the Lehman/AIG events of 2008 when Brussels sat frozen, and Germany dragged its feet. On that occasion France took charge, in the nick of time. Today's events will not wait. The rocketing cost of (CDS) default insurance on Iberian debt speaks for itself. Lisbon retreated from a €500m bond issue last week, even before the government lost a crucial finance vote. Can Athens raise money at all on viable terms?
There are echoes of early 2009 when East Europe blew up, with contagion hitting global bourses, commodities, and iTraxx credit indices. That episode was halted by the G20 deal to triple the IMF's fire-fighting fund to $750bn. The odd twist today is that Greece cannot turn to the IMF because that offends EMU pride, yet no other help is on offer because the EU has no fiscal authority. Greece lies prostrate between two stools. Both the City and Brussels seem certain that Europe will conjure a rescue, crossing the Rubicon towards fiscal federalism and a debt union. The emergency aid clause of Article 122 is on everybody's lips. Insiders talk of a "Eurobond".
On balance, such a rescue is likely. Yet leaving aside whether North Europe can afford to guarantee Club Med debt – or whether a bail-out pollutes more countries, as HBOS polluted Lloyds – there is one overwhelming fact missing from the debate: Germany has not endorsed any such rescue. Jurgen Stark, Germany's champion at the European Central Bank, said markets are "deluding themselves" if they think others will pay to save Greece. He shot down Article 122, saying Athens was responsible for its own mess.
Bundesbank chief Axel Weber said it would be "politically impossible" to ask taxpayers to bail out a profligate state. Both the finance and economy ministers have forsworn a rescue. Die Welt has called for Greek withdrawal from the euro. I cannot judge how much is brinkmanship, pressure to make Club Med sweat. But I remember vividly lunching with the British prime minister's economic adviser in August 1992 and being told that Germany would soon rescue sterling in the Exchange Rate Mechanism by cutting rates. Such was the self-deception of the British elite. Anybody following German politics – such as George Soros– knew it was nonsense.
Germany is harder to read today. The euro is a giant step beyond the ERM. Yet there are powerful counter-currents. Germany's constitutional court issued a crushing put-down of EU pretensions last June, ruling that the sovereign states are "Masters of the Treaties" and that EU bodies lack democratic legitimacy. So if you are betting that Germany must forever more efface itself for the European Project, be careful. Berlin hawks might prefer to lance the Club Med boil sooner rather than later.
Spain battles to convince financial markets it is a 'solid' country
When renowned academic Nouriel Roubini said that Spain, not Greece, was Europe's No 1 problem, he created a stir. He also created a problem for an old university friend, Spain's economics secretary José Manuel Campa, who has since been forced to work round the clock to reassure international investors that Spain is a "solid" country and should not be compared to its fellow eurozone struggler.
Roubini, the man who foresaw the sub-prime crisis, raised the heat on Spain, where the financial crisis has left nearly 20% of the workforce unemployed as the country's model of growth based on a construction boom has unravelled. The past week has forced up interest rates on Spanish bonds and the share prices of profitable companies such as Banco Santander have dropped by 13%. Putting on a brave face, Campa told the Observer: "Markets react drastically, we're better off this week than last before we announced our budget cuts."
The country's four million jobless are certainly not better off. Far from Madrid's bureaucratic centre, or the elite gatherings of Davos, thousands live on €1,000 (£870) a month. Service sector and office workers have their salaries capped at this level as employers know that, with 18% unemployment, they are unlikely to rebel. "We're all taken by the balls – we can be forced to go at any minute and you don't know if you'll find anything else," says Maria, an employee of a fashion chain in Barcelona. "They give me three-month contracts, so if they want to get rid of me, they won't have to pay me. I spent one year unemployed, without being able to go out."
An hour's drive south along the Mediterranean coast, schoolchildren in Tarragona do not go on school trips as their parents can't afford the €12 cost. "You can see some children buy their textbooks at the beginning of the month, after pay day," says a teacher. Further south, in Jaén, "where nothing, is moving," Javier Díaz's family ring constantly for advice as they seek to follow him to Madrid where he has found work as a taxi driver. But opportunities are scarce even in the capital. "Things are going to get worse as soon as people stop receiving their unemployment benefits," he says.
Every Spaniard seems to know somebody caught in the real estate bubble burst. Cheap credit and the arrival of about six million immigrants over the past decade allowed the construction sector to become the country's leading economic driver, representing as much as 25% of gross domestic product at the peak of the boom. Villages on the Valencia coast, dependent on fish and agriculture for centuries, started building state-of-the art glass buildings in a country that has always been more labour- than capital- intensive. Properties worth €1m stretch along a coast that, far from Madrid and Barcelona, rarely generated much wealth. People on €1,300 a month owned BMWs and couples making €30,000 a year bought €500,000 homes.
Campa and economy minister Elena Salgado are working to help the unemployed, and to make services and tradable goods fill the part of GDP that construction once accounted for. "This won't be a good year for jobs, but at least the rate of job destruction is slower," Campa says. As he spoke last Friday, financial markets kept hitting Spain. Although it has not had to spend billions to bail out banks, the country has lost credit in the international community, which is "looking for the next Greece, and looks at the numbers, instead of politicians talking the talk", says Gary Jenkins, at Evolution Securities in London.
Last week Spain announced higher taxes and draconian cuts to the deficit from a staggering 11.4% of GDP to reach the EU target of 3% by 2013. But markets have been unimpressed and now demand a record $183,000 to insure $1m of Spanish debt, twice as much as Britain. Alien to the London-based derivative markets, most Spaniards are suffering the consequences: winegrowers in the Priorat area are idle as the prices for grapes are lower than the cost of harvesting them. "Many winery owners are selling out – they can't afford to pay for the loans," says Rafael de Haan, owner of Bodegas Albanico, a wine exporter. "Some are selling top-quality wine at wholesale prices – and in wholesale amounts." But while the wine may be cheap, with some economists saying Spain won't recover until 2016, there is not much to celebrate.
Secret summit of top bankers
The world's top central bankers began arriving in Australia yesterday as renewed fears about the strength of the global economic recovery gripped world share markets. Representatives from 24 central banks and monetary authorities including the US Federal Reserve and European Central Bank landed in Sydney to meet tomorrow at a secret location, the Herald Sun reports. Organised by the Bank for International Settlements last year, the two-day talks are shrouded in secrecy with high-level security believed to have been invoked by law enforcement agencies.
Speculation that the chairman of the US Federal Reserve, Dr Ben Bernanke, would make an appearance could not be confirmed last night. The event will be dominated by Asian delegations and is expected to include governors of the Peoples Bank of China, the Bank of Japan and the Reserve Bank of India. The arrival of the high-powered gathering coincided with a fresh meltdown on world sharemarkets, sparked by renewed concerns about global growth and sovereign debt. Fears countries including Greece, Portugal, Spain and Dubai could default on debt repayments combined with disappointing US jobs data to spook investors.
Australia's ASX 200 slumped 2.4 per cent, to a its lowest close since November 5, echoing a sharp fall on Wall Street. Asian share markets were also pummelled, with Japan's Nikkei 225 down almost 3 per cent and Hong Kong's Hang Seng slumping 3.3 per cent. The damage was also being felt by European markets last night with London's FTSE 100 down sagging 1 per cent in early trade. Sovereign debt fears rippled through to the Australian dollar which was hammered to a four-month low of US86.43 and was trading at US86.77 cents last night.
