Financial Crisis

Chris Cook

The Office for Budget Responsibility is going to irritate lots of people this week. When it comes out with its assessment of the Budget, its multipliers and assumptions will come under attack. After years now (years!) of phoney arguments about the deficit, this will be A Good Thing. Indeed, all the Labour leadership candidates should embrace the new institution.

First, it should improve the credibility of the fiscal framework. No Briton can credibly claim that any fiscal rules could have any real disciplining effect: only an institution that can nip at the government can do that now. This framework offers the golden combination of clear red lines for governments and the flexibility to respond to as-yet-unforeseen economic circumstances.

Second, farming out forecasting should improve the quality of projections that inform fiscal decisions. As an excellent Social Market Foundation pamphlet puts it, an independent forecaster would help overcome some problems with internal forecasting:

  • Organisational bias in projection-making: promotion, reward and status may be linked - most likely implicitly – potentially excluding valuable contrarian opinions from influencing fiscal projections. This effect may be particularly strong if fiscal decision-makers have significant powers over the institution. Indeed, academic research has shown that in several European countries, official growth forecasts used for fiscal policymaking are biased toward being over-optimistic.
  • Policymakers risk being subject to group-think where all elements of fiscal policymaking are housed in the same institution with no institution charged with an “official challenge” role. For example a shared belief in what is actually unsustainable growth may be self-reinforcing and amplified if all the functions of a fiscal policymaking are combined in the same institution.
  • When combined with the credibility associated with longstanding institutions, such as that of HM Treasury, this can also lead to another behavioural economic phenomenon known as anchoring, whereby other, non-governmental organisations take the cue for their economic forecasts from HM Treasury. This is particularly likely to occur since no institution wishes to stand out against received wisdom: for any independent forecaster it is far less reputationally damaging to be wrong with everyone else than to be wrong on their own.

At the moment, being seen to have credible forecasts is particularly worthwhile: investors have, in recent months, fixated on suspect growth forecasts. But all of those benefits rely on the OBR actually becoming independent – something it currently is not.

The body – now established on an interim basis – is a Whitehall beast. Sir Alan Budd, OBR chief pro tem, leads a team of Treasury lifers, based in the Treasury, running Treasury models. This is all forgiveable: the apparatus was set up rapidly and has yet to find its feet.  It is important, however, that it does not become a permanent feature of the OBR.

The most important aspect of the institution’s independence is staffing. OBR staff cannot be borrowed from the chancellor, going back to the Treasury at the end of a stint at the slide-rule. Otherwise they will still be creatures of their political masters. The OBR needs its own recruitment stream. (I’m sure George Osborne will be alive to this issue: he has long had an interest in the independence of Bank of England monetary policy committee members.)

As David Miliband has written, the OBR should, moreover, answer to parliament – not to the Treasury. Furthermore, MPs and peers should be allowed to submit written questions to the institution and it should be ultra-transparent.

Chris Cook

The new UK government, which will present its first Budget next Tuesday, has pledged to learn its lessons from the retrenchment in Canada between 1994 and 2000. Good for them: Paul Martin did much right.  He realised that, if you are going to rein in a colossal structural deficit, you need a wide consensus. The Canadian regime has also recognised that consolidation requires you to cut where the fat is. It did not salami-slice every budget, but went for where there were savings to be found.

But the Ottawan lesson only goes so far. As Paul Krugman says, it doesn’t help the UK with the macroeconomics of cutting. Its retrenchment took place as the US was booming. The political pain of cutting would have been much higher, the process much more difficult and the results less successful if its giant cousin to the south hadn’t had its nose in the punchbowl.

Britain is going to cut its deficit in what will probably be a weak neighbourhood. German manufacturing has been roaring, but the eurozone is weak and vulnerable. The whole continent’s states are tightening their belts. So while the weak pound might help the UK build market share, the market might be sickly. George Osborne’s confidence that Britain can grow while consolidating looks like hubris.

So what is to be done? Well, the chancellor of the exchequer should press ahead with his ambition to rein in the structural deficit. I don’t really want the government spending more on pay and pensions to prop up output. Stimulus needs to be temporary programmes that come to a defined end. Raising structural spending, only to slash it when the economy recovers, is bonkers. So Mr Osborne should work out temporary packages to offset the deflationary effects of his structural cutting.

The FT has come to the view that Mr Osborne needs to prepare stimulus measures, and so has Martin Wolf. In his open letter to George Osborne, he asked the chancellor:

Are you going to stand by if the economy goes into a steep decline? … In such circumstances, the most effective instrument might be central bank financing of additional public spending. But your commitment to pre-programmed spending cuts would seem to rule this out. The alternative might be a temporary reduction in taxes, of the kind you condemned under the previous government. In any case, the UK should have a plan for growth of nominal demand at a rate of 6 per cent and preferably more, for some years. Who is to take responsibility for this and how?

There are major attractions to setting out plans for stimulus measures now. Moving towards a clearer rule-based system for discretionary fiscal policy would make it possible to take stimulatory action without spooking holders of gilts. You can make sure they’re ready to go where they’re needed. The Treasury should compile a list of names and addresses to which it could post cheques. In case the UK’s troubles are longer-term, the finance ministry should prepare a list of infrastructure projects it would like to build.

Setting out such contingency plans would require a bit of political bravery. Mr Osborne would be the first chancellor to admit that he is not, in fact, in charge of the economy and not its master. He would be required to admit there is uncertainty in the world and limits to his powers and foresight.

Now that would be new politics.

James Mackintosh

Nouriel Roubini built his reputation, and that of his Roubini Global Economics consultancy (RGE), on his gloomy, but accurate, predictions of financial doom. He isn’t always right though; and the decision by RGE to publish a call for a military overthrow of the democratic Brazilian government is clearly a mistake.

Ricardo Amaral, a Brazilian economist, pulls no punches in an article on the RGE web site (EDIT: RGE has taken the post down. Here’s the Google cache of the article):

I am suggesting that the military should seize power again in Brazil through a coup d ‘état, because we all know that this massive crime problem that is devastating the Brazilian population can’t be solved under a democratic system of government, and because of the actions that have to be taken to bring peace to all neighborhoods in Brazil. It is time for a benevolent military dictator to take power in Brazil and get the job done.

Mr Amaral even recommends General Augusto Heleno Ribeiro Pereira, commander of the UN Stabilisation Mission in Haiti, as a possible candidate.

This comes after hagiographies of the last three “benevolent dictators” of Brazil, who he credits with laying the groundwork for Brazil’s economic success.

Under the dictatorship of a civilian politician, and later under the dictatorship of the military important economic changes were adopted and implemented in Brazil that planted the seeds for long-term Brazilian economic prosperity.

So who is Mr Amaral? It turns out he’s a direct descendant of José Bonifácio de Andrada e Silva, Brazil’s “patriarch of independence” – and Mr Amaral’s first example of a benevolent dictator, although technically he was minister under the then Prince Regent. Mr Amaral wrote a book about him: “Jose Bonifacio de Andrada e Silva – The Greatest Man in Brazilian History”.

Would Mr Amaral take a post in a new military government? No idea. But here’s what he says in his biography:

Mr. Amaral is a member of the two most politically influential families in Brazilian history the “Andrada Family” and the “Souza Queiroz” – The “Andrada Dynasty” in Brazil is still alive and well, and in the last 200 years we had more than 50 members of our family who were Prime Ministers, Finance Ministers, Secretary of various branches of government, state Governors, Mayors, Attorney General, various Ambassadors, and so on.

It is worth highlighting that RGE explicitly distances himself from anything written for its Economonitor web site, which aims to reflect different views; a sort of online op-ed page. From personal experience I can say it is often hard to convince readers that opinions expressed on the FT op-ed page are not necessarily the opinions of the newspaper; it will be harder still for an economic consultancy to pull that off. One has to wonder how welcome Mr Roubini will be in Brasilia from now on.

James Mackintosh

Thought the short sellers were up to no good? You’re not alone, at least when it comes to short-selling collateralised debt obligations (CDOs), one of the acronyms behind the financial crisis. And now you can sing along to the tune. US hedge fund Magnetar, according to an investigation by ProPublica, took a leading role in pumping up subprime debt by helping create the CDOs it then went on to short. Even better than the article, which should be a must-read for everyone involved with Wall Street, is the music, put together to go with it by This American Life (h/t Daily Intel).

However, we already knew that John Paulson’s Paulson & Co, together with Goldman Sachs, Deutsche Bank and other banks, had done something similar. But the scale of the Magnetar CDO creation seems to set it apart: it sourced the bulk of the CDO market in late 2006, shorting some of the CDO debt it had helped create while buying the super-toxic CDO equity, which CDO creators usually found tough to shift. Its losses on the equity were in at least one case more than covered by the eventual profits from the debt when the CDO tanked, ProPublica reports. Worth noting is Magnetar’s explanation: it insists it was net long all its own CDOs, which means it would lose money when they defaulted, and that it ran a market-neutral strategy, meaning it aimed to make money whether the mortgage/CDO market went up or down.

James Mackintosh

While hedge funds are the focus of attacks on “speculators” from Greek, French, German, Spanish and Portuguese politicians for allegedly trashing the euro and Greek bonds, the funds don’t seem to have made money from it.

According to Hedge Fund Research, which tracks the industry, so-called “macro” hedge funds – those trading interest rates, currencies and government debt around the world – have lost money this year, suggesting they were betting the wrong way on Greece, lost big money elsewhere or had ignored the Greek trade altogether (although there are exceptions – at least one was coining it at the start of the crisis, while others deliberately closed their trades because they expected a political fracas).

But Bloomberg reports on a lovely irony: at least one of those betting against Greek bonds using the dreaded CDS was an American mutual fund. Fully regulated, respectable, and run by one of America’s oldest fund managers. The mission of Eaton Vance, according to founder Charles Eaton:

Professional investment management entails an obligation of responsibility of the highest order. It is a very serious matter to accept the obligation to be responsible for the investment of anybody’s money.

The eurocrats currently planning to ban the use of “naked” CDS to make such bets – a bad move with worse motivation – must be choking into their cappuccinos. They’ll be even more annoyed when they realise that a ban in Europe will have no impact at all if the US continues its opposition to such a move and allows CDS to be used not just to protect existing bond holdings, as Europe wants, but also to speculate.

James Mackintosh

Reading the interesting argument between readers commenting on Paul Murphy’s strong backing for speculators in Saturday’s FT prompted me to re-read chapter 12 of Keynes’ General Theory, and his prose is every bit as good as last time I read it, almost 20 years ago.

Keynes is quite convincing of the awfulness of speculation (although he doesn’t mention his own efforts in the currency markets). He’s right, but the current attack on speculators being led by the French and Greeks suggests a shift further away from markets towards the state would be an improvement. It wouldn’t.

James Mackintosh

For those baffled by all the talk of repos, accounting rules and hidden leverage, a quick round-up of those against whom the court-appointed Anton Valukas, “examiner” of Lehman Brothers, found that legal claims would have “sufficient credible evidence to support a finding by a trier of fact” – what he calls “colorable claims”. You can read the full 2,200 page report here.

At Lehman, thanks to the discovery of “repo 105″, used to hid borrowing and make levels of leverage look lower:

  • Dick Fuld, chief executive – who seems to be channelling Jeffrey Skilling of Enron
  • Christopher O’Meara, former chief financial officer
  • Erin Callan, former chief financial officer and until recently at Credit Suisse
  • Ian Lowitt, chief financial officer

All “in connection with their failure to disclose the use of the practice”.

James Mackintosh

So, from the dream team that brought Barclays through the financial crisis without a bail-out (as John Varley and Bob Diamond might like to be described), come proposals to buy an American retail bank.

Three reasons why Barclays, one of Britain’s biggest banks, should not be trusted with such a deal:

1. Barclays wanted to be Royal Bank of Scotland. It tried to buy ABN Amro, and was only stopped by a combination of RBS’s willingness to pay even more than the insane sum (€64bn) Barclays offered and a campaign by Atticus Capital, the New York hedge fund, to make it see sense. Had Barclays succeeded, it would be Varley, not Sir Fred Goodwin, who was having his windows broken.

2. Barclays almost became a combination of Lloyds TSB and Bank of America. If it hadn’t been for Alistair Darling and the FSA, Barclays would have bought Lehman Brothers the weekend before it went bankrupt, in a sweetheart deal brokered by Hank Paulson, then Treasury secretary, and Tim Geithner, then head of the New York Fed and now Treasury secretary. Had Barclays succeeded, Varley would be joining Eric Daniels of Lloyds (now Lloyds Banking Group, following its disastrous HBOS takeover and state bail-out) and Ken Lewis (ex) of BoA (the not-so-proud owner of Merrill Lynch) in the competition for the title of worst takeover deal ever. [EDIT: Note that a large chunk of the most toxic assets would have been left for Wall Street to pick up; bad assets embedded in the balance sheet would still have been terrible news for Barclays, but perhaps - perhaps - it could still have avoided falling under state control.]

3. Barclays is already too big to fail. Allowing it to grow bigger simply exposes the British taxpayer to further contingent risk, which quite clearly Britain is not capable of taking on.

In addition, the dismal history of British banks in the US gives good reason for caution: most famously HSBC, but RBS of course had big operations there and NatWest Bancorp was never successful.

Rather than letting Barclays buy more, it should – as with other big banks – be forced to shrink, ideally by making it pay its true cost of capital, which would render many operations of all the banks unprofitable.

James Mackintosh

Politicians across Europe and the US worrying about credit default swaps and the supposed speculative attack on Greece should put this article by Sam Jones at the top of their reading list.

Hedge funds stand accused of using CDS – which allow bets on the creditworthness of a country’s or company’s bonds – to undermine the Greek economy by sparking fear. I explained yesterday why this is nonsense, but Jones has dug into the data and found that the CDS are actually encouraging bond spreads to move tighter, thanks to what is known as “negative basis”.

Basically, the hedge funds that used CDS to short Greece over the past year or two are now covering their positions, writing insurance for other people who are worried about their exposure to Greece, particularly banks. As a result, if anything, hedge funds are actually helping keep Greek bond yields lower than they otherwise would be (although I suspect the effect is tiny, just as the shorting had little, if any, effect – the bond market is far far bigger).

This should be essential reading for Christine Lagarde, French finance minister, Spanish politicians, and German and US regulators, before they rush into ill-considered new bans on the use of CDS to short. Apart from anything else, hedge funds would just use slightly less convenient methods, anyway.

James Mackintosh

Here we go again. Germany, France, Spain, Greece and Portugal are talking about extra regulations on credit default swaps, the insurance-like derivatives that let investors bet on debt problems, accusing the international media of a conspiracy or shouting about “speculators”. Some of the more excitable reports even suggest governments have called in the secret services to keep an eye on the hedge funds, although in typical German fashion Berlin called in its financial regulator, instead.

New regulations are already being mooted, with Jean-Claude Juncker, who chairs the eurozone finance ministers, warning of “torture equipment” ready to be used against speculators. But we’ve been here before. At the height of the banking crisis, short-selling bank equity (and in the US much other equity too) was banned, as short-sellers were blamed for the problem – including by John Mack (head of Morgan Stanley, then the biggest servicer of hedge funds wanting to short) and the Archbishops of York and Canterbury (the Church of England invested in hedge funds).

It is true that aggressive, co-ordinated short selling could create a problem at a bank by damaging confidence, starting a run on its short-term funding. But that could only create a liquidity problem. It turns out, of course, that the short-sellers were shorting precisely because there was already a confidence problem caused by the (correct) belief that the banks had a solvency problem. If there was any co-ordinated shorting – which remains unproven, but is being investigated – that was not the problem.

In Greece, the same argument applies. Is a loss of confidence causing the problem, or is the Greek economy like souvlaki – totally skewered?

A loss of confidence is much harder in a country than a bank: you can’t have a run. But theoretically the price of raising sovereign debt, and so commercial debt, could be pushed up, costing the country more. This is happening – but it isn’t happening because of the “shorting” effect of hedge funds buying CDS protection.

Quite the opposite. Hedge funds are – or at least were – buying CDS protection years before the problems emerged, because they believed the market had too much confidence in Greek debt. Greece is a serial defaulter, had a credit-fuelled bubble created by importing German interest rates, and saved far too little.

On top of that, Adair Turner, chairman of Britain’s Financial Services Authority, on Tuesday pointed out that short selling was not the big deal it is being made out to be. He is no fan of CDS – he has warned several times that some financial instruments are “not socially useful” – but he is also pragmatic, having been happy with the short selling ban on banks.

Here’s what Turner told MPs, according to Reuters:

It is important that even if we look at this issue we don’t overstate it. A fundamental issue that can drive volatility on spreads on Greek bonds is a whole load of long investors not being willing to buy.

I believe the total amount of CDS short positions in the area of Greek problem debt is only 3-4 per cent of outstanding Greek sovereign debt. The biggest driver is confidence levels and actions of long investors.

In other words, pension funds and other “good” investors are shy of buying Greek debt, not surprisingly. So not only is it not bad that hedge funds were shorting Greek debt, they weren’t even driving down its price by doing so. The current bail-out talk is already creating the risk of a short squeeze, bringing in spreads, as the WSJ points out.

None of this is likely to stop eurozone finance ministers blaming nasty foreign Anglo-Saxon casino capitalists for their troubles; some hedge funds closed out their short positions on troubled countries weeks ago because they feared exactly this political intervention (although they are now shorting the euro as a whole instead).

However, there is a genuine debate to be had about whether the use of CDS to take speculative positions, rather than simply to hedge existing positions, should be banned. Taking out insurance on something you do not own (which is akin to a “naked” CDS trade) is banned precisely because it creates the incentive to do what you can to damage the thing insured – in this case Greek debt. Plenty of people have argued CDS should be treated on a par with other forms of insurance, famously including Warren Buffett and most recently James Rickards, the former LTCM general counsel, and FT columnist Wolfgang Münchau.

I tend to the view that the incentive is different to fire insurance, and best controlled through regulation; owners of shares, after all, have an incentive to drive up the price through foul means, which we are quite happy to see controlled through regulation. But perhaps the CDS market cannot be made transparent enough, and liquid enough, to prevent it being used for large-scale manipulation, in which case it should be restricted.

In Greece, though, it does not appear to be manipulation by hedge funds which is causing the wide bond spreads. So finance ministers should address their problems at home, before trying once again to turn speculators into scapegoats.

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Christopher Cook is an FT editorial writer. Before joining the FT in 2008 as a Peter Martin Fellow, he worked for three years for the Conservative party.

Lorien Kite is deputy comment editor, a post he took up in 2009 after four years as a commissioning editor on the analysis page. He joined the FT in 2000.

Ian Holdsworth became assistant features editor in 2009 and was previously chief production journalist for the features pages.


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