James Saft

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

HUNTSVILLE, Ala. – Europe is demonstrating that a sovereign nation without a true central bank is just an uninsured bank, liable to be tipped over by the markets.

While the ECB is a central bank in almost all respects, what it isn’t is a lender of last resort for individual euro zone nations, a role that is expressly ruled out by the European Treaty.
A lender of last resort is what stops a bank run on a solvent institution from bringing it down due to a lack of liquidity. In the case of a nation, a lender of last resort, usually the central bank, can simply print money to satisfy debts in its own currency. And though we’ve all become terribly cynical about the concept of liquidity crises in the past couple of years, not least because so many people in authority have used it as a place to hide when the real issue was solvency (Greece, Lehman Brothers), the fact is that markets take on their own momentum.
Just as no-one viewed euro zone debt as anything other than a safe haven for the currency area’s first decade, now investors are busy driving up the price of even German default insurance.
This is the terrible logic of markets when they view sovereign borrowers as credit risks; it is almost inevitable that they push, and in pushing weaken the un-backstopped borrower and ultimately bring it down. This is a process which needs a circuit breaker, and Europe has no adequate circuit breaker, unlike Britain or the U.S.
“Rather than viewing government bonds as risk-free, safe-haven assets, financial markets now view and trade euro area sovereigns mainly as credit risks. This has very profound consequences for the stability of financial markets,” economist Elga Bartsch of Morgan Stanley wrote in a note to clients.
“For it seems to me that some markets have lost their ability to find a new, stable equilibrium. This is because, instead of moving in sync with the business cycle, government bond yields now move against the cycle, ie, rising in a downturn. This seriously undermines the ability of the government sector to stabilise the economy and the financial sector.”
Bartsch looked at all sovereign borrowers since the mid-1990′s whose spreads above Treasuries rose to at least 10 percentage points, an indicator of distress. In only 20 percent of the cases did a debt restructuring, or default, ensure. Some were rescued by the IMF but many righted themselves.
Thus Europe is at the mercy of markets, left without a central bank or outside force which can break the cycle and impose order. The ECB has purchased government bonds as a back door means of providing support, but this is awkward, will ultimately test the limits of the bank’s capital and, as being against the spirit of EU law, is deeply divisive. The EFSF fund is not well suited for playing this role either.

FOOL ME ONCE

You could object that, of course, all sovereign borrowers are ultimately credit risks. Even if one is repaid in the sovereign’s currency, that currency can be debased by inflation or the money printing press. True, but markets do not seem to impose the same penalty on inflation risk that they do on default risk.
There are two main take-aways from this. The first, of course, is that if you don’t have a proper central bank you ought to keep your debt profile slim so as not to attract too much attention to your vulnerability. This worked for Germany, whose Bundesbank was similarly forbidden by charter from printing money to buy government debt. Not borrowing too much is good advice but not terribly helpful in the current circumstances.
The second is that Europe needs a democratic way in which to agree to monetize or otherwise write down its debts. Failing that, the risk is that the domino-style run on government credit becomes self-fulfilling, as we’ve seen is the risk with ever larger sovereign borrowers like Italy being weighed by the markets and found wanting. This ultimately will break the euro, probably at about the point when Germany realizes it is picking up France’s dinner check.
This is not an argument in favour of suppressing markets by banning short selling or other measures, as is so often the impulse in Europe. Those arguments are raised by people, be they politicians or investment bank CEOs, who want to be insulated from the consequences of their own decisions. It is instead about clarity about who pays.
Europe suffers from unclear lines of accountability. There are easy fixes for that, but imposing them quickly will be difficult. That is certainly how markets are trading, and the result may be a self-fulfilling fracturing of the euro.

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

HUNTSVILLE, Ala. – Tim Geithner went a very long way on Friday to accomplish very little, flying to Poland to pitch to the assembled euro zone finance ministers the same tactics that have worked so poorly in the U.S.

Faced with another debt problem, Geithner once again proposed more debt as the solution, suggesting that Europe should leverage its EFSF bailout fund so it can have enough firepower to buy up the debts of weak euro zone nations. This mislabels a debt problem as a price problem, and is an almost exact analogue to the U.S.’s own tactics in addressing its own financial system problem — creating leveraged funds to buy up toxic debt and thereby massage the balance sheets of banks.

This is the deflationary equivalent of reacting to runaway inflation by deciding to lop a zero off the end of prices; things will appear better but the underlying issue is not resolved. This is borne out in the U.S., where private fortunes continue to be made in banking, but where the system is unable to play its role in capital intermediation. Many lenders are still wary, rightly, of funding U.S. banks and are unconvinced that the toxic debt problem is gone for good.

The Europeans don’t appear to be buyers either. “We are not discussing the expansion or increase of the EFSF with a nonmember of the euro area,” said Jean-Claude Juncker, the chairman of the Eurogroup.

He also ruled out any further fiscal stimulus, something Washington has also called for. “Fiscal consolidation remains a top priority for the euro area,” he said.

Austria’s Finance Minister Maria Fekter went further, describing how Geithner urged the group to commit more money to the rescue, but flat out rejected the idea of funding the bailout with a financial transaction tax.

“I found it peculiar that even though the Americans have significantly worse fundamental data than the euro zone, that they tell us what we should do and when we make a suggestion … that they say ‘no’ straight away.”

Remember, Geithner isn’t proposing borrowing more money so that the deeply destructive cuts the euro zone is requiring in Greece and elsewhere can be eased. It is not money for teachers, it is money to support bond prices, which in effect is money to support the capital positions of the banks which would be left broken if the true market price prevailed.

SOVEREIGN CREDIT RISK ROULETTE

The problem with this is that ultimately supporting the banks may swamp the sovereign’s credit rating. A massive increase in the size of the EFSF would surely call into question France’s AAA rating. While Europe has a problem over who is going to pay, with Germans unwilling to underwrite what they see as Mediterranean profligacy, it also has a profound problem with which lenders to make whole.

A look at a study from the Bank for International Settlements into the interaction of sovereign credit risk and bank funding really shows the limits of Geithner’s leverage-happy approach.

Released as part of its quarterly review, the central bank’s central bank described sovereign credit risk as posing “a significant and urgent challenge to banks.”

Bank are massive holders of sovereign debt; indeed bank regulation hard-wires holdings into their business model. That leaves banks open to losses on sovereign loans held on their balance sheets, and in turn those loans are worth less as collateral for loans from the market or from central banks. On top of that, as the state is the ultimate insurer of its banking system, downgrades to the sovereign are effectively downgrades to its banks, raising their funding costs.

In other words, buying up sovereign debt at inflated prices without properly restructuring the debt will result in an ongoing European bank funding crisis, with ever more leverage needed until the day comes that the sovereign is no longer credit worthy. The bank funding and sovereign credit dynamic is one that must ultimately be broken by sovereigns repairing the stability of their finances.

Banks can mitigate these risks by holding fewer government bonds, and by funding themselves more conservatively, but those steps will tend to make them less willing and able to provide credit to the economies they are supposed to support. That is probably the way banks need to be run, but operating a bank conservatively in an economy in which debts have already been properly written down will result in good solid growth. Doing it in a make-believe economy with make-believe asset prices will result in years of stagnation.

That is what the U.S. is seeing. Europe should choose a different path.

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 battle between the banks and nation states is shaping up as something that lies between a phony war and a rout.

The bald facts are that three years after the crisis in which banking almost brought down the global economy, the biggest banks are bigger, more global and more entrenched in their positions courtesy of a now all-but-explicit government guarantee.

All three factors make large banks harder for individual nations to control, even the U.S., and even if the U.S. manifested the desire to pull out of its heads-you-win-tails-we-lose bargain.

“Too big to fail (banks) really creates a capture problem … They are now larger than single nations,” Andrew Sheng, chief adviser to the China Banking Regulatory Commission said on Saturday at a conference at Bretton Woods sponsored by the Institute for New Economic Thinking.

“The top 25 banks comprise 73 of global GDP and 45 percent of total assets of the banking system … They are so powerful they are essentially Godzillas.”

Sheng argues, rightly, that the creation of momentum upwards in asset prices by financial engineering combines dangerously with lax and co-opted regulation and an incentive scheme at banks that encourages risk taking.

The result: repeated and ever-larger crises that begin in the banking system but the costs of which are borne by taxpayers.

The global nature of banking makes single-nation regulation largely impotent. The Dodd-Frank legislation recently enacted has a resolution program that, though intended to combat the risks of a large bank failing, can do very little due to the global nature of such institutions’ assets, liabilities and networks.

Even if this starts as a regulatory problem, it almost inevitably ends as a political one, as a glance at Iceland shows. Voters in Iceland rejected by a 59-41 percent vote an accord that would have allowed for the repayment of $5 billion to Britain and the Netherlands, the second time voters have refused to pay to make good the debts of their formerly out-sized banking system.

Iceland, you will remember, was the host nation to a group of global banks which borrowed and lent unwisely and when they collapsed left the nation of 320,000 with a staggering liability.

The most recent “No” may be foolish, as it will shut Iceland out of international capital markets and may be reversed by international courts anyway, but it is a good example of how people react to debts which may be legal but are certainly not just.