"This does feel like '08 and '07 all over again whereby we had these sort of little fires pop up and they are supposedly contained but in reality they are not quite contained,'' said H3 Global Advisors chief executive Andrew Kaleel. "Dubai should have been an isolated incident and now we are seeing issues with Greece, Portugal and Spain.'' It wasn't all bad news with the RBA yesterday upping its Australian growth forecasts and flagging more interest rate rises this year. The central bank estimates the economy grew 2 per cent in 2009, and will expand by 3.25 per cent in 2010, and by 3.5 per cent in 2011. The outlook for global growth is likely to be a key theme of the high level central bank talks.
The gathering also comes at an important time for the BIS as it initiates an overhaul of the global banking system which will include new capital rules applying to banks and more stringent standards regulating executive pay. A key part of the two-day talkfest will be a special meeting of Asian central bankers chaired by the governor of the Central Bank of Malaysia, Dr Zeti Akhtar Aziz. Influential BIS general manager Jaime Caruana is also expected to take a prominent role in the talks. Federal Treasurer Wayne Swan will address the central bank officials at a dinner on Monday night.
'Tidal wave' of British business failure feared as tax help scheme ends
The Government has been warned that it faces a "ticking time bomb" of company closures and job losses when a scheme to allow firms to delay their tax payments is wound up. Experts say the "time to pay" programme has been a resounding success and has kept many businesses afloat in the recession, since HM Revenue & Customs (HMRC) would normally have first call on their money and could have pushed them into liquidation or administration.
But insolvency firms expect that the £4.8bn scheme, which has helped 160,000 businesses employing 1.2 million people, will be axed after the expected May general election, so companies will have to stump up their delayed VAT, national insurance and other tax payments. Malcolm Shierson, a partner at Grant Thornton's recovery and reorganisation practice, said the number of business failures fell in the last three months of 2009 but were still a near historic high. "We expect the number of liquidations to shoot up even further when the future government stops extending the 'time to pay' tax scheme," he said.
Colin Burke, a partner at Milner Boardman corporate rescue and recovery firm, said a significant number of companies helped by the scheme were now falling behind with their payments and increasing the size of their debts to the Government. He said: "This leaves HMRC with no option but to take action to prevent further default and recover the arrears, thus triggering formal insolvency proceedings. And whereas in the past such proceedings were evenly spread over a period, the Business Payment Support Service has created a backlog which some fear will lead to a tidal wave of business failures. I don't think there is any doubt that it will happen, it's just a matter of when."
George Bull, head of tax at Baker Tilly accountants, said: "I think to bring down the guillotine after an election would be a grave mistake because the system has worked really very well to help clients who want to pay, but cannot, to get more time to pay. If the right was suddenly halted after an election that would be desperately bad news." Ric Traynor, executive chairman of Begbies Traynor Group, said: "Government support measures are providing welcome relief to the UK's struggling companies in the short term but they may exacerbate problems for some businesses as the need to repay debt catches up with them later in the year." He said the "insolvency peak" of the recession remained some way off even though Britain officially returned to economic growth in the final quarter of last year. "While business finance is expected to become more readily available during the first half of 2010, we anticipate a rise in the levels of financial distress during the second half of 2010, as temporary financial support measures are unwound."
Government sources admit that there could be a delayed effect on company closures and unemployment when the outstanding tax payments are finally demanded. They point out that many of these firms would have gone under without the state help and insist that most of them will survive since only viable businesses experiencing cash flow problems are being helped. Officials say it is impossible to estimate how many firms might eventually be pushed into closure when they settle their bills or how many jobs might be at risk. Ministers promised that the scheme would not be scrapped overnight and that the Government would ensure as much flexibility as possible – the whole point of the help in the first place, they said.
A Treasury spokesman said last night: "The 'time to pay' scheme has been hugely beneficial for businesses facing difficulties and will continue to run as long as necessary. Any suggestion that it will end suddenly and businesses forced to repay is incorrect and runs counter to what the scheme was set up to achieve." The Treasury said more than 90 per cent of tax payments are being repaid on time. Of the £4.8bn deferred in tax, some £3.69bn is already in the process of being repaid.
Ireland's suffering offers a glimpse of Britain's future under the Tories
Last December, on the same day that Alistair Darling delivered his pre-budget report to parliament, the Irish government announced its own plans for tax and spending. Darling said he would delay Britain's fiscal pain; Ireland's Fianna Fáil finance minister, Brian Lenihan, tackled his country's budget deficit head on. Darling has no intention of being swayed by critics who say that Ireland is showing how deficit reduction should be done. Indeed, he would quite welcome some interest being taken in events across the Irish Sea, for if Greece is the right's nightmare vision of where the UK is heading under Labour, Ireland is Labour's dystopia of a Tory Britain.
Unlike Britain, the United States, France, Germany, China and the rest of the G20, Ireland has not rediscovered Keynes. It has spurned counter-cyclical budgetary policy and instead has been raising taxes and cutting spending in a series of budgets and mini-budgets that have sucked demand out of the economy. Lenihan has cut child benefit by 10%, public-sector pay by up to 15%, and raised prescription charges by 50%. One eighth of the working population has no job, yet unemployment benefit is being cut by 4.1%. For the young unemployed, the measures are even more draconian: the dole has been slashed by 50%.
The consensus view in the markets is that Ireland will be rewarded for its prudence. Bond yields will come down because investors will grow less anxious about a default. The ratings agencies will think again about downgrading Ireland's credit rating. This, though, is by no means guaranteed. Ireland has experienced near-depression conditions over the past 18 months, and the expectation that budget cuts will lead to spontaneous recovery through which the private sector will compensate for the retreat of the public sector is unproved. Indeed, there is a considerable risk that removing spending power from the economy will lead to more companies going bust and deter the survivors from investing more.
Greece, Spain and Portugal – all under pressure to follow the Irish lead – also have to balance the struggle for "credibility" in the markets against the short-term hit to demand. Jonathan Loynes, chief European economist at Capital Economics, said Ireland was further down the road with its austerity measures than Greece, having already imposed a squeeze amounting to 5% of GDP in the past year. "Meanwhile, Greece's deficit reduction plans rest heavily on a strong recovery in the economy, which we think is unlikely to materialise. As such, we expect that the deficit will come down rather more slowly," Loynes said.
"But these uncertainties are not exclusive to Greece. Indeed, while we expect Greek GDP to drop by around 2% in 2010, we expect Ireland (and Spain) to fare little better. And if Ireland's earlier fiscal tightening ends up keeping the economy deep in recession, that could clearly have an adverse effect both on its fiscal position and its commitment to further deficit reduction."
Unlike in Greece, there has been no rioting on the streets. Ireland has a corporatist system of government in which the social partners seek consensus rather than confrontation. The onset of austerity, according to some commentators, has been greeted with a certain stoicism, as if there had to be payback time after the excesses of the boom years. Even so, the fiscal retrenchment is stretching the social fabric to its limits. David Begg, general secretary of Ireland's Congress of Trade Unions, has described the policies of the Fianna Fáil/Green coalition as a "charter for exploitation" that puts "very deep blue water between this government and the majority of Irish people".
The options for a young Irish worker, Begg says, "are to take a job at any price or emigrate. Once again, we will see our youngest and best-educated either beaten down by exploitation or forced overseas." The Irish Labour leader Eamon Gilmore described the Lenihan package as "viciously anti-family, fundamentally unfair and socially divisive". The Celtic Tiger years of the 1990s seem a long, long time ago as Ireland accepts real cuts in living standards as the price for keeping the bond market vigilantes sweet. Both Ireland and Greece were enthusiastic founder members of the single currency; they are now painfully discovering the dark side of the euro.
Labour and the Conservatives agree that the current pain being imposed on the weaker members of the eurozone emphasises the wisdom of keeping Britain outside the single currency. Ireland's property boom-bust during the noughties was a textbook example of what can happen if a country loses control of its own monetary policy – rates were too low early in the decade, leading to a colossal misallocation of resources away from exports towards construction, whose share of the economy more than doubled from 6% to 14%.
Windfall tax receipts from the builders and the bankers financing them provided the government with the false impression that the budget was healthier than it was. When the inevitable bust came, Ireland (like Greece and Spain) found it had no independent tools available. Over-heating in the boom led to a loss of competitiveness, which could only be regained through deflation by diktat. The stability and growth pact decreed that the budget deficit be brought below 3% of GDP within three years.
This was precisely the scenario that left-of-centre critics of the single currency warned of when Britain was debating membership of monetary union back in early 2003. Far from being a progressive panacea for Britain's (very real and enduring) economic problems, it was said the euro would cause severe instability. Giving up macro-economic autonomy would leave the government with no alternative but to adjust to an economy shock through cuts in public spending and reductions in real wages. As in Ireland, the burden of that would fall on the weakest members of society.
Stephen Lewis, chief economist at Monument Securities, said: "It is surely now evident to all who would see that a 'one-size-fits-all' monetary policy is not well suited to a range of economies as disparate as those that make up the eurozone. Further, the absence of any fiscal counterpart to the monetary union is a recipe for economic instability in the zone's member states. "EU policymakers are presenting the problems of Greece and other peripheral eurozone members as if they were solely financial, to be solved through vigorous budgetary action alone. However, the yawning fiscal gaps in some of the weaker economies reflect fundamental forces that will not be easily ameliorated."
Nick Parsons, head of markets strategy at nabCapital, said that while membership of the single currency might make sense for a small country such as Ireland, which risked being picked off by the speculators if it remained outside the single currency, it was a different story for Britain, where the Bank of England failed to prevent a bubble developing in the housing market even with the bank rate at 5% and above. "It shows the advantage of the UK being outside the eurozone. What would it have been like with a 2% interest rate in an open economy like the UK?" Parsons said.
It would, of course, have been utterly inappropriate, creating the conditions for a boom-bust that would have put Ireland's in the shade. Which is why the lesson for Britain is not that there should be immediate, swingeing budget cuts – but that staying out of the euro was the best decision Gordon Brown ever made.
Industry and unions in Ireland join forces to oppose budget cuts
Lobby groups ranging from the trade unions to the food industry have been rallying opposition to Ireland's drastic budget cuts and the impact they are having on the country's social fabric. Anger within the public sector workforce has smouldered over the last few months at plans to cut spending by 15% and protests organised by the unions have spread to the traditionally conservative rank and file of the police force.
The Garda Representative Association warned yesterday that the cuts were not sustainable in the long term. A spokesman for the GRA said: "Garda saw their pay savagely cut. To put a figure on it, a police officer with less than ten years' service saw their take home pay typically reduced by more than €80 (£70)a week – a decrease of 18% – compared like-for-like with net earnings last year. Young gardaí barely able to pay their mortgages are in real trouble; and that takes money away from businesses that service police officers and the wider community. This situation is not sustainable in the long term.
"Cutting public sector pay isn't working in Ireland; now the debate is moving towards reducing the minimum wage for the private sector – and yet taxation remains voluntary for the very rich." Last week also saw the launch of the Love Irish Food campaign to stop the leakage of consumer spending out of the Republic caused by shoppers desperately seeking bargains with their euros in the north.
Irish economist Jim Power, who is chairman of the campaign, said southerners who shop in the Northern Ireland are destroying the Republic's economy and driving young people to emigrate from the state. Power said the continued "Tescoisation" of Irish consumer spending with weekly shop trips to Northern Ireland would lead to further emigration. He said that those shoppers going north should put their savings in a deposit account which they could use to buy tickets to visit their children who will be forced to emigrate.
As Ireland braces itself for more public sector cuts this winter the economic indices in the Republic make grim reading. The latest unemployment figures show that 86,000 of those on the dole are now under 25 with nearly a quarter of those jobless living in the Greater Dublin area. The main opposition party Fine Gael has claimed that a new wave of net emigration out of Ireland is masking the real unemployment figures. Fine Gael Senator Paschal Donohoe accused Brian Cowen's government of relying on emigration to keep Irish unemployment figures below the 500,000 mark.
Senator Donohoe said: "In the absence of any action, the government has, to date, relied on the pressure valve of emigration or young people taking up further study to stem the flow of unemployment which has been another abysmal failure. We are now faced with a situation whereby the country is experiencing a brain-drain and every two hopeful students here are competing for every college place available." There remains widespread discontent among Irish public sector workers and the unemployed that they are being asked to pay for the recession caused by the greed of bankers and property tycoons. The Irish taxpayer has pumped billions of euros into the Irish banking sector to shore up the banks including the purchase of its toxic assets, most of which relate to property developments with falling values .
Bull Market Can’t Last If You Mind the Gap: Mohamed A. El-Erian
In some Underground stations in London, you are repeatedly reminded to "Mind the Gap" as you enter and exit the train. The aim is to reduce injuries occasioned by a structural anomaly that results in a large gap between the platforms and the trains. Judging from market valuations, I sense quite a gap between consensus market expectations and key political and economic realities, especially in the U.S. If the gap isn’t bridged by the validation of the more optimistic expectations, investors may well find that January’s global equity sell-off was just a precursor to a disappointing year for several asset classes, including stocks.
I am not a political expert but I respect and listen to the insights of many who are. Their messages are eerily consistent, and quite concerning. The political atmosphere in Washington is tense and increasingly polarized. Bipartisan backing for measures is harder. With the political center shrinking, the ability to "manage to the middle" is growing more elusive while the more partisan wings don’t command sufficient broad-based support. The situation isn’t helped by the diminished trust in key institutions, both public and private. Policy decisions, past and present, are second-guessed. Banks’ standing in society is severely shaken. The regulatory framework is in flux, with agencies fighting for turf. And the divide between large and small firms is as big as I have ever seen it, as is the disparity between the rich and the less-fortunate segments of the population.
All this comes at a time of great economic fluidity and challenge. The global financial crisis has undermined growth and job creation; it has clogged many of the pipes that allocate funds to productive uses; and it has rapidly taken public debt and the budget deficit to worrisome levels. I am particularly concerned about the surge in joblessness. In the absence of bold structural measures, most of which face political headwinds, we are looking at a period of persistently high unemployment that will disproportionately affect the young. We risk significant welfare losses and skill erosion, lower labor-market flexibility, and yet another burden on the country’s stretched public finances.
These are consequential political and economic questions. They speak to a more protracted post-crisis resetting of the U.S. economy -- what Pimco labeled last year as a bumpy multiyear journey to a new normal. All this is consistent with the academic literature on post-crisis periods. Such research reminds us of the extent to which massive disruptions -- such as the one experienced in 2007-09 -- expose structural cracks that, at best, can only be masked temporarily by a massive cyclical policy response.
