MacroScope

The words “European bailout” normally conjure up images of inefficient public sectors, bloated pensions, corrupt governments. But market analyst John Hussman, in a recent research note cited here by Barry Ritholtz, says the reality is a bit more complicated:

The attempt to rescue distressed European debt by imposing heavy austerity on European people is largely driven by the desire to rescue bank bondholders from losses. Had banks not taken on spectacular amounts of leverage (encouraged by a misguided regulatory environment that required zero capital to be held against sovereign debt), European budget imbalances would have bit far sooner, and would have provoked corrective action years ago.

In other words, even if state actors mishandled government finances, Wall Street was, at the very least, an all-too-willing enabler.

The mantra that regulation is holding back the U.S. economic recovery is playing into Wall Street’s efforts to prevent significant reforms of the financial industry in the wake two major crises – one of which continues to rage in the heart of Europe. The sector’s staunch opposition to reform was captured in JP Morgan’s CEO Jamie Dimon’s claim that new bank rules are “anti-American.”

A new report from the Organization for Economic Cooperation and Development (OECD) suggests the opposition to substantially higher capital requirements is misguided. In particular, economist Patrick Slovik argues that a move away from the Basel accords’ “risk-weighted” approach to capital rules toward a hard-and-fast leverage ratio is the only way to prevent banks from finding creative ways to hide their true risk levels.

When the Basel accords first introduced the calculation of regulatory capital requirements based on risk-weighted assets, it was not expected that for systemically important banks the share of risk-weighted assets in total assets would consequently drop from 70% to 35%. Nor was it expected at the time that the financial system would transform high-risk subprime loans into seemingly low-risk securities on a scale that would spark a global financial crisis.  […] Tighter capital requirements based on risk-weighted assets aim to increase the loss-absorption capacity of the banking system, but also increase the incentives of banks to bypass the regulatory framework. New liquidity regulation, notwithstanding its good intentions, is another likely candidate to increase bank incentives to exploit regulation.

Paul Volcker famously joked in the wake of the 2008 credit crisis that the most important financial innovation of the last few decades had come not from Wall Street’s fancy footwork but rather the engineering acumen that created the ATM. A paper published by the National Bureau for Economic Research lends some academic credence to Volcker’s view. In particular, the research of Alp Simsek, a Harvard economist, finds the very uncertainty that esoteric new securities introduce into financial markets eats away at benefits arising from greater credit availability:

Financial innovation always decreases the uninsurable variance because new assets increase the possibilities for risk sharing. My main result shows that financial innovation also always increases the speculative variance. This is true even if traders completely agree about the payoffs of new assets. The intuition behind this result is the hedge-more/bet-more effect: Traders use new assets to hedge their bets on existing assets, which in turn enables them to place larger bets and take on greater risks. This effect suggests that financial innovation is more likely to be destabilizing in more complete financial markets and when it concerns derivative assets.

The author argues that rules prohibiting too many new types of securities from being introduced at once – so that traders don’t go too crazy too quickly – isn’t enough. As the crisis showed, when push comes to shove, hard-and-fast rules deliver better results than efforts at industry self-discipline.

Looking at the commentary from bank economists on this morning’s “stronger-than-expected” employment report, you would think the country is on a clear path to recovery. Jack Ablin, chief investment officer