The mechanics and merits of Iceland’s situation are not fundamentally different from those of the U.S. or Britain; the chief difference is scale.

CAN GOLDMAN FAIL?
As the scale of losses rises, it is possible that the politics of TBTF banks change in the world outside of Iceland, but it looks as if that will wait until a further crisis breaks.

For now banks have bested the nation states. Compared to 2007 there exists the same incentives to take risks, largely, while the funding and trading positions of the largest banks are, relative to their smaller peers, now better because the world has had an object lesson in their special government guaranteed status.

Simon Johnson, the MIT professor and former chief economist at the IMF, conducted a thought experiment with the audience at the Bretton Woods conference, asking who believed that Goldman Sachs would be allowed to fail if, for whatever reason, it found itself on the brink.

No one, it appeared, in the audience thought Goldman would be allowed to follow Lehman Brothers into history, and Johnson reports that having tried that question on several audiences he has thus far only found one person who does, an evidently somewhat overenthusiastic Goldman short seller in New York.

Of course Goldman cannot be allowed to fail, at least in their current form and in the current state of play.

Of the ideas for righting this few have much chance of working, and those have little chance of coming to reality. Higher capital, especially on a sliding scale linked to size, might work, but at levels perhaps well above those currently being debated.

Resolution authorities would have to be international, making an agreement out of reach for the foreseeable future. The same can probably be said of a financial transactions tax, which again would only truly be effective if global.

That is even before we consider the fact that both regulators and elites in much of the world have largely been captured by finance. Where do you think people go to work when their days as public servants are through?

So, it is on to the next banking crisis. Whenever it sees fit to come it will be larger and may finally make the rest of the world a bit more like Iceland.

(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. Email: jamessaft@jamessaft.com)

If you have forgotten the credit crunch it appears you have company: U.S. banks are lending again.

Bank earnings reports and data from the Federal Reserve confirm that, at long last, banks are beginning to step up lending, a much-needed ingredient for a stronger and more sustainable recovery.

The good news is that lending is growing to commercial and industrial companies — exactly where you want to see growth if the U.S. is going to address its unsustainable dependence on domestic consumption. That’s good so far as it goes, but with a fragile euro and an undervalued yuan the upside is decidedly limited.

That’s because, in part, consumers are still quite restrained, or are being restrained, at least to judge by weak to middling lending levels to consumers and to support house purchases.

With 17 of the top 25 U.S. banks by assets having reported earnings, a lending turnaround is in evidence. Among the 10 largest regional banks, loan books expanded by 0.6 percent in the fourth quarter, according to FBR Capital markets, and nudged up slightly at the four mega-banks. This compares to a 2 percent shrinkage in the previous quarter and real carnage in the two years before that.

According to Federal Reserve data, commercial bank loans and leases shrank by 10.3 percent in 2009 and 6.3 percent last year, both a cause and a result of the recession and the sluggish and largely jobless growth which followed. Fed data from December shows business lending growing at a very good 7.4 percent annual clip, with continued weakness in home equity, commercial real estate and consumer lending.

The growth in commercial and industrial lending is significant, given the strength of the turnaround, but that sector is going to have to row very hard if consumers are unable or unwilling to spend freely.

A look at the Fed data for the first two weeks of January shows continued mild expansion of business lending combined with stability in real estate lending and a small fall in consumer lending.

NECESSARY NOT SUFFICIENT
It is for this reason, if none other, that the U.S.’s seeming inability to convince China to allow the yuan to strengthen poses such a threat to U.S. growth and to its medium-term prospects. Even if the Federal Reserve engineers asset price inflation, there is really little chance that domestic demand over the next few years can provide strong growth. The U.S. must export more, both for its own sake and for those of its creditors.

Consumer credit has actually been stronger than the headline figure if you adjust for loans the banks consider unlikely to be repaid, according to James Marple, senior economist at TD Economics.

“Correcting for charge-offs shows that household deleveraging did lead to a slowdown in credit issuance. On a year-over-year basis, revolving consumer credit was slightly negative in early 2010 — a new phenomenon for credit cards — while nonrevolving net credit issuance slowed, but did not actually contract,” Marple wrote in a note to clients.

“Importantly, over the last several months, there has been a considerable improvement in consumer credit growth. Even with the impact of charge-offs, total consumer credit rose in both October and November — the first two consecutive monthly gains since June and July of 2008.”

Remember, in a fiat money economy the creation of credit is the creation of money. The Federal Reserve couldn’t make banks lend by dropping interest rates, but it appears that its program of quantitative easing may have worked, at least on this measure.

The Fed’s recent Survey of Senior Credit Officers, which measures conditions in the business of lending to hedge funds and other securities firms, showed a similar thawing of conditions.

Banks are more willing to take on risk, according to the survey, and are making money available to financial markets more cheaply and on less stringent terms.

If QE has prompted the banking system to begin to create money again, will inflation be unleashed? My guess is that there is still too much slack in labor markets for that to happen, but there is every chance that we will see, or are already seeing, bubbles in asset markets.

While credit creation can be a self-reinforcing cycle, it is only a virtuous one if the credit is invested in areas that are productive.

The sweet spot for the U.S. would be consumer stability combined with a gently falling dollar so the country can, over years not months, export its way out of its woes.

The rest of the world is not, judging by recent events, going to want to cooperate.

(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.  email:jamessaft@jamessaft.com)

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

U.S. plans for a public-private fund to buy up toxic assets are likely to amount to a fig leaf with which to hide subsidies to failing banks.

It is also, inevitably, an entirely new subsidy to outside investors, who by definition will only participate if they get better terms than now available in what we formerly thought of as the free market.

Treasury Secretary Tim Geithner last week announced the plan, which will provide between $500 billion and $1 trillion of financing to private sector funds which will use the money to lever up their own capital and make offers for complex and doubtful securities now clogging balance sheets. Further details are to follow.

But it's likely the plan won't work, if by work we mean come up with a believable price for these assets.

Banks won't sell at market prices because to do so would make many fall over bankrupt. The U.S. can surely manipulate prices by providing cheap and plentiful leverage - sound familiar? - but that will be seen for what it is; a subsidy for the funds and the banks rather than a firm base to allow confidence to return.

As it is, there's a standoff in markets as to how to price these assets. For the sake of illustration, let's pretend that banks have a security marked on their books at 90 cents on the dollar, while similar securities change hands at 60 or 65 cents when bought and sold in arms length transactions.

The first thing to recognize is why the market and bank prices are so far apart for these assets, many of which are tied to real estate or consumer loans. It partly reflects uncertainty about how the underlying loans will perform given the poor economic outlook. But it also reflects the potential that assets will get cheaper still, that banks will become forced sellers later and so why commit your capital now as prices may well fall when banks disgorge.

It finally and powerfully reflects the fact that there is very, very little secure term funding at a reasonable price available with which to buy this stuff. That means you have to be a cash buyer with a long time horizon, meaning the return has to be pretty juicy.

The banks have a partly legitimate beef with what they see as a market failure and partly are applying self-serving valuations in order to avoid going bust. The assets may throw off more income than implied by market prices, in other words those returns to cash buyers may be a bit rich, but on the other hand these high carrying prices are very convenient for the banks which would fail if market prices were applied.

BETTER THAN PAULSON BUT STILL FLAWED

The earlier Paulson held-to-maturity plan was aimed at buying up these loans at higher than market prices, the justification being that there was a market failure and the government would actually make a "profit" on the deal.

That plan failed while the new one hopes to use private investors to set prices, thus justifying the numbers. It will avoid some issues, lessening the chances that banks just fork over the worst loans or that the auction is corrupt, but it won't achieve a market price.

Imagine for a moment that you are a hedge fund manager and in your subjective view a security now held by a bank will generate a return of five percent over its lifetime at the price at which the bank is willing to sell. No deal.

But if the Treasury will lend you eight times your capital for five years at 2 percent, well then that works pretty nicely, at least from the hedge fund's point of view.

Competition between funds for access to the leverage can improve the outcome for the taxpayer, but banks have to be willing to sell and won't do it if it drives them under. The U.S. can and I fear will simply increase the amount of leverage it will give relative to capital until the returns to the funds are good enough to justify them buying the asset for a price that keeps the banks magically solvent.

Sound familiar? It should because that kind of leveraged speculation is everyone was doing until the summer of 2007. Only then they were doing it with money borrowed from banks, now they are doing it with taxpayer money. Actually, in retrospect it always was taxpayer money.

So, it's a bit better than the Paulson plan, and maybe we want to spread subsidies across funds and banks to help soothe the problem. But will it work to restore faith in banks? I am not sure it is enough money to do that without getting a multiplying effect from the rest of us believing the prices. If the result appears to be fixed, that won't happen.

-- 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. For previous columns, click here. --

One of the best things about Davos is the conversations you overhear. It's like no place else.

Sitting minding my own business, typing away I became aware of a central banker from a medium sized emerging market sitting nearby. He was joined by a gentleman from a bank in his home country. After a few muffled preliminaries the central banks said:

"So, how much trouble are you in?"

The banker responded in what sounded like soothing tones but I couldn't make out exactly what he was saying. The only other line that came through clearly was that after a long speech the banker said to the central banker, with an air of exasperation.:

"The prices are very low, but there are no buyers!"

That's it, in a nutshell.