To make things even more complex, the resetting of the U.S. is occurring in the context of secular shifts in global growth and wealth dynamics -- principally on account of some systemically important emerging economies (such as Brazil, China and India) having reached development breakout stages. The evidence is overwhelming: Economic and political indicators are urging us to adopt a forward-looking structural mindset. Yet too many markets -- and, I would also argue, too many private and public institutions -- seem hostage to cyclical forces. This inconsistency is apparent in the seemingly unquestioned manner that so many have assumed in regard to the following six scenarios for 2010:
-- First, an orderly handoff from temporary sources of growth (think government stimulus and inventory rebuilding) to sustainable components of final private demand.
-- Second, a smooth exit from unconventional measures, with policies regaining much-needed degrees of operational flexibility.
-- Third, the government’s delivery of a credible, pro- growth medium-term fiscal adjustment program.
-- Fourth, a rebound in bank lending that alleviates the enormous pressures facing small businesses.
-- Fifth, the ability to defend the institutional integrity of key public institutions.
-- And finally, effective global policy coordination.
A more realistic assessment of these factors would caution against an excessive focus on changes in growth rates at a time when absolute levels are horribly out of whack. It would encourage greater awareness of what the important insights of behavioral finance tell us about the challenges of navigating regime changes and resetting systems. And it would remind us to mind the gap between structural realities and cyclical fantasies. The longer this is delayed, the greater the scope for policy mishaps and market disappointments.
Debt: The U.S. Is on the Edge of a Cliff
There are still buyers aplenty for Treasury obligations. But if Uncle Sam's borrowing gets much higher, investors could abruptly lose confidence in the U.S. Is the U.S. approaching a tipping point with global investors? That was a natural question to ask on Feb. 1 after President Barack Obama released a federal budget that envisions big deficits out to 2020, adding to the government's already enormous pile of liabilities. Big debts aren't a new problem, of course. And so far, despite offering near-record-low interest rates, the U.S. government has had no problem finding buyers for its Treasury bills, notes, and bonds. But with total federal debt projected to equal the size of America's annual gross domestic product by fiscal 2011 or 2012, many economists worry that investors could suddenly lose confidence in the U.S., demanding higher interest rates to reward them for the risk they're taking.
As Greece is discovering to its chagrin, a loss of investors' confidence can quickly spin out of control. If the U.S. has to pay higher rates to finance its borrowing, its total interest payments will shoot up. At that point, the government will either have to cut spending and raise taxes or take out new loans to cover the interest on the old ones. The first solution is politically unpopular and the second is lethal to market confidence. If creditors conclude the U.S. doesn't have the political will to get its deficit spending under control, they may well panic, driving rates even higher, pushing up interest payments further, and so on in a vicious and dangerous cycle.
In a paper published last month called "Growth in a Time of Debt," economists Kenneth Rogoff of Harvard University and Carmen Reinhart of the University of Maryland say that historically, advanced economies have slowed noticeably when their debt-to-GDP ratio has exceeded 90%. (That's total debt, not just the publicly held portion.) According to the Obama Administration's Office of Management & Budget, the total debt-to-GDP ratio was 83% in fiscal 2009 and is on track to hit 94% this year, 99% in 2011, and 101% in 2012. Debt could go even higher if the President fails in his quest to allow the expiration of Bush-era tax cuts on families earning over $250,000 a year and to freeze nonsecurity discretionary spending for three years.
The U.S. experience with very high debt goes back to the years immediately following World War II, when the government tightened its belt to work off the costs of financing the war and the economy fell into recession. In an interview, Rogoff says investor confidence is more of a concern now than it was then. "Wartime expenditures come down easily. Plus, you have a huge labor force you can absorb, which boosts growth." This time around the U.S. has neither advantage: There's no easy way to cut spending, and the economy doesn't seem capable of absorbing the huge mass of unemployed. So, says Rogoff, "It's much harder to convince markets, as Obama will learn, that you really mean business."
Rogoff says the threshold for the U.S. may be higher than 90% this time, giving a few more years of breathing room. Also, he says, the reaction of investors may be less abrupt than it was for Greece. Still, he argues, "It happens more gently, but it has to happen." Economists Nancy Marion of Dartmouth College and Joshua Aizenman of the University of California at Santa Cruz also see economic lessons in America's immediate postwar experience. But they draw a more positive conclusion. In a new research paper, "Using Inflation to Erode the U.S. Public Debt," they say that average growth in the decade after the war ended was actually pretty good. Inflation was higher, but that wasn't so bad, since inflation eroded the real value of the government's debt, lightening the burden on taxpayers. The same thing could happen this time. "Eroding the debt through inflation," they write, "is not far-fetched."
Far-fetched? Perhaps not. But it is risky. In an interview, Aizenman acknowledges that investors could quickly bail out if they sense that the U.S. is letting inflation rise on purpose. Globalization makes it easier to shift funds to other countries than it was in the 1940s. As the financial crisis demonstrated, things can go to hell in a hurry.
Housing Rebound in Canada Spurs Talk of a New Bubble
Dominic Carrasco first tried to sell his studio apartment [in Toronto] in January 2009. The only offers the 42-year-old massage therapist got were well below the 166,900 Canadian dollars he'd paid for it five years earlier. Last month, Mr. Carrasco tried again. The condominium was snapped up by the woman in charge of posting the information to the real-estate listing site, for C$209,900, or US$196,003, 40% more than the highest bid last year. "I couldn't believe it," says Mr. Carrasco, who says he's both relieved and unsettled by his change in fortune. "If my condo can go up that much in one year, it doesn't make sense."
As the U.S. struggles to get out of its housing slump, its neighbor to the north faces a different challenge: Canada's housing recovery has been so rapid that some here are worrying about a bubble. Last Wednesday, a housing-price index for Canada's six biggest cities posted its seventh straight monthly gain, showing home prices in November are now back to their prerecession peak. Another broader measure shows the average home price in 2009 hitting a record. Home building has picked up too, with housing starts in December jumping to their highest level since October 2008. Economists expect that growth to continue when January figures are released Monday.
Canada's finance officials say they're watching home prices carefully. The finance minister in December outlined steps he can take to cool things down, if needed. The central bank last month said it is watching the booming market with "vigilance, but not alarm." Some observers foresee trouble. "It's a mania. It's going to end badly," says Garth Turner, a former cabinet member who just published a book predicting that prices of real estate and other assets will fall.
Several other nations have taken action over concerns that their real-estate markets are heating up too quickly. In China, a housing boom has been lifting property prices at a 20% annual rate, helping fuel economic expansion of more than 8% in 2009. As evidence of a Chinese real-estate bubble mounts, the government there has tightened controls on bank lending. In South Korea, record-low interest rates led to frenzied home buying, and the government last year lowered the maximum amount that would-be homeowners can borrow.
In Canada, nearly 40% of gross domestic product historically is generated by exports, mainly to the U.S., where economic weakness persists. To stimulate its economy, the government has focused on the domestic slice. In an effort to boost internal consumption, it has kept a key interest rate near zero—resulting in exceptionally low mortgages rates—and has offered various financial incentives and tax credits. Consumers have responded. Average home prices in Canada have risen 23% from their trough in January 2009. Home-sales volumes are up 70% over the same period. Canada never had the kind of bubble created by risky "subprime" home loans that the U.S. had, thanks in part to conservative lending practices. The S&P Case-Shiller index—a U.S. index of home prices in 20 cities—more than doubled between January 2000 and late 2006, then fell 33% during the economic slump. In Canada, a similar home-price index of six major cities rose 90% between 2000 and mid-2008, but fell only 9% during the slump.
Not everyone agrees that Canada's recent price increases are cause for concern. Bubble skeptics say they aren't yet seeing other symptoms of froth such as speculative buying, looser lending standards or a run-up in land prices. Canada's central bank and finance ministry say there isn't currently any reason for alarm. But some economists who are concerned point out that home prices are rising far faster than other measures of economic health. The 2009 price increase of more than 20% came as personal income in Canada fell nearly 1% and total employment was 1.4% lower than the year earlier. In a December report, the Bank of Canada warned that household debt—largely mortgages—was 1.42 times disposable income during the second quarter of 2009, a record high.
Another possible danger: Because Canadian banks typically reset adjustable-rate mortgages every few years, those who are buying now at low rates will likely see increases soon. Toronto-Dominion Bank forecasts suggest that the rate to which many Canadian mortgages are pegged, the prime rate, could nearly double by the end of 2011. The Bank of Canada warned in its December report that if interest rates increase as expected, by mid-2012 about 9% of Canadian households could have so much debt that they'd be "financially vulnerable." "This is exactly what happened in the U.S., when affordability had moved way out of whack with prices," says David Rosenberg, an economist who witnessed America's housing bubble at Merrill Lynch in New York, and now sees similar trends up north from his post at Toronto-based wealth-management firm Gluskin Sheff.
The Canadian housing market's roller-coaster ride began in September 2008 with the collapse of Lehman Brothers in the U.S. and the freeze in global credit markets. Brad Lamb says his Toronto real-estate firm noticed a drop in buyers. Sales volume plummeted and the company lost money, he says. Heather Holmes, one of his top agents, says that at one point she was handling 17 sellers at the same time, but had only a trickle of offers, at well below asking prices. To supplement income, she started handling rentals. "There was a lot of fear," she recalls.
Vaughn Gray, one of her clients, had agreed to buy a one-bedroom apartment the week Lehman collapsed. As he was completing the paperwork, his mortgage agent called with a request to increase his down payment to 15% of the condo's value, from the 5% they'd discussed earlier. Mr. Gray couldn't produce the cash, and the deal fell through. "It was heartbreaking," recalls Mr. Gray, a concierge at a clothing retailer. By December 2008, the average home price in Toronto was 9% below the year-earlier level, and sales volume was down 50%, the Toronto Real Estate Board reported.
But Canada's housing slump didn't last long. In October 2008, the Bank of Canada made the first of a series of rate cuts that eventually lowered the target for its key overnight lending rate to 0.25%, which in turn reduced banks' prime rate—the basis for calculating variable-mortgage rates in Canada—to 2.25% by April 2009. In Canada, nearly all mortgages have rates that adjust at least every few years. Currently, rates on some loans have fallen to 2% or lower. Canada never saw the wave of foreclosures that the U.S. did, and the balance sheets of Canadian banks stayed strong. As the global credit crunch began to ease at the end of 2008, Canada's big lenders, which handle the bulk of residential mortgages, started to market more aggressively.
Toronto-Dominion Bank boosted its mortgage sales force by 10%, says Tim Hockey, head of the Canadian banking operations. Don Peard, the Royal Bank of Canada's mortgage chief for Alberta, told his sales people to double the number of calls they made seeking mortgage referrals from real-estate agents and home builders. Home sales started to rise again in February 2009. By midyear, Ms. Holmes, the Toronto real-estate agent, was seeing the kinds of bidding wars that were common in 2007. "It's all the people that would have bought during the slowdown," she says. In September, she says, one condominium she handled had 15 offers—her personal record. The low interest rates and the eagerness of banks to lend attracted buyers such as Cindy Gerard of Red Deer, Alberta, who invests in residential real estate to supplement the money her husband earns as a welding inspector for the oil-and-gas industry.
Ms. Gerard has been buying and renting out apartments for years. In 2009, she went into overdrive, buying six units in six months, with mortgages at rates ranging from 2.45% to 3.95%. She says she "maxed out" on the last mortgage, which pushed the family's ratio of debt service to income into the mid-40% range—above the level many Canadian lenders are comfortable with. Ms. Gerard says she bought all the properties for below the asking prices. "Money is growing on trees these days, lending rates are so low," Ms. Gerard wrote in December in an online forum for real-estate investors. "There are loads of properties to choose from, and the banks want to lend!"
Nevertheless, with housing prices rising, recent buyers are finding deals harder to come by. Ms. Holmes, the agent, explains that a few years ago monthly mortgage payments on downtown Toronto condos were far enough below rents that investors could count on making a profit. Now, she says, new investors are more commonly just breaking even. Bryce Wilson, an elementary-school teacher in Toronto who bought two condominiums in December, says a 20% drop in the value of his mutual funds prompted him to shift money into real estate. He's planning to rent out one property—a one-bedroom apartment in a new condo building—for C$1,500 a month, netting him C$360 a month after mortgage and maintenance fees. He says he is prepared for his 2% mortgage rate to rise. "I've budgeted for the rate doubling," he says.
Economists at Toronto-Dominion Bank say they think current home prices are about 12% above where they should be based on income and interest trends—not enough for a bubble, they say, so long as future price increases are slowed by home building and rising mortgage rates. Mr. Hockey, Toronto-Dominion's domestic banking chief, says housing prices are "of interest but not a concern." If the situation worsens, he says, the bank will consider steps like raising the hurdles for borrowers.
The government is mulling action too. Finance Minister Jim Flaherty has said that if it's warranted, he would consider tightening the terms for home buyers seeking government-insured loans, shortening maximum mortgage lengths from their current 35 years, or raising minimum down payments from the current 5%. But Canada's central bankers appear reluctant to take any steps that would hurt the economy. In a Jan. 11 speech, a representative of the Bank of Canada said: "If the Bank were to raise interest rates to cool the housing market now…we would, in essence, be dousing the entire Canadian economy with cold water, just as it emerges from recession." For now, the housing boom shows no sign of abating.
Mr. Gray, the Toronto concierge whose home deal fell through at the end of 2008, is looking again for a condo, although he's had to increase his budget to around C$350,000, from C$250,000. Ms. Gerard, the housewife in Red Deer, says she hopes to buy a seventh unit in a few months—after she pays down enough of her credit-card debt to qualify for another mortgage. Mr. Carrasco, the Toronto massage therapist whose condo rose in value by 40% in one year, says he's glad he sold when he did. "I think we're in a housing bubble," he says. "I'm going to put stuff in storage, rent cheap and buy again when prices come down."
German Bounty Tears Veil Off Swiss Secrecy
The Swiss are shocked again, this time over the German decision to buy a list of some 1,500 possible tax cheats saved on a disc lifted from a Swiss bank. It’s stolen property, say the Swiss bankers. It’s bank robbery, cry the lawyers. It is behavior unfitting of a "civilized state," harrumphed one Swiss politician. Wait a minute. Who’s talking here? This is a country that for centuries has relied on banking-secrecy laws to benefit from the dishonesty of others. Maybe the Swiss should think first before crying foul.
The Germans are right to agree in principle to pay a former bank employee 2.5 million euros ($3.4 million) for information on the Swiss accounts -- provided, of course, that it’s genuine --just as they were right to make a similar acquisition of secret bank data in Liechtenstein in 2008. That 5 million-euro deal led to the recovery of 180 million euros in taxes and turned Klaus Zumwinkel, the former head of Deutsche Post AG and a flagrant dodger caught red-handed, into a poster child for local tax collectors. Not only did German taxpayers come out ahead in the Liechtenstein case, but there has so far been no successful legal challenge to the use of stolen information.
This time, the Germans’ moral dilemma has raised a storm at home, as well as in Switzerland. The Frankfurter Allgemeine Zeitung has warned against behavior that could lead to the "erosion of the foundations of the rule of law." German Chancellor Angela Merkel’s decision to accept the deal faces opposition within her own conservative party, the Christian Democratic Union. "It’s a very questionable position to be in, the state essentially obtaining contraband," Michael Fuchs, the CDU’s deputy leader in parliament, said this week.
There’s another way to consider the issue, which requires a shift in vocabulary. What if, instead of thief, the informant were to be called a "whistleblower"? And what if, instead of talking about "payoffs," the money offered was a "bounty"? The terms are a little imprecise. Whistleblowers, at least in popular mythology, don’t reveal information for money. A bounty, in the U.S., refers to the money bondsmen pay to catch a fugitive who has slipped bail. Most other countries don’t permit bounty hunting, which they tend to regard as kidnapping.
The point is that governments do pay for information. You don’t have to watch movies about New York cops, or CIA agents operating in Middle Eastern souks, to suspect that cash does, on occasion, change hands. The U.S. Internal Revenue Service even has a program to pay money to people who inform on others who have failed to pay the tax they owe. The "whistleblower" can be eligible for as much as 30 percent of the taxes and penalties the IRS then collects.
Like money, information is fungible. It’s hard to trace its origins, and hard to control where it flows: Consider the case of Herve Falciani, an ex-employee of HSBC Private Bank. He was at the source of another stolen computer disc, delivered to the French government last year with the names of 3,000 tax evaders. "Once the information is out, you can’t put the genie back in the bottle," says Peter Henning, a law professor at Wayne State University Law School in Detroit and a former U.S. criminal-fraud investigator. "We’re not talking about a stolen car: It’s a breach in the dike."
In the French case, the government reached an agreement with the Swiss to return the original data to Switzerland, and use copies for its own "domestic legal procedures." In the end, those copies may be all that the French need to persuade their taxpayers to come clean. In the German case, the stolen data has already become a bargaining chip, both with the Swiss and with errant taxpayers. German Finance Minister Wolfgang Schaeuble has taken the opportunity to warn tax evaders to turn themselves in. The Swiss government, while insisting it won’t help with any tax inquiry based on stolen data, has hastened to add that it is keen to maintain good relations with Germany, a major trading partner.
One by one, Switzerland’s neighbors and friends -- including the U.S. and Canada -- have joined in an assault on the banking secrecy that has protected Swiss bank accounts from outside scrutiny for so long. The Italian government has launched a campaign "to dry out" Lugano as a haven for tax evaders: by some estimates, four-fifths of the Italian money held in that Swiss city may be undeclared. Even as the Germans debate the morality of buying stolen lists, the Dutch, Belgian and Austrian governments have indicated they want to share any information they may yield. Maybe it’s time Switzerland got the message.
Testy Conflict With Goldman Helped Push A.I.G. to Edge
by Gretchen Morgenson and Louise Story
Billions of dollars were at stake when 21 executives of Goldman Sachs and the American International Group convened a conference call on Jan. 28, 2008, to try to resolve a rancorous dispute that had been escalating for months. A.I.G. had long insured complex mortgage securities owned by Goldman and other firms against possible defaults. With the housing crisis deepening, A.I.G., once the world’s biggest insurer, had already paid Goldman $2 billion to cover losses the bank said it might suffer. A.I.G. executives wanted some of its money back, insisting that Goldman — like a homeowner overestimating the damages in a storm to get a bigger insurance payment — had inflated the potential losses.
Goldman countered that it was owed even more, while also resisting consulting with third parties to help estimate a value for the securities. After more than an hour of debate, the two sides on the call signed off with nothing settled, according to internal A.I.G. documents and an audio recording reviewed by The New York Times. Behind-the-scenes disputes over huge sums are common in banking, but the standoff between A.I.G. and Goldman would become one of the most momentous in Wall Street history. Well before the federal government bailed out A.I.G. in September 2008, Goldman’s demands for billions of dollars from the insurer helped put it in a precarious financial position by bleeding much-needed cash. That ultimately provoked the government to step in.
With taxpayer assistance to A.I.G. currently totaling $180 billion, regulatory and Congressional scrutiny of Goldman’s role in the insurer’s downfall is increasing. The Securities and Exchange Commission is examining the payment demands that a number of firms — most prominently Goldman — made during 2007 and 2008 as the mortgage market imploded. The S.E.C. wants to know whether any of the demands improperly distressed the mortgage market, according to people briefed on the matter who requested anonymity because the inquiry was intended to be confidential. In just the year before the A.I.G. bailout, Goldman collected more than $7 billion from A.I.G. And Goldman received billions more after the rescue. Though other banks also benefited, Goldman received more taxpayer money, $12.9 billion, than any other firm.
In addition, according to two people with knowledge of the positions, a portion of the $11 billion in taxpayer money that went to Société Générale, a French bank that traded with A.I.G., was subsequently transferred to Goldman under a deal the two banks had struck. Goldman stood to gain from the housing market’s implosion because in late 2006, the firm had begun to make huge trades that would pay off if the mortgage market soured. The further mortgage securities’ prices fell, the greater were Goldman’s profits. In its dispute with A.I.G., Goldman invariably argued that the securities in dispute were worth less than A.I.G. estimated — and in many cases, less than the prices at which other dealers valued the securities.
The pricing dispute, and Goldman’s bets that the housing market would decline, has left some questioning whether Goldman had other reasons for lowballing the value of the securities that A.I.G. had insured, said Bill Brown, a law professor at Duke University who is a former employee of both Goldman and A.I.G. The dispute between the two companies, he said, "was the tip of the iceberg of this whole crisis." "It’s not just who was right and who was wrong," Mr. Brown said. "I also want to know their motivations. There could have been an incentive for Goldman to say, ‘A.I.G., you owe me more money.’ " Goldman is proud of its reputation for aggressively protecting itself and its shareholders from losses as it did in the dispute with A.I.G.
In March 2009, David A. Viniar, Goldman’s chief financial officer, discussed his firm’s dispute with A.I.G. in a conference call with reporters. "We believed that the value of these positions was lower than they believed," he said. Asked by a reporter whether his bank’s persistent payment demands had contributed to A.I.G.’s woes, Mr. Viniar said that Goldman had done nothing wrong and that the firm was merely seeking to enforce its insurance policy with A.I.G. "I don’t think there is any guilt whatsoever," he concluded. Lucas van Praag, a Goldman spokesman, reiterated that position. "We requested the collateral we were entitled to under the terms of our agreements," he said in a written statement, "and the idea that A.I.G. collapsed because of our marks is ridiculous."
Still, documents show there were unusual aspects to the deals with Goldman. The bank resisted, for example, letting third parties value the securities as its contracts with A.I.G. required. And Goldman based some payment demands on lower-rated bonds that A.I.G.’s insurance did not even cover. A November 2008 analysis by BlackRock, a leading asset management firm, noted that Goldman’s valuations of the securities that A.I.G. insured were "consistently lower than third-party prices." To be sure, many now agree that A.I.G. was reckless during the mortgage mania. The firm, once the world’s largest insurer, had written far more insurance than it could have possibly paid if a national mortgage debacle occurred — as, in fact, it did.
Perhaps the most intriguing aspect of the relationship between Goldman and A.I.G. was that without the insurer to provide credit insurance, the investment bank could not have generated some of its enormous profits betting against the mortgage market. And when that market went south, A.I.G. became its biggest casualty — and Goldman became one of the biggest beneficiaries. For decades, A.I.G. and Goldman had a deep and mutually beneficial relationship, and at one point in the 1990s, they even considered merging. At around the same time, in 1998, A.I.G. entered a lucrative new business: insuring the least risky portions of corporate loans or other assets that were bundled into securities.
A.I.G.’s financial products unit, led by Joseph J. Cassano, was behind the expansion. To reduce its own risks in the transactions, the company structured deals so that it would not have to make early payments to clients when securities began to sour. That changed around 2003, however, when A.I.G. began insuring portions of subprime mortgage deals. A lawyer for Mr. Cassano said his client would not comment for this article. A.I.G. also declined to comment.
Alan Frost, a managing director in Mr. Cassano’s unit, negotiated scores of mortgage deals around Wall Street that included a complicated sequence of events for when an insurance payment on a distressed asset came due. The terms, described by several A.I.G. trading partners, stated that A.I.G. would post payments under two or three circumstances: if mortgage bonds were downgraded, if they were deemed to have lost value, or if A.I.G.’s own credit rating was downgraded. If all of those things happened, A.I.G. would have to make even larger payments. Mr. Frost referred questions to his lawyer, who declined to comment.
Traders loved Mr. Frost’s deals because they would pay out quickly if anything went wrong. Mr. Frost cut many of his deals with two Goldman traders, Jonathan Egol and Ram Sundaram, who had negative views of the housing market. They had made A.I.G. a central part of some of their trading strategies. Mr. Egol structured a group of deals — known as Abacus — so that Goldman could benefit from a housing collapse. Many of them were actually packages of A.I.G. insurance written against mortgage bonds, indicating that Mr. Egol and Goldman believed that A.I.G. would have to make large payments if the housing market ran aground. About $5.5 billion of Mr. Egol’s deals still sat on A.I.G.’s books when the insurer was bailed out.
"Al probably did not know it, but he was working with the bears of Goldman," a former Goldman salesman, who requested anonymity so he would not jeopardize his business relationships, said of Mr. Frost. "He was signing A.I.G. up to insure trades made by people with really very negative views" of the housing market. Mr. Sundaram’s trades represented another large part of Goldman’s business with A.I.G. According to five former Goldman employees, Mr. Sundaram used financing from other banks like Société Générale and Calyon to purchase less risky mortgage securities from competitors like Merrill Lynch and then insure the assets with A.I.G. — helping fatten the mortgage pipeline that would prove so harmful to Wall Street, investors and taxpayers. In October 2008, just after A.I.G. collapsed, Goldman made Mr. Sundaram a partner.
Through Société Générale, Goldman was also able to buy more insurance on mortgage securities from A.I.G., according to a former A.I.G. executive with direct knowledge of the deals. A spokesman for Société Générale declined to comment. It is unclear how much Goldman bought through the French bank, but A.I.G. documents show that Goldman was involved in pricing half of Société Générale’s $18.6 billion in trades with A.I.G. and that the insurer’s executives believed that Goldman pressed Société Générale to also demand payments.
In addition to insuring Mr. Sundaram’s and Mr. Egol’s trades with A.I.G., Goldman also negotiated aggressively with A.I.G. — often requiring the insurer to make payments when the value of mortgage bonds fell by just 4 percent. Most other banks dealing with A.I.G. did not receive payments until losses exceeded 8 percent, the insurer’s records show. Several former Goldman partners said it was not surprising that Goldman sought such tough terms, given the firm’s longstanding focus on risk management. By July 2007, when Goldman demanded its first payment from A.I.G. — $1.8 billion — the investment bank had already taken trading positions that would pay out if the mortgage market weakened, according to seven former Goldman employees.
Still, Goldman’s initial call surprised A.I.G. officials, according to three A.I.G. employees with direct knowledge of the situation. The insurer put up $450 million on Aug. 10, 2007, to appease Goldman, but A.I.G. remained resistant in the following months and, according to internal messages, was convinced that Goldman was also pushing other trading partners to ask A.I.G. for payments. On Nov. 1, 2007, for example, an e-mail message from Mr. Cassano, the head of A.I.G. Financial Products, to Elias Habayeb, an A.I.G. accounting executive, said that a payment demand from Société Générale had been "spurred by GS calling them."
Mr. Habayeb, who testified before Congress last month that the payment demands were a major contributor to A.I.G.’s downfall, declined to be interviewed and referred questions to A.I.G. The insurer also declined to comment for this article. Mr. van Praag, the Goldman spokesman, said Goldman did not push other firms to demand payments from A.I.G. Later that month, Mr. Cassano noted in another e-mail message that Goldman’s demands for payment were becoming problematic. "The overhang of the margin call from the perceived righteous Goldman Sachs has impacted everyone’s judgment," he wrote to five employees in his division. By the end of November 2007, Goldman was holding $2 billion in cash from A.I.G. when the insurer notified Goldman that it was disputing the firm’s calculations and seeking a return of $1.56 billion. Goldman refused, the documents show.
In many of these deals, Goldman was trading for other parties and taking a fee. As the mortgage market declined, Goldman paid some of these parties while waiting for A.I.G. to meet its demands, the Goldman spokesman said. But one reason those parties were owed money on the deals was that Goldman had marked down the securities. Adding to the pressure on A.I.G., Mr. Viniar, Goldman’s chief financial officer, advised the insurer in the fall of 2007 that because the two companies shared the same auditor, PricewaterhouseCoopers, A.I.G. should accept Goldman’s valuations, according to a person with knowledge of the discussions. Goldman declined to comment on this exchange.
Pricewaterhouse had supported A.I.G.’s approach to valuing the securities throughout 2007, documents show. But at the end of 2007, the auditor began demanding that A.I.G. provide greater disclosure on the risks in the credit insurance it had written. Pricewaterhouse was expressing concern about the dispute. The insurer disclosed in year-end regulatory filings that its auditor had found a "material weakness" in financial reporting related to valuations of the insurance, a troubling sign for investors. A spokesman for Pricewaterhouse said the company would not comment on client matters.
Insiders at A.I.G. bridled at Goldman’s insistence that they accept the investment bank’s valuations. "Would we call bond issuers and ask them what the valuation of their bonds was and take that?" asked Robert Lewis, A.I.G.’s chief risk officer, in a message in January 2008. "What am I missing here, so I don’t waste everybody’s time?" When A.I.G. asked Goldman to submit the dispute to a panel of independent firms, Goldman resisted, internal e-mail messages show. In a March 7, 2008, phone call, Mr. Cassano discussed surveying other dealers to gauge prices with Michael Sherwood, Goldman’s vice chairman. At that time, Goldman calculated that A.I.G. owed it $4.6 billion, on top of the $2 billion already paid. A.I.G. contended it only owed an additional $1.2 billion.
Mr. Sherwood said he did not want to ask other firms to value the securities because "it would be ‘embarrassing’ if we brought the market into our disagreement," according to an e-mail message from Mr. Cassano that described the call. The Goldman spokesman disputed this account, saying instead that Goldman was willing to consult third parties but could not agree with A.I.G. on the methodology.
By the spring of 2008, A.I.G.’s dispute with Goldman was just one of its many woes. Mr. Cassano was pushed out in March and the company’s defenses against the growing demand for payments faltered. By the end of August 2008, A.I.G. had posted $19.7 billion in cash to its trading partners, including Goldman, according to financial filings. Over that summer, A.I.G. had tried, unsuccessfully, to cancel its insurance contracts with the trading partners. But Goldman, according to interviews with former A.I.G. executives, would allow that only if it also got to keep the $7 billion it had already received from A.I.G. Goldman wanted to keep the initial insurance payouts and the securities in order to profit from any future rebound.
In addition to offering to cancel its own contracts, Goldman offered to buy all of the insurance A.I.G. had written for several other banks at severely distressed prices, according to three people briefed on the discussions. Negotiating with Goldman to void the A.I.G. insurance was especially difficult, Federal Reserve Board documents show, because the firm did not own the underlying bonds. As a result, Goldman had little incentive to compromise. On Aug. 18, 2008, Goldman’s equity research department published an in-depth report on A.I.G. The analysts advised the firm’s clients to avoid the stock because of a "downward spiral which is likely to ensue as more actual cash losses emanate" from the insurer’s financial products unit.
On the matter of whether A.I.G. could unwind its troublesome insurance on mortgage securities at a discount, the Goldman report noted that if a trading partner "is not in a position of weakness, why would it accept anything less than the full amount of protection for which it had paid?" A.I.G. shares fell 6 percent the day the report was published. Three weeks later, the United States government agreed to pour billions of dollars in taxpayer money into the insurer to keep it from collapsing. The government would soon settle the yearlong dispute between Goldman and A.I.G., with Goldman receiving full value for its bets. The federal bailout locked in the paper losses of those deals for A.I.G. The prices on many of those securities have since rebounded.
Lawyers, Guns, and Money
Among Bank of America’s 50 million customers, Pierre Falcone was far from ordinary. An infamous global arms dealer who unlawfully sold weapons to Angola for its civil war and an international fugitive, Falcone was convicted of tax fraud and illegal arms dealing in 2007 and 2009 and is currently serving six years behind bars. Yet for nearly two decades, Falcone and his relatives freely used 29 different bank accounts to funnel at least $60 million into the US from secretive havens like the Cayman Islands, Luxembourg, and Singapore, and from shell corporations and secret clients. Despite his criminal record and worldwide notoriety, Bank of America essentially treated him like any other depositor.
The story of how a criminal like Falcone used Bank of America—which later received billions in a taxpayer-funded bailout—and the US financial system to advance his criminal activities appears in a new report by the Senate investigations subcommittee, led by Sen. Carl Levin (D-Mich.). In revealing the operations of Falcone and others—in most cases for the first time—the report offers a lurid primer explaining how big banks, powerful attorneys, influential lobbyists, and a host of other businessmen in this country help launder dirty foreign money.
The report highlights several gaping holes in American money laundering and corruption laws, including an exemption made by the Treasury Department in 2002 to the Patriot Act. "Foreign officials still get access to our financial system at times because US officials aid and abet their actions," Levin told reporters on Tuesday. The 325-page report sets the stage for a hearing Thursday featuring US enforcement officials as well as some of the main players who abetted secretive individuals like Falcone and the corrupt former president of Gabon, the late Omar Bongo.
Although Congress has passed significant anti-money laundering provisions in the past decade, the law still contains major gaps through which corrupt foreign individuals like Falcone and Obiang can move their cash. For instance, due to the Treasury’s Patriot Act loopholes, US realtors and escrow agents aren’t required to ask who is sending funds to them or to scrutinize or disclose whether the sender is on an international list of "politically exposed persons" (PEP) who have been red-flagged for dubious activities. That exemption, the report shows, allowed Teodoro Obiang, the high-flying son of the despotic president of Equatorial Guinea, to use realtors and escrow agents as conduits to dodge US law—ultimately enabling Obiang to buy a $38.5 million jet and a $30 million house in Malibu.
Obiang also secretly laundered millions via two Beverly Hills-based attorneys, Michael Berger and George Nagler. Because attorney-client and law office accounts lie outside the scrutiny of dirty-money laws, the two attorneys were able to move his money by creating multiple shell corporations with names like Beautiful Vision, Unlimited Horizon, and Sweetwater Malibu. Nagler devised one such corporation called Sweet Pink Inc., and Obiang’s then-girlfriend, hip-hop star Eve Jeffers, was named president and CFO. In total, Obiang brought $110 million into the US using these under-the-radar practices, the report says. In turn, he feted his US associates with access to exclusive events, like the Playboy Mansion's 2007 "Kandy Halloween Bash," after which Berger emailed Obiang to gush, "I met many beautiful women, and I have the photos, e-mail addresses and phone numbers to prove it."
In some cases, corrupt officials didn’t need shell corporations or sneaky lawyers: big American banks proved helpful enough. Peppered throughout the subcommittee's report are stories of banks like Wachovia, Bank of America, and Citibank turning a blind eye—or failing to notice—the shadowy sources of money pouring into their accounts. There was arms dealer Pierre Falcone's decades-long funneling of millions through Bank of America. The New York office of HSBC, the report says, handled funds for a private Angolan bank yet failed to investigate the bank's officers and clientele, a number of whom appeared on the PEP list. The most glaring gaffe, however, belongs to Citibank—another major bailout recipient—and its response to investigators' concerns about its management of Obiang's accounts.
Between 2002 and 2006, Obiang wired more than $37 million into the US through Citibank. Some of those funds landed in Obiang-related accounts at other banks, while others went directly to places like a Beverly Hills Audi and Porsche dealership, a US yacht company, a luxury vacation company, and a private jet service. Obiang even used wired funds to pay off his American Express bills of around $2.5 million. But here's the kicker: Although Citibank was aware that Obiang was on the PEP list and that he was using Citi to wire dirty money into the US, the bank informed the investigation’s subcommittee that it has no plans to beef up its safeguards against money laundering. Why not? "Identifying, freezing, and investigating these wire transfers," Citibank told the subcommittee, "would generate too much work for its anti-money laundering staff."
And when lawyers and big banks won't do, a well-connected lobbyist will suffice. As the report describes, the late Omar Bongo, former president of Gabon and another PEP-listed figure, used an American lobbyist named Jeffrey Birrell as an agent to funnel money into the US and attempt to buy military vehicles for his regime. Bongo, who granted himself indefinite term limits and squandered Gabon's oil revenues, used Birrell’s bank accounts to move nearly $18 million, with which Birrell tried to buy three US-made armored cars, three more US automobiles, and six C-130 military transport planes (he even got US government authorization to purchase the planes). Birrell also helped Bongo launder millions of dollars by funneling them through US accounts and then sending those same funds to banks in Malta and Belgium linked to Bongo.
Lawmakers hope the investigation subcommittee's meticulous report and Thursday's hearing will prompt new crackdowns on money laundering exploits like those carried out by Obiang and Bongo. The report lays out a series of proposed reforms, from tougher oversight of lobbyists to improved disclosure rules, aimed at staunching the flow of money in to the US from corrupt foreign figures. The impetus for the investigation, Levin told reporters, came in part from concerns that terrorists could use the same loopholes to move their money into the US. Levin added that he hopes the committee's revelations will also pressure the Treasury to revoke the Patriot Act exemption for realtors and escrow agents.
With financial regulatory reform currently moving through Congress, Levin may consider adding anti-money laundering provisions to the Senate’s reform bill. He told reporters that banks "are doing a lot better" combating corrupt foreign funds, but said plenty of work remains to be done to prevent the kinds of cases his subcommittee unearthed. "We’ve got to lead," he said, "on the issue of corrupt money and money laundering." And the report's account of big Wall Street players like Bank of America and Citibank and their failure—or refusal—to block the flow of dirty cash from abroad certainly won't ease the public's distrust.