James Saft

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.

While Treasury Secretary Tim Geithner prepares for a “financial deepening” he hopes will be a boon to U.S. banks, we may be steering instead for broader, shallower waters which will drive down margins in financial services and favor simplicity.

Geithner told The New Republic that he sees a coming boom for demand for financial services from emerging markets as a newly affluent middle class seeks new and more sophisticated financial products.

“I don’t have any enthusiasm for … trying to shrink the relative importance of the financial system in our economy as a test of reform, because we have to think about the fact that we operate in the broader world,” Geithner said.

The vision, perhaps unspoken, is for a recapitalized U.S. banking system with strong enough titans at the top to compete globally to sell complex financial services to Indian corporations as well as Chinese households.

On this reading, the decision to not take effective action to whittle down the too-big-to-fail banks makes sense; the new world will need Citigroups, not community banks.

Besides the false underlying assumption that regulation can mitigate the risks of TBTF banks, the financial deepening thesis is likely wrong on at least two additional counts. First, it assumes that the newly middle class of the world will want the kinds of products that only a huge bank can provide, and second, it assumes that the financial landscape of the future is like that of today, only bigger.

Now, to be sure, if you subsidize something it will grow. So, TBTF banks, enjoying a U.S. backstop and the funding advantage that goes along with it, will have some success in devising products to sell in emerging markets that arbitrage that subsidy. There is doubtless an unmet need for these products in India just as there was an unmet need for liar loans in California’s Central Valley. Look at some of the horrific experience with micro-credit in India, where the poor borrow to simply finance current consumption.

What is not clear is what complex financial services this new world will need, and why only a large global bank enjoying an implied government guarantee will be able to provide it. Certainly there will be capital markets services needed in emerging markets, such as share listings and bond financing, but it is unlikely that the advantage that a TBTF bank will get based on its size alone compared to the cost, to taxpayers and to the economy, is justified. Surely a smaller Goldman Sachs could compete in this arena without an implied guarantee.

A WIDENING
The real action will be not in fancy products devised by math PhDs, though devise them they will, but in simple utility-like functions like transfers and simple risk sharing such as life or property insurance.
Economist Barry Eichengreen, writing in the Wall Street Journal, argues compellingly that the dollar will lose its role as the main global reserve currency over the next decade.

One of the forces he cites is technology, which will make it easy for trade to happen outside of the dollar, for example between Korea and Chile, where before trade had to be routed through the dollar as an intermediary step.

This kind of round tripping into and out of the dollar is one of the main drivers for foreign exchange market volume and for hedging. If it goes away we will not see a deepening, but a shallowing. We would see just as much global trade as before, but a heck of a lot less foreign exchange trading and dollar hedging. The same thing may also be possible in the oil market, which is denominated in dollars and which drives a huge market in foreign exchange and hedging as a result.

It does seem likely that many hundreds of millions of additional people will become consumers of financial services, but like telephony this growing demand will likely come with falling margins.

Think, for example, of the agricultural middlemen in India who have lost their advantage now that farmers can easily access prices via mobile phones. Banks may find themselves in the same position, because of the same forces.

The payments and transfers business will grow tremendously, but this is a utility function and, likely as not, competition from outside of financial services, from technology or communication companies, will drive margins down.

My guess would be that, if the market were left to itself, the financial deepening will belong to Google Bank rather than Citigroup or J.P. Morgan. The too-big-to-fail subsidy may slow or distort that, and that is bad policy.

(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)

Call it what you like — war, tragedy or farce — but the disagreement over global currency exchange rates shows no sign of coming to a peaceful negotiated agreement.

Asked last week if loose Federal Reserve monetary policy was to blame for inflation in emerging markets, Ben Bernanke stoutly denied that it was anything to do with him, maintaining in central banker-speak that he’d been tucked up in bed at home at the time.

“I think it’s entirely unfair to attribute excess demand pressures in emerging markets to U.S. monetary policy, because emerging markets have all the tools they need to address excess demand in those countries,” the Fed chief told reporters assembled at the National Press Club in Washington.

“It’s really up to emerging markets to find appropriate tools to balance their own growth.”

Now on the face of it, that statement is a nonsense: regardless of emerging markets, like say, China, having tools at their disposal to put out the fire of domestic inflation, it is still possible, even likely, that Fed policy is partly responsible for widespread commodity price pressures.

Bernanke is right that rising living standards in emerging markets play an important role in price pressures and right too to point out that emerging markets have unused tools at their disposal.

“They can, for example, use monetary policy of their own. They can adjust their exchange rates, which is something that they’ve been reluctant to do in some cases,” Mr Bernanke said.

Bernanke argued that inflation in the U.S. did not yet appear to be a threat while high rates of unemployment were. Unsaid in this is that China’s policy of artificially keeping the yuan cheap has played a role in high rates of U.S. unemployment.

The U.S. stepped up its rhetoric against Chinese policy in a report from the Treasury Department last week, stopping short of labeling China a currency manipulator but calling the yuan “substantially undervalued” and complaining that “progress thus far is insufficient and that more rapid progress is needed.”

China for its part seems utterly unlikely to do very much to substantially address the issue of a weak yuan, based both on its track record and recent body language.

The truth is that this is a dangerous and destructive way to manage competing global interests, dangerous both in terms of the threats of inflation and hunger and destructive in the ways that Chinese policy has helped to distort the global economy over the past decade, albeit with a massive helping hand from overly loose U.S. policy.

A WIDENING CONFLICT
No one should expect the rest of the world to sit by as the dueling Chinese and American policies spray stray bullets into the crowd.

French Finance Minister Christine Lagarde on Sunday was forthright, blaming a, for her, highly inconvenient strength in the euro on the U.S and the Chinese.

“We must reform the international monetary system so that the euro is not caught in the middle, hit by the expense of trade-offs between two currencies that are deliberately weak,” Ms. Lagarde said in an interview on French television.

And while the word “China” did not pass his lips, U.S. Treasury Secretary Geithner’s meaning was clear on Monday on a visit to Brazil:

“Brazil is seeing a surge in capital inflows. This is happening for two reasons. First, investors around the world see Brazil growing at a faster pace and offering higher rates of return relative to other major economies. But these flows have been magnified by the policies of other emerging economies that are trying to sustain undervalued currencies, with tightly controlled exchange rate regimes.”

That is both true and not true; Chinese policy is terrible for Brazilian industry, threatening to turn the country into a larder for natural resources while suppressing other exports, but a lot of the money which is flooding the country and pressuring its currency upward is part of a huge carry trade that is directly attributable to U.S. monetary policy.

In this way perhaps the real risk of the currency skirmishes is that all countries are so focused on getting their share of global growth that they fail to take individual steps to control inflation, and thus allow it to grow rapidly in a way that proves difficult to control.

It does not have to work out that way; an inflation shock that does not become self-reinforcing will kill asset returns but whittle down debts in a very useful way.

The truth though is many countries are all trying to control the same knife at the same time and that is a tough way to whittle.

(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. --