The Great Debate UK

from James Saft:

Britain eats (leverages) its young

James Saft is a Reuters columnist. The opinions expressed are his own.

Four years, several failed banks and at least one global recession later, Britain has finally discovered what its young people need: 19-1 leverage.

Britain has announced a new housing initiative, the centerpiece of which is a plan to entice first-time buyers into buying newly-built properties with as little as 5 percent down.

Under the plan both builders and the government would contribute funds to partially indemnify lenders against what I am betting are the inevitable losses. Borrowers, who are almost by definition younger and less well off, will still bear all losses, but will be rewarded with the chance to take out the kind of loan which has proven time and again to be a bad idea.

This is utterly wrongheaded -- the best possible thing that can happen for first-time buyers, and arguably for most Britons, is for housing prices to fall to a level commensurate with earnings.

Why are houses in Britain so difficult to afford? Partly because of problems with supply, issues that the housing plan takes some steps, almost certainly insufficient ones, to address. And also because Britons, first out of necessity and then in the fever of greed, borrowed so much money in order to wedge themselves into what little housing was available that they drove prices up to unaffordable levels.

Again, as in Europe and the U.S., we have governments which, when confronted with problems that are fundamentally about debt, decide that piling yet more debt on top is the answer. Like the European Financial Stability Facility, which has proved utterly ineffective in supporting Italian debt, this plan too will fail, but not before many people will be tempted into taking on houses and debts they ought not to risk.

from Felix Salmon:

Lagarde leads from the front on Europe

Going into the Jackson Hole conference, everybody was breathlessly awaiting Friday's speech from Ben Bernanke, which turned out to be incredibly boring. The most important speech of the meeting, by far, came on Saturday, and came from the new head of the IMF, Christine Lagarde. In decidedly undiplomatic prose she came right out and said what needed to be done:

Two years ago, it became clear that resolving the crisis would require two key rebalancing acts—a domestic demand switch from the public to the private sector, and a global demand switch from external deficit to external surplus counties... the actual progress on rebalancing has been timid at best, while the downside risks to the global economy are increasing...

I would like to delve deeper into the different problems of Europe and the United States.

I’ll start with Europe...

Banks need urgent recapitalization. They must be strong enough to withstand the risks of sovereigns and weak growth. This is key to cutting the chains of contagion. If it is not addressed, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalization—seeking private resources first, but using public funds if necessary. One option would be to mobilize EFSF or other European-wide funding to recapitalize banks directly, which would avoid placing even greater burdens on vulnerable sovereigns...

The United States needs to move on two specific fronts.

First—the nexus of fiscal consolidation and growth. At first blush, these challenges seem contradictory. But they are actually mutually reinforcing. Credible decisions on future consolidation—involving both revenue and expenditure—create space for policies that support growth and jobs today. At the same time, growth is necessary for fiscal credibility—after all, who will believe that commitments to cut spending can survive a lengthy stagnation with prolonged high unemployment and social dissatisfaction?

Second—halting the downward spiral of foreclosures, falling house prices and deteriorating household spending. This could involve more aggressive principal reduction programs for homeowners, stronger intervention by the government housing finance agencies, or steps to help homeowners take advantage of the low interest rate environment.

The diagnosis of what needs to be done in the U.S. is spot-on. Revenues have to be raised -- in the future, not yet. Mortgage principal needs to be reduced. And the government needs to help the private sector translate low interest rates into growth, because right now it's looking like a deer in the headlights and refusing to take advantage of them.

But it's Lagarde's diagnosis of her native Europe which is proving highly controversial. Anonymous "officials", quoted in the FT, rapidly said that she had it all wrong:

Officials said Ms Lagarde’s comments missed the point of banks’ current difficulties. “The key issue is funding,” said one experienced central banker. “Banks in some countries have had trouble securing liquidity in recent weeks and that pressure is going to mount. To talk about capital is a confused message.

This is simply delusional: anybody who knows anything about banking knows that the distinction between a liquidity problem and a solvency problem is not nearly as clear-cut as this makes out. Indeed, if there weren't any worries about European banks' solvency, then they wouldn't have any kind of liquidity problems. If a bank has "trouble securing liquidity," any responsible regulator must take that as a message that the markets are worried about that bank's solvency -- especially if the problems are happening, as these ones are, in a broader global context where liquidity remains abundant.

And if the markets are worried about a bank's solvency, then that bank's solvency is what must be addressed -- perception is reality in such matters.

from Felix Salmon:

Why the Fed needs to replace bark with bite

Antony Currie has a response today to those who say that the Fed's U-turn on swipe fees "makes it look as if it can be cowed by the kind of intense lobbying the banks unleashed." (Yes, that would be me.)

Antony reckons that the final figure of 21 cents "is actually a decent compromise," and that "the Fed made the right call" -- but it's not entirely obvious why he thinks that. He says that the lower 12-cent figure was opposed by banks (duh) and "other senior banking authorities"; this is true, but it's not in and of itself a reason to backpedal.

Banking regulators are interested in safety and soundness, and a multi-billion-dollar stream of risk-free income, in the form of debit and credit interchange fees, undoubtedly makes banks safer and sounder. But is that is not a good reason to gouge merchants every time someone makes a purchase using a debit card. And as Antony points out, banks somehow seem to survive elsewhere with much lower interchange fees: America's are by far the highest in the world.

The farce that is "signature debit" is a big reason why, as Antony writes:

Though it rethought the fees, the Fed still missed an opportunity. U.S. debit fees are higher than elsewhere because Americans still sign for almost two-thirds of transactions — and banks keep pushing signature debit despite its being more susceptible to fraud. Browbeating banks to use PIN codes more would be safer and cheaper for all.

Behind this is the bizarre logic of US banks. First they encourage consumers to sign for debit purchases despite the fact that such purchases are much less secure; then they argue that they need high interchange fees because they have high fraud costs. This is financial chutzpah incarnate: the equivalent of the man who kills both his parents and then pleads for clemency on the grounds that he's an orphan.

The Fed is well aware of how hollow this argument is. And it can persuade banks to move to PIN purchases in one of two ways: either by "browbeating," as Antony would have it, or by simply making the finances of interchange uneconomical for signature debit. The second is what the Fed proposed in December, and it was powerful. The missed opportunity here was precisely to keep debit interchange at 12 cents. Now, the Fed can attempt the browbeating route, but it's not clear what kind of browbeating Antony has in mind, and it's even less clear that any such "moral suasion" would actually do any good.

from Felix Salmon:

Greenspan squanders his final reserve of credibility

Thank you, internet: Henry Farrell and his commenters have all the snark so desperately required in response to Alan Greenspan's ludicrous op-ed in the FT. And they're not alone: as Alex Eichler notes, "everyone is laughing at Alan Greenspan today". Greenspan could hardly have made himself look like more of an idiot if he'd tried, not only because the "notably rare exceptions" construction is so inherently snarkworthy, but also because it's so boneheadedly stupid. Anything which normally makes money is a good idea if you ignore the times that it doesn't work.

That said, it's worth looking in a bit more detail at Greenspan's nutty ramblings, because scarily they're actually representative of what much of the financial sector believes these days. (And Clive Crook, too.) The context is the GOP-controlled Congress, which has the ability to hobble or even abolish key parts of Dodd-Frank. And Greenspan is urging them on, saying that the early consequences of Dodd-Frank "do not bode well". In order to do this, he first sets up a straw man, saying that Dodd-Frank was designed to "readily address" the causes of the financial crisis. It wasn't, of course, but Greenspan pretends it does, and proceeds to give five examples of how it fails to do so, helpfully delineated with bullet points.

The first is that the credit rating agencies didn't like the idea that they should take responsibility for their ratings. Well of course they didn't like that idea -- but the SEC was so captured that it happily waived the relevant bit of Dodd-Frank. Is it true, pace Greenspan, that the SEC's supine reaction could not have been "readily anticipated"? Maybe. But the point here is that the unintended consequence of Dodd-Frank was a significant weakening of Dodd-Frank. Greenspan should be happy about this one! It's the intended consequence of Dodd-Frank that he didn't like.

Greenspan's second point is that banks "contend" that they won't afford to be able to issue debt cards if the Durbin amendment to Dodd-Frank goes through. This contention is silly, of course: no one's going to stop issuing debit cards at all. But Greenspan believes them, maybe because his entire career was based on trusting whatever he was told by the banks, since banks are always going to do what's best for their shareholders, and what's good for bank shareholders is good for America. Or something along those lines, anyway.

Back in 2008, Greenspan admitted that there was "a flaw" in that reasoning, and that he was "very distressed by that fact". But he's clearly got over his distress at this point, and is back to his old tricks of simply parroting the spin of the very entities he was purportedly regulating. "Concerns are growing," he writes, "that without immediate exemption from Dodd-Frank, a significant proportion of the foreign exchange derivatives market would leave the US."

Who has these concerns? Greenspan doesn't say, but I'll let you into a secret: it's bankers. They like trading derivatives because trading derivatives makes them lots of money. Does it help the broader economy, or create a significant number of jobs? That doesn't really matter, and neither does any specificity as to what the word "significant" might mean in this context. This isn't argument, it's inchoate scaremongering.

Greenspan then moves on to the Volcker Rule, complaining that it puts US banks at a competitive disadvantage. Well, yes. If you have a central bank which takes its regulatory function seriously, then less fettered banks are likely to be at a competitive advantage to your own. Ask Canada. Which is feeling pretty smug, these days, about putting its banks at a competitive disadvantage.

The silent revolution in banking

By Sanjeev Sinha

Media coverage of the banking industry was once confined to newspapers’ business pages, but has now spilled over to headline coverage. Recently the remuneration of bankers has been treated with even more interest than the salaries of top football players.

Yet while newspaper readers have become familiar with the LIBOR rate and discussions about cash reserves, there has been a long process of banks restructuring operations that has nothing to do with mergers or nationalisation. A behind-the-scenes revolution has been taking place, driven not only by the need for cost saving but, more importantly, to improve efficiency, and enable them to compete in global markets. Increasingly, banks have been looking at outsourcing a wider range of functions as a response to global market challenges.

High street banks have long embraced outsourcing in order to have the freedom to focus on their core business. But the independent expertise of an outsourcer becomes even more valuable when facing competition from new entrants such as Metro, the first new high street bank to be set up for a hundred years, and Tesco and Virgin, companies that grow by using their brand value won in other areas to enter financial services.

According to the World Retail Banking Report 77 percent of retail banks now outsource at least one part of their operating model, from their back office functions such as collections and the processing of payments to IT.  Common industry estimates shows that outsourcing provides clients with 20-40 percent savings, depending on whether processes are located onshore or offshore.

One of the proven benefits of outsourcing is the ability of an outside company to measure operational efficiency and identify areas for improvement. Outsourcers have process improvement experts who can identify ‘pinch-points’ — inefficiencies in the business processes.

In mortgages, for instance, a major outsourcer cuts the processing time for mortgage applications for one client after noticing that the speed of the flow from application to offer was extremely variable, resulting in missed valuation deadlines. On examination, they found that most of the company’s valuations were not being diverted to the most responsive valuers. When the client acted on this feedback, the average valuation turnaround time was reduced from 14 days to 10 days.  This not only enabled the client to increase the mortgage offer uptake through more efficient turnaround time, it also increased mortgage revenues. The client’s Net Promoter Score (NPS) also increased significantly.

from Felix Salmon:

Goldman’s Facebook plan falls apart

When the news came out that Goldman Sachs was orchestrating a private offering of Facebook shares at a $50 billion valuation, those shares overnight became an even hotter commodity than they had been up to that point. Check out the results of the periodic SecondMarket auctions: the three auctions in December, before the Goldman news was public, cleared at between $21.01 and $22.75 per share. The first auction after the Goldman news, by contrast, cleared at an all-time record of $28.26 per share -- that's a valuation of over $70 billion.

Clearly the Goldman news moved markets -- a lot. And equally clearly, that's very problematic in terms of securities law. Andrew Ross Sorkin explains why Goldman now feels forced to restrict its offering to non-US investors:

Federal and state regulations prohibit what is known as “general solicitation and advertising” in private offerings. Firms like Goldman seeking to raise money cannot take action that resembles public promoting of the offering, like buying advertisements or communicating with media outlets.

This is a point which was made before Goldman's latest announcement, for example by Chris Whalen:

Look, for example, how the Facebook portal got a lot of ink last week because of the superlative public relations job by GS. In feeding their "private investment" hype to the Big Media, GS was effectively front-running their own private market, the little ghetto called Face Book that they created apparently to evade securities laws.

All of this serves to underline the difficulties inherent in trying to put together a private market in Facebook stock. In Goldman's ideal world, and quite possibly in Facebook's ideal world too, Goldman could broker private transactions in Facebook shares for years to come, obviating the need for Facebook ever to go public.

Received opinion has it that Facebook might as well go public once it exceeds 500 shareholders and starts making public large amounts of information about itself in 2012. And today's news only serves to underline how difficult it is for a highly-visible company, and its advisers, to maintain a market in its securities while remaining private.

from Felix Salmon:

Dealing with Britain’s overpaid bankers

Bagehot has a very odd column about Britain's overpaid bankers. Part of it is spot on:

One shorthand description for the New Labour boom years is: Gordon Brown let a deregulated City rip, then used the tax revenues to fund a dramatic expansion of the state.

He's quite right about this. If a government starts seeing tax revenues from banks rise sharply, it should worry: that's a sign of a dangerous financial bubble. The exception to that rule, of course, is when a government deliberately tries to cut the financial sector down to a more sensible and sustainable size by taxing it more.

But that's not the way that Bagehot sees it. For him, the question of whether bankers are paid too much is exactly the same as the question of whether, if they were paid less, they would move to some other country.

That's silly. An overpaid banker in Hong Kong or Sao Paulo is still an overpaid banker. And the UK must make its own determination as to whether or not it wants to be home to a large contingent of overpaid bankers.

Bagehot might be right that if London's contingent of overpaid bankers were to shrink, then its financial-sector tax revenues would probably shrink as well. But if you're addicted to the fiscal crack cocaine that is City taxes, that's a reason to give up those taxes -- it's not a reason to keep on going back for an extra fix, even after bitter experience has taught you how damaging your addiction will prove to be in the long run.

Bagehot writes:

from Felix Salmon:

Facebook doesn’t care where Goldman gets its funds

The NYT is reporting that Goldman Sachs only made its $450 million investment in Facebook after its in-house private equity fund, Goldman Sachs Capital Partners, passed on the deal.

Many people -- including the NYT -- have been talking a lot in recent days about the "ancillary business" that Goldman is likely to get as a result of this investment, including fees from any future IPO and wealth-management fees for looking after Mark Zuckerberg's fortune. There's no formal agreement about any such things, I'm sure, but the general understanding seems to be that if Goldman scratches Facebook's back by raising a couple of billion dollars for it now, then Facebook will scratch Goldman's back in future with various lucrative bits of investment-banking business.

Goldman, it seems, would have loved to get all those fees without having to put its own money into the deal -- and then when GSCP said no, it ponied up the requisite cash itself.

But that means something important: that from the point of view of Facebook, Goldman's client, there's really no difference between Goldman investing and GSCP investing -- whether the money was borrowed from the Federal Reserve or invested by rich clients. Goldman Sachs and GSCP are two faces of the same company and either way Goldman is likely to end up with those ancillary fees.

That, in turn, makes a mockery of all the talk about Chinese Walls between banks' sell-side and buy-side operations, or the idea that speculative trading is fine, the Volcker Rule notwithstanding, just so long as it takes place in the asset-management arm rather than the bank itself. (Ask Bear Stearns just how insulated a parent bank is from losses at a subsidiary fund.)

If an investment from a bank's asset-management operation gives that bank all of the relationship-based upside of a principal investment by the bank itself, then it's clearly silly to think of those investment subsidiaries as being divorced from the investment-banking business. It's something regulators should think hard about, as they put together clear rules and guidelines about what kind of activity is acceptable where.

from Felix Salmon:

Is Ireland’s problem a Basel problem?

Does the Ireland crisis bespeak a major weakness in the Basel capital-adequacy regime? Simon Nixon thinks so: the fact that investors won't lend to Bank of Ireland, he says, "highlights a major weakness of the Basel capital rules that European banks operate under."

This is an interesting idea: Ireland's problem is a banking problem, banking problems are Basel problems, and therefore it stands to reason that Ireland's problem might be a Basel problem. But if you look more closely at Nixon's reasoning, his thesis ends up falling apart.

Nixon lays the blame at the feet of Basel's well-known weakness: the fact that it concentrates on risk-weighted assets rather than total assets. And he implies that there might be large national differences when it comes to the ratio of risk-weighted assets to total assets, while conceding that thesis " is impossible to prove from regulatory disclosures."

But there are three huge things missing from Nixon's piece. First, he takes just one bank from each of four different countries (Santander in Spain, BNP Paribas in France, Barclays in the UK, and Deutsche Bank in Germany) to illustrate national differences. He would be much more interesting, and much more compelling, if he presented a couple more datapoints in each country, to help give readers a better idea of whether French banks in general tend to have a higher ratio of risk-weighted assets to total assets than German banks in general, or whether we're just looking at idiosyncratic differences between BNP Paribas and Deutsche Bank.

Second, Nixon thinks that the credibility problem in Ireland is a function of the way that the banks' risk-weighted assets are calculated. He's right that the market is skeptical that Bank of Ireland really has a core Tier 1 ratio of 8%. And he's right that risk-weighted assets are a key part of that calculation, and can throw it off. Essentially, the ratio is (A-L)/R, where A is total assets, L is total liabilities, and R is risk-weighted assets. If R is artificially low, then that makes the ratio artificially high.

But the fact is that it's not the denominator here that the markets are worried about. Instead, it's the numerator. The key problematic number is A, Bank of Ireland's total assets. Many of those assets are Irish commercial real-estate loans for which there's essentially no buyer right now except for the Irish government. And a huge proportion of the rest are Irish residential mortgages, which might be performing for the time being but which would surely sell for much less than par if the bank tried to sell them on the open market.

Any mark-to-market valuation of BoI's assets, then, would almost certainly show the bank to be insolvent. (This is not news: it's true of all banks in all crises.) And the reason that the market won't lend to BoI is that it fears the bank is insolvent. And that has nothing to do with its risk weightings at all: it doesn't matter what the denominator is, if the numerator is negative.

from Felix Salmon:

Why Wall Street won’t get shrunk

This week's New Yorker features 8,000 words from John Cassidy on how financiers extract rents from the real economy rather than adding real value. His article features not only The Epicurean Dealmaker, star of blog and Twitter, but also Paul Woolley, a former fund manager who now runs the Woolley Centre for the Study of Market Dysfunctionality, a man who knows how to give great quote:

“I realized we were acting rationally and optimally,” he said. “The clients were acting rationally and optimally. And the outcome was a complete Horlicks.” ...

“Mispricing gives incorrect signals for resource allocation, and, at worst, causes stock market booms and busts,” Woolley wrote in a recent paper. “Rent capture causes the misallocation of labor and capital, transfers substantial wealth to bankers and financiers, and, at worst, induces systemic failure. Both impose social costs on their own, but in combination they create a perfect storm of wealth destruction.”

Cassidy is good at focusing on excessive pay in the industry:

Perhaps the most shocking thing about recent events was not how rapidly the big Wall Street firms got into trouble but how quickly they returned to profitability and lavished big rewards on themselves. Last year, Goldman Sachs paid more than sixteen billion dollars in compensation, and Morgan Stanley paid out more than fourteen billion dollars. Neither came up with any spectacular new investments or produced anything of tangible value, which leads to the question: When it comes to pay, is there something unique about the financial industry?

Thomas Philippon, an economist at N.Y.U.’s Stern School of Business, thinks there is. After studying the large pay differential between financial-sector employees and people in other industries with similar levels of education and experience, he and a colleague, Ariell Reshef of the University of Virginia, concluded that some of it could be explained by growing demand for financial services from technology companies and baby boomers. But Philippon and Reshef determined that up to half of the pay premium was due to something much simpler: people in the financial sector are overpaid. “In most industries, when people are paid too much their firms go bankrupt, and they are no longer paid too much,” he told me. “The exception is when people are paid too much and their firms don’t go broke. That is the finance industry.”

Cassidy concludes with an ode to an earlier era:

In 1940, a former Wall Street trader named Fred Schwed, Jr., wrote a charming little book titled “Where Are the Customers’ Yachts?,” in which he noted that many members of the public believed that Wall Street was inhabited primarily by “crooks and scoundrels, and very clever ones at that; that they sell for millions what they know is worthless; in short, that they are villains.” It was an extreme view, but public antagonism toward bankers and other financiers kept them in check for forty years. Economic historians refer to a period of “financial repression,” during which regulators and policymakers, reflecting public suspicion of Wall Street, restrained the growth of the banking sector. They placed limits on interest rates, prohibited deposit-taking institutions from issuing securities, and, by preventing financial institutions from merging with one another, kept most of them relatively small. During this period, major financial crises were conspicuously absent, while capital investment, productivity, and wages grew at rates that lifted tens of millions of working Americans into the middle class.

Since the early nineteen-eighties, by contrast, financial blowups have proliferated and living standards have stagnated. Is this coincidence? For a long time, economists and policymakers have accepted the financial industry’s appraisal of its own worth, ignoring the market failures and other pathologies that plague it.

Cassidy's view is a clear-eyed and straightforwardly reported version of, say, this, from Noam Chomsky: