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

Repeat after me: “I believe in a strong dollar as the primary global reserve currency, I believe in a strong dollar as the primary global reserve currency.”

Better hope it works, because the current debate over a far-in-the-future new monetary system may bring on a here-and-now dollar selloff and a whole new leg of the crisis.

Sadly, what worked when the children espoused their faith in Tinkerbell may not for a currency backed by the full faith and credit of a debtor nation which has socialised its banking system’s risk and needs to sell trillions in further debt to pay that and other bills.

Russia, India and, most significantly, China have all questioned the U.S. dollar’s central role in global trade and currency reserve management in the run-up to this week’s meeting of the Group of Eight industrialized nations in Italy. The future, it seems, is not greenback.

Russian President Dmitry Medvedev termed the system based on the dollar “flawed.” Suresh Tendulkar, a top Indian economic advisor said he was telling India to reduce the dollar’s weighting in setting the value of the rupee, comparing the situation to the classic “prisoner’s dilemma.”

It’s a good comparison, and as such makes his advice, and his choosing to make it public, puzzling. In the prisoner’s dilemma, two people are held for a crime and, being held apart, must decide whether to rat the other out. If both remain silent, they each get six months’ jail time, if one implicates the other he goes free and the other gets ten years, if both turn on one another they both get five years.

If holders of U.S. dollars can somehow maintain confidence in the currency, the value of their reserves will be protected, but the temptation to get a first mover’s advantage and get out while the getting is good may be overwhelming, though it will only work for that individual if everyone else more or less keeps faith.

Because, if they don’t the selloff could be so disorderly and damaging to the global economy that it will make concerns over the value of reserves look silly.

China, for its part, seems to be furiously paddling in both directions at the same time; saying that the dollar will retain its central status for “years to come” while also doing things like setting up a system to allow companies to settle cross border trades in yuan.

Writing in a newspaper published by the Chinese central bank, Li Ruogu, Chairman of the state-run Export-Import Bank of China said that Special Drawing Rights (SDRs), a unit of account used by the International Monetary Fund, could be molded to serve as a more representative global settlement unit, based on a basket of currencies. This echoes suggestions made by Chinese officials in March and can leave little doubt that the Chinese are preparing for a very different future.

“The financial crisis caused the global economy to suffer heavy losses and it also let us clearly see how unreasonable the current international monetary system is,” Li, a former central bank vice governor, said.

WHAT’S THE ALTERNATIVE?

He’s right, the old set up under which China kept its currency weak and U.S. borrowing rates lower than they otherwise would be made it too easy for the U.S. to load up on debt and almost surely was the fundamental underlying driver that led to the sub-prime mortgage crisis. It created conditions under which the huge risk management failure within banking was more likely. After all, when money is cheap and people are desperate for a bit extra yield, bad loans will begin to look safe.

Of course there are no credible current alternatives to the dollar at this point; not the euro, which might fracture or grow, or the yen or even the Chinese yuan.

And there is the danger: the very knowledge that the current dispensation is under review, and for extremely sound reasons, means that there is a small but dangerous chance that it unravels, that holders of dollars and buyers of U.S. debt lose faith leading to an uncontrolled fall in the dollar and in dollar-based assets.

It is all very similar to the banking crisis. A bank is only sound so long as we believe it to be, and the dollar, given the U.S’s weak fundamental position is only strong and worth holding so long as holders keep faith.

Really all we are observing is the continuation of the banking crisis on another plane. Last year the world lost faith in the U.S. banking system. The U.S., feeling it had no alternative, stepped up as effective guarantor of its banks and its financial system.

Well and good, and here’s hoping it works. It only will succeed however if faith in the U.S. and its dollar remain.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

– Christopher Swann is a Reuters columnist. The views expressed are his own –

People can be divided into three classes, it has been said: the haves, the have-nots and the have-not-paid-for-what-they-haves. The prevalence of the third category may be the biggest single source of vulnerability for the U.S. recovery.

A stress test of the consumer could reveal more distressing results than the one conducted on the banking system.

Debt is at high levels — 130 percent of disposable income, or more than twice its peak in the late 1980s. A slide in net wealth has reduced the collateral Americans can draw upon for emergency loans. Finally, it is now harder to borrow money for new consumption or to roll over existing debt.

Like a compromised immune system, this weakness makes consumers extremely susceptible to further shocks. Traumatic as the recent bout of retail restraint may have felt, worse may be in store. After all, consumption rose by 18.5 percent in the seven years to 2008. So far it has only fallen back by less than 2 percent.

There are several potential mishaps that could swiftly undermine consumer spending and set the recovery back to square one.

Among the most likely problems would be a continued slide in house prices. Even on the conservative measures used by the Federal Reserve, the value of residential real estate has fallen 18 percent since 2006.

With signs of recovery still tentative, a further 10 percent slide is well within the realm of possibility — inflicting a further blow on the balance sheet and sense of well-being of American households. (If nervousness over swelling government debt pushes up bond yields, the outcome could be still worse.)

Homeowner’s equity, already down to 40 percent from close to 60 percent, would plunge to 35 percent. This would send household wealth down to its lowest level since the mid-1980s. While Americans can’t immediately rebuild the $12 billion of net worth lost over the past 2 years — equivalent to more than a year’s worth of consumption — further losses will heighten their sense of caution.

A second threat is also looking increasingly likely — wage cuts. Fifteen percent of employers surveyed by the Society for Human Resource Management reduced pay in the past six months, a threefold increase from earlier this year. It is no longer implausible to imagine nominal wages starting to decline on a nationwide basis.

The Employment Cost Index is already rising at its slowest rate since the early 1980s. Wage deflation would make it even harder for Americans to repay the $10.5 trillion of mortgage debt they hold or the $2.5 trillion of consumer credit.

Martha Olney, a professor at Berkeley, envisages disproportionate cuts in spending if wages dip. “For households that are paying 60 percent of their income in mortgage and credit payments a 10 percent pay cut does not mean a 10 percent fall in disposable income,” she says. “It’s a 25 percent fall.” This is the danger of leverage.

Even under a rosy scenario it could take years for American consumers to repair their finances. If the savings rate rises to 8 percent of disposable income — about $860 billion a year — it will now take four years for debt to return to its 2002 level. This steady drain alone is equivalent to almost 10 percent of consumer spending.

After such a substantial loss of wealth, Americans will be pressed to be even more frugal. Along the way American will be hyper-sensitive to any jolts from weaker than expected employment, house prices or financial markets.

Consumer spending may not merely stagnate as most economists expect. It could yet decline more sharply. And like the banks, consumers will almost certainly need more support from the central bank and government before this economic malaise is over.

– John Kemp is a Reuters columnist. The views expressed are his own –

Economic history is the only field of human endeavor where the past changes as much if not more than the present and the future. Policymakers and practitioners struggle to define and write a “narrative” of the past as a means to control how policy responds to current and future problems.

The debate now over financial reform is a case in point. Even though the banking system has only just emerged from the most severe shock since the 1930s, the battle over how to define the events of the last 18 months, and what they should mean for investors and regulators in future, is already well underway.

Contrasting speeches last week by Federal Reserve Governor Kevin Warsh and Bank of England Governor Mervyn King illustrate the two extremes around which the debate is polarizing:

* Warsh speech

* King speech PDF

The financial sector will exploit these differences to derail any fundamental overhaul of regulation.

Warsh’s speech characterized the crisis as the “panic of 2008″ and set it in the context of the previous two decades of rapid non-inflationary growth, implying the crisis was an irrational aberration in an otherwise well-functioning economic and financial system.

In effect, Warsh reprised a philosophy associated with former Fed Chairman Alan Greenspan: occasional, wrenching crises are a price worth paying for an innovative, dynamic and wealth-generating form of capitalism. Policy should focus on ameliorating the after-effects rather than risk stifling growth by aiming to prevent crises altogether.

In contrast, King made the case for fundamental reform. He highlighted the real costs which a crisis that originated in the financial system is imposing on the real economy, as well as the more intangible but no less profound impact on attitudes towards wealth-creation, reward and regulation.

While noting there was no support for “excessively bureaucratic regulation”, King made clear “change to the structure, regulation and indeed culture of the banking system is necessary. Blaming individuals is no substitute for acknowledging the failure of a system, of a certain type of banking.”

STABILITY VERSUS GROWTH

King’s speech echoes the famous analysis set out in Hyman Minsky’s “Stabilising the Unstable Economy”. Minsky made a compelling case that periodic crises were an essential part of a financial-capitalist system in which massive long-term investment projects were financed by issuing large volumes of debt. By breeding over-confidence and increasingly risky capital structures, periods of stability laid the seeds of their own destruction.

But unlike Greenspan, Minsky argued such crises were not a “price worth paying”. Appropriate regulation was both necessary and desirable to constrain risk-taking to an acceptable level, and could be achieved without sacrificing growth. King’s speech appears to be advocating something similar.

Warsh is re-fighting an old debate between “stability-first” and “growth-first”. It is a false choice, as a closer look at the historical record suggests.

The problem with his speech is its truncated view of history. He notes U.S. output (measured by real GDP) grew at an average rate of more than 3 percent a year between the mid-1980s and 2007, and was significantly less volatile than in earlier periods. Unemployment averaged less than 5.75 percent, a full percentage point lower than in the previous 15 years.

But this is a tendentious use of dates. Warsh has picked the start and ends points to support a pre-determined conclusion. It specifically excludes the last two years of underperformance (2008 and 2009) from the period of the Great Moderation (as if the current problems had nothing to do with the policies pursued in the preceding years).

And by choosing the start point as the mid-1980s, then going back 15 years, it lumps both the Volcker recession of 1980-1982 and the oil shock of 1973 into the same base period for adverse comparison. With a selective use of statistics like this, it is possible to prove anything.

It is worth looking further back, in a more neutral manner. The attached PDF chart shows annual GDP growth since 1930 and the average rates for 20-year periods (1930-1949, 1950-1969, 1970-89 and 1990-2009).

While annual GDP growth was certainly less volatile during the most recent period, the average growth rate (2.5 percent) was not especially high compared with the previous 20 years (3.2 percent) or the two decades of the 1950s and 1960s (4.3 percent).

Warsh focuses on the undoubted benefits that openness to trade and rapid financial innovation delivered during the 1990s and the first part of the current decade, describing them as the principal achievement of the Great Moderation. Minsky’s own golden era was the 1950s and 1960s, when relatively conservative bank balance sheets and strict regulation appeared to tame the violent boom-bust cycle of the pre-war years while still enabling brisk growth and unprecedented prosperity.

But it is not obvious from the historical record whether macroeconomic management has been superior over the last 20 years to the 1950s and 1960s. Nor is it obvious policymakers have to choose between financial stability and economic growth. It is possible to have respectable growth and stronger financial supervision.

KEEPING OPTIONS OPEN

Minsky attributed the stability of the 1950s and 1960s to the impact of wartime finance, which had swapped a large part of the private securities on bank balance sheets for government debt, increasingly their liquidity, coupled with the development of a more extensive system of lender-of-last-resort, deposit protection and bank regulation.

Much of that framework of prudential oversight and conservative balance-sheet management has been swept away in the last 20 years as policymakers have relied more heavily on “market discipline”. The debate is how far to go in trying to recreate it.

Bank of England Deputy Governor Paul Tucker has already suggested banks should be forced to hold a greater cushion of highly liquid assets (for which read government debt) to reduce liquidity risks. In his speech, King reiterated the point.

He went on to suggest it was unsustainable that banks could take highly risky investment strategies while backed by an implicit (and free) state guarantee. Either regulation must be tightened, banks must pay for the guarantee, or it must be restricted to a range of “narrow banks” performing utility-like payments and basic lending services.

Rather than a set of detailed and perhaps politically unrealistic policy prescriptions, King’s speech should be seen as a plea to keep the debate and options open, not close them down prematurely and revert to business as usual.

King is right to try to encourage a deeper examination of the origins of the crisis. But radical reform seems unlikely. Wall Street and the City of London are already fielding an army of well-paid, silver-tongued lobbyists to deflect it. And as the divisions between King and Warsh reveal, regulators are too ham-strung by disagreements among themselves to force fundamental restructuring on a reluctant the industry.

- Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of "Verdict on the Crash" published by the Institute of Economic Affairs. The opinions expressed are his own. -

We could see it coming, couldn't we? Those gigantic over-leveraged hedge funds were bound to come crashing down, as their massive bets turned sour, forcing them to default on their bank loans and bringing the banking system to its knees.

Except that it never happened. Instead, the system was destroyed by the greed and incompetence of the insiders, including some of the most blue-blooded investment and commercial banks in the world. Highly regulated as they were said to be, they were allowed in every country except Spain simply to move their riskiest investments off balance sheet, where they were free to bet the bank on investments in the notoriously toxic mortgage-backed securities.

Note the absence of hedge funds and private equity - Alternative Investment Funds or AIF’s - from this story.

Nonetheless, with proposals to impose new reporting requirements and controls on management, the EU is concentrating its regulatory fire on the dog that didn’t bark, with the clear intention of reducing the competitiveness of AIF’s and tying the hands of their managers (with a side swipe at the offshore financial centres where many are legally domiciled).

Since the only investors in this type of fund are high net worth individuals and institutions like pension funds, insurance companies and mutual funds who ought to be capable of looking after their own interests, official concern can only be justified if there is a potential threat to the banking system – something which you might have thought would have been best left to the banks to monitor. The fact that the EU feels the need to make these proposals amounts to a vote of no confidence in bank managements.

Now confidence in bankers may, understandably, be as low these days as in MPs. But are there any better grounds for trusting regulators who allowed the crisis to occur under their very noses? If regulators have indeed now learned the lessons of the crisis, should they not concentrate on applying them to the banks in their charge?

Ironically, hedge funds do remain problematic. First, pre-crisis academic research had already shown hedge fund managers to be incapable on average of earning high enough returns, even in a bull market, to justify their high fees. The crisis offered them a golden opportunity – which they have mostly missed - to show that they could make good on their promise to shield investors from losses in a bear market.

Second, AIF’s should carry some of the blame for the crisis, but their sin was one of omission, not commission. As major players, they could have done far more to rein in empire-building bank managements. For example, instead of short selling RBS to prevent its catastrophic purchase of ABN AMRO, they sold too little and too late – when RBS was already beyond recall. Moreover, they could have used their voting power far earlier to insist on remuneration packages for executives that were properly aligned with shareholders’ interests. Instead, by their inaction they endorsed management decisions either explicitly or by default.

But then this last is an accusation which could have been directed at any of the traditional investment vehicles – mutual funds, insurance companies, pension funds etc – though this fact is apparently of no concern to EU Commissioners, fixated as they are on their vendetta against the “locusts".

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

The most revealing verdict on the results of the U.S. banking stress test was delivered not by shareholders but by the vigilantes of the bond market, who shunned an auction of 30-year government debt.

This makes sense: if the U.S. is letting banks off too lightly it will be taxpayers and the people who lend the U.S. money who will have to pick up the bill.

The stress test, which showed that 10 large banks will need to raise about $75 billion in capital, was greeted with euphoria by bank shareholders, despite being heavily leaked.

That’s no surprise, the stress test is useful not so much as a set of forecasts about the economy or bank losses, those being arguably too optimistic, but as a signal from government to capital about the rules of the game. It matters not because it is true but because of who is saying it.

Think of it as a term sheet in which the U.S. seeks junior minority investors to take some of its exposure to its banking system. The message is we will give you enough rope to try to earn your way out of your hole; if it works the rewards will be huge.

The U.S. has already said that none of the 19 banks would be allowed to fail, and if the past year has taught us anything it is that banks are creatures of government, the corollary being that that government has to pick up the pieces if banks fail.

So how do we interpret the very poor debt auction, or the fact that 30-year bonds ended the day yielding about 25 basis points more than in the beginning, a very large move when yields are only a bit over 4.3 percent?

It’s possible that this is a green shoots story, that bond market investors are looking for a healthy pick up in growth and inflation, but I doubt it.

More likely is that it is a combination of unease about budget indiscipline, about the amount of debt the U.S. will have to sell and about the bills that will come due if the stress test gets an F from reality.

— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–

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

Even without a huge fiscal boost or a hell-for-leather central bank, Europe could have a recovery, albeit a tepid one, on the cards by the end of the year.

Recent forward looking economic data is still grim, but hides within it the seeds of a rebound, as the absolutely brutal fall in manufacturing over the past six months burns itself out.

The euro zone’s economic situation is still dire and it still faces outsized risks; its banking system must deleverage and has the potential for disastrous losses while it remains unclear who in the world exactly is going to be buying enough goods to stoke a sustained recovery.

But nothing goes in the same direction forever, and absent a health or banking disaster it is reasonable to expect positive surprises from demand as the year wears on.

As those who are betting on a recovery are generally backing U.S. growth, that surprise when it comes could give a nice boost to European markets.

“There is good convincing evidence that the inventory cycle in the euro area is turning favorably,” said Aurelio Maccario, chief euro zone economist at UniCredit Group.

To come out of a recession two very important preconditions are that businesses successfully run down their stocks of goods and, at the very least, enjoy stabilization in demand.

Data from the euro zone indicates that we are moving towards such a state. The manufacturing component of Markit’s Eurozone Flash Services Purchasing Managers’ Index (PMI) was up 2.7 points to 43.6 while inventories were being run down at a record pace at 43.6. Manufacturing orders were up sharply, by 6.4 points to 37.4.

“It’s significant,” Maccario said “It’s the second consecutive increase and may represent the first signal that the trend is inverting, which is key.”

What that likely shows is that the pace of the recession is slowing, the second quarter will certainly show negative growth but also certainly be better than the first.

Other recent data was also showed improvement. The ZEW index, a measure of German analyst and investor sentiment showed that optimists on a six month view actually outnumbered pessimists for the first time since the blithe days of July 2007. A survey of French business sentiment carried out by INSEE jumped by a record amount in April.

Of course sentiment is ephemeral and could easily run into the brick wall of job losses and credit availability.

DELEVERAGING IN A LOAN INTENSIVE ECONOMY

But whereas U.S. banks have made some progress in deleveraging, the same is less true for financial institutions in the euro zone, leaving open the possibility of a cut back in lending crimping growth.

In their favor, euro zone households are less indebted - owing money equal to 93 percent of GDP - than their U.S. peers, who have gorged on debt up to 130 percent of GDP. Similarly, they are less vulnerable to falls in stocks and houses because they own fewer of the first and their was generally less of a bubble in the second, a huge supporting factor for Europe as the next few years of very low growth grind on.

But Europe’s capital markets are smaller in relation to their economy than in the U.S. and their banks bigger. That mostly comes into play in the corporate sector, which has increased their debt burden in recent years and which, especially among smaller enterprises, is heavily dependent on bank borrowing.

Loans to the private sector grew at an annual rate of 3.2 percent in March, according to the ECB, down fairly sharply from February’s 4.3 percent rate. A survey by the ECB of bank lending released on Wednesday showed that banks were still tightening standards in the first quarter, but doing so less drastically than at the end of 2008.

The ECB has thus far avoided intervening directly in credit markets, preferring instead to provide financing to banks on securitizations which the banks themselves continue to own.

But ECB Executive Board member Lorenzo Bini Smaghi on Tuesday indicated that the central bank could move to buy bonds directly from banks, thus presumably freeing up money for further lending to consumers and businesses.

This makes a great deal of sense. The ECB is expected to announce “additional measures” next week which are widely expected to include some form quantitative measures such as credit purchases.

The euro zone could surprise, and pleasantly, but the longer term is still looking like a slog. U.S. demand cannot be counted on and Asian competition for what is less will only sharpen.

So it may turn out to be a rainy day, but it will seem very welcome compared to the darkness of the winter just passing.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –

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

Deep breath. Ok, here goes: For the first time in a very long time U.S. housing might actually be a reasonable buy on a five-year view.

As a long-time housing bear and someone who believes there is still considerable pain to come in the U.S. economy and banking system that is quite a hard thing to say.

However historically cheap long-term fixed-rate financing (less than 5 percent on a 30-year mortgage) and the prospect of some nasty inflation a year or two out, both courtesy of current Federal Reserve and government policies, make owning a real asset that is debt financed a lot more attractive than would have been the case just three or six months ago. For full coverage of the U.S. housing market click here.

What I am not doing is calling the bottom of the housing market; there are still reasonable falls to come on top of the 20 percent or so declines we have already seen nationally.

Futures show an expected decline of about 4 percent on the Case-Shiller 20 City national index between May of this year and May 2010 and a recovery to current levels only in 2012. I actually think it might get a good bit worse than that; there are still substantial repossessions that need to filter through, unemployment will surely rise from here and an economic recovery, when it comes, will likely be pretty weak. This is not an argument about the housing cycle turning and leading us, as it has so many times before, out of recession.

Having said that one very important thing seems clear: the Federal Reserve will do what it takes, and very possibly a good deal too much, to stop deflation.

Indeed, there is a reasonably high risk that inflation will get away from the Fed or that buyers of Treasuries take a pass. This inflation will be very handy for those who’ve leveraged up to buy housing.

Economist Tim Lee of Greenwich, Connecticut-based pi Economics, a long time “deflationista”, now thinks that while deflation may still have the upper hand, current policies will inevitably be inflationary.

“The amount the Fed is doing will be enough to cause inflation, and I think that’s even if economic growth is fairly poor,” Lee said in an interview last week.

Broad money supply in the U.S. is rising at a more than 14 percent annual clip, the fiscal deficit will be about 13 percent of GDP this year and the Fed’s balance sheet has ballooned.

A REASONABLE ALTERNATIVE

And while housing won’t exactly thrive in a period of high inflation and low growth, it may perform reasonably well compared to the alternatives. Government bonds will get whacked by inflation and stocks may do a bit better than bonds over the medium term though they will suffer as the quality of earnings declines.

Stock market investors now are conflating the end of the very steep declines in the economy with a return to productive investment and a sustained rebound that will drive profits. That might be an optimistic reading. Stocks do offer some protection against inflation but they are far from a perfect hedge.

It is also heartening that investors are returning to many of the hardest-hit real estate markets in the U.S., such as Florida. These are people who do not rely on a lot of leverage and are happy to take the very positive cash flow from rents.

Mortgage rates are at an all-time low despite the absolutely terrible performance of recent vintage mortgages. This partly reflects the very low interest rate environment, but also is a function of the Fed intervening directly into credit markets in order to drive down rates to below where they very likely would be if investors demanded the kind of premium you would expect given recent experience. It also remains true that if things become really terrible, you can always walk away from a loan in the U.S., though it is pretty unlikely that this comes into play for a borrower who puts 20 percent down now.

Remember too that stabilization in the housing market is an absolute precondition for a recovery in banking and the economy generally, and it is clear from the steps the Fed and government have taken, in driving rates down and keeping the taps of government insured loans flowing, that they understand this and will act on it.

They will likely not be successful enough to save some of our largest banks, and all too successful from the standpoint of staving off deflation, and for someone borrowing at five percent interest for 30 years to buy a house in a part of the country which is not dependent on financial services, they may be very successful indeed.

It almost certainly won’t look that way in a year, but could well in five or seven.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –

The weekend revelation National Economic Council chief Lawrence Summers received almost $5.2 million in salary and other compensation last year from hedge fund DE Shaw and Co, and hundreds of thousands more in speaking fees from other banks, has dealt another blow to the administration’s fast-waning credibility on financial reform.

Summers and protege Treasury Secretary Timothy Geithner have already attracted criticism for a strategy many commentators believe is unduly favorable to Wall Street.

For all the talk of beefed up supervision and stringent capital requirements in future, financial assistance to the banking system has come with few conditions. Anxious not to offend powerful Wall Street interests, Treasury staff have consistently pushed back against attempts to impose compensation restrictions or other penalties on recipients of public funds.

It all stands in marked contrast to the tough line being taken with General Motors and Chrysler. Bank chiefs were invited to discuss the industry’s future at the White House; GM CEO Richard Wagoner was summarily dismissed.

Wall Street’s special treatment is justified by citing the industry’s pivotal credit-creating role. But there is a widespread suspicion financial interests have captured the government agencies, legislators and senior officials meant to regulate them. It is the type of rent-seeking behavior common in emerging markets and associated in the past with militant industrial unions and President Dwight Eisenhower’s military-industrial complex.

In a thoughtful article in the latest edition of The Atlantic magazine, former IMF chief economist Simon Johnson argues U.S. policy has been controlled for the past two decades by a “financial oligarchy” which exercises influence through campaign contributions and the regular exchange of top personnel between Wall Street firms and the White House, Treasury and other institutions meant to regulate them. It promotes an identity of views between the regulators and the regulated.

The disclosure of Summers’ earnings simply fuels that impression, and the administration’s decision to publish the disclosure forms on a Friday afternoon shows awareness of the embarrassing appearance of business as usual for an administration that came to power promising “change we can believe in.”

No one is accusing Summers or other senior officials of impropriety. His deep involvement with Wall Street was known at the time of his appointment and the fees were all earned before he accepted a position. But with his highly quantitative approach, assumption the solution to most problems is a market-based one, plus instinctive hostility to most forms of regulation, Summers epitomizes the financial revolution that so visibly failed in 2008. He is a leading exponent of the ancien regime. It is hard to imagine he will really press for significant reform in the months and years ahead.

If the president wants more funding from Congress, and to demonstrate he is serious about changing the way Wall Street works, he needs to broaden his circle of advisers.

The president is not short of advice. But he needs to reach out beyond the tight circle of Summers-Geithner-Rubin-Gensler to consider alternative views, then have the courage to trust his reformist instincts rather than the status quo views of the Wall Street-Washington establishment.

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

The shadow banking system in Europe isn’t so much dead as being kept on life support by banks and central banks in what amounts to a desperate but risky attempt to avoid the reckoning.

You might be forgiven for thinking that the biggest single month ever for securitization in Europe and Britain was sometime before we all realized that we were in a credit bubble, sometime like the sunny days of 2006.

In fact, the biggest month ever, by some margin, was December 2008, when more than 212 billion euros of securitizations were issued in Europe.

One small problem however is that there was almost no demand for them, with only about 8 billion euros in public deals intended to be bought by actual investors wanting to take on actual risk.

The rest were “retained” deals, almost always structured so they were eligible for financing by central banks under repo arrangements.

The numbers involved are staggering, with more than 750 billion euros of these retained deals having been created in 2008, according to Unicredit Group data. Retained securitizations in Spain total about 144 billion euros, according to UBS, or the equivalent of 14 percent of annual GDP. Before the deluge, banks in Europe and Britain pursued risky strategies of either originating and distributing — making loans and then selling them on via securitization to some bigger chump — or relying on wholesale funding so they could grow their balance sheets beyond their ability to gather actual deposits from bona fide savers.

When that dispensation fell apart, central banks stepped in as “emergency” sources of funding, with the argument being that the banking system needed liquidity to get it through an unforeseeable storm. Central banks will repo, or finance, securities that meet certain criteria, applying a discount to the face value to protect them but exchanging good old cash for hard-to-sell securities.

That storm is now about 20 months long and what were once emergency measures are now, more or less, the business model for banking.

Banks now lend money to homebuyers, businesses and consumers, turn those loans into securities, park the security with a friendly central bank and get cash back, thus allowing them to effectively take on more risk and continue lending despite balance sheet pressure.

This suits central banks, especially the ECB, as it keeps credit flowing and arguably supports asset valuations that would otherwise crush bank balance sheets and result in far more banking failures. Details of exactly how much and what kind of securitizations are parked with the ECB and other central banks are not available.

But like what came before, it is an inherently unstable arrangement, however convenient or useful.

“The structure-to-repo model is not sustainable. Repo-financing will be limited in 2009, or at least will not experience the same growth of 2008,” said James Zanesi, an analyst at Unicredit Group in Munich.

WHO BEARS THE RISK, WHO HOLDS THE BAG?

This strategy, which amounts to lending into a deteriorating collateral environment, is by definition riskier for the banks than originating and selling it on. After all, mortgage loans in Spain or Britain, where prices may fall another 15-20 percent and where unemployment is rising rapidly are probably not the world’s best risk right about now.

Bank investors will bear this risk, and you only need to look at the equity prices of European banks to see what the market thinks of it. It is also possible that people above equity holders in the capital structure could end up being hurt, though market orthodoxy now is that to hit bond holders would be suicidal.

Central banks and taxpayers may be on the hook as well, if banks with securities they’ve financed fail and the collateral proves worth less than they thought it would be.

The banks, for their part, are engaged in a Darwinian all-or-nothing bet. If they stop lending they are probably toast anyway, so may as well lend and hope that they are amongst the survivors and can then grow rich on fat margins.

Need I mention that there is a fair amount of moral hazard here. Banks have every incentive to make as many loans as ever they can, take on as much risk within the framework as can be managed and park as much as possible with their central bank.

The risk may bring with it the money they need to earn out of their problems and if things come apart, well then, the authorities have all the more reason to keep them alive if they are looking at an ugly loss if they fail.

Who says the days of big leveraged bets are over.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

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

Banks in the U.S. face a new source of write-downs and failures in the coming year as loans made to developers to finance residential and commercial property development rapidly go bad.

And as these loans are old-fashioned and concentrated in smaller banks, their fate is particularly interesting as it indicates that issues with the banking system go far deeper than the so-called “toxic assets” belonging to the largest lenders that have thus far gotten most of the attention and government aid.

They are also a great illustration of the difficulties of stopping a housing and deleveraging crash.

Called Acquisition, Construction and Development (ADC) loans, they total 8.4 percent of all bank loans, just below a 30 year peak, and are used by developers to buy land, put in infrastructure and construct housing or commercial and office space.

And because they are dependent on a reasonably healthy real estate market — someone who is willing to buy or rent the properties — when projects are completed, they are now in deep trouble.

“Everyone in the media is focused on consumer foreclosures. What they’re not focused on is the builder developer foreclosures which are only in the early innings and which will continue to wreck havoc as these assets are liquidated at depressed prices. Until they are cleared there can’t be a stabilization in home prices,” said Ivy Zelman, a longtime housing analyst at Zelman & Associates, who thinks the pressure will cause “hundreds of banks” to be closed and liquidated.

“The Federal Deposit Insurance Corporation doesn’t have the funds to deal with all this. They don’t have the scalability to deal with all these problem banks. They can’t examine the smaller banks fast enough,” she said.

Zelman estimates that U.S. banks risk having to charge off an additional $84 billion of ADC loans between now and 2013, equal to a hit of nine percent of Tier 1 capital.

That is damage banks can ill afford just about now, given the rising trend in delinquencies on consumer and home purchase loans, not to mention a deteriorating outlook for commercial loans.

Non-performing ADC loans hit 8.5 percent at the end of the year, up from just 3.2 percent the year before. Loans delinquent between 30-89 days are also up, by 25 percent in the quarter to 2.9 percent. And developers, struggling to try to survive without reliable cash flow from sales, are drawing down on commitments from banks that are not secured. The percentage of unsecured construction loans drawn down hit 73 percent, above the peak seen during the 1990s real estate slump and a crucial sign of builder distress.

FDIC FUNDING CRUNCH

Of particular concern is the way in which ADC loans are concentrated in smaller and community banks, which tend to have long and deep relationships with local developers. ADC loans account for 47 percent of non-performing loans at small banks as against 14 percent at larger banks.

And you can’t blame mark-to-market or toxic securitizations for these losses. They are considered held-to-maturity and are not typically included in any complex securities.

Chris Whalen of Institutional Risk Analytics, which specializes in bank risk analysis, sees ADC loans as part of the difficulties banks face with commercial real estate, and believes that regulators will be forced to get tough with banks in forcing them to write down exposure to struggling firms and deals.

“It will be subject to an impairment test and than they will have to start charging it off. The regulators are already beginning to force the community banks,” he said.

And while smaller banks being closed by the FDIC may not get the attention of a bailout of a big bank like Citigroup, every failure depletes resources and hurts credit availability.

The FDIC fund fell by almost half in the fourth quarter alone, touching $18.9 billion as it set aside a large portion of money for actual and expected bank failures. The FDIC has said it needs a bigger cushion but moves to impose special fees on healthy banks will inevitably hit profitability and credit availability.

Democratic Senator Christopher Dodd, chairman of the Senate Banking Committee, is moving to introduce legislation that would more than triple — to $100 billion — the FDIC’s line of credit with the Treasury Department.

But even beyond bank failures, ADC loan woes point to the intractable problems of a real estate bust.

Banks, while trying to reduce their overall exposure to these loans, have been reluctant to pull the rugs from under borrowers because, as with a house foreclosure, they end up owning a hard-to-sell underlying asset. But more foreclosures are coming, and with them fire sales as banks compete with those developers who still are in business and with homeowners and with foreclosure sales to liquidate inventory.

That will drive land and real estate prices down further and suck others into what amounts to a negative self-reinforcing cycle.

That’s true for housing, true for banking and true for the economy.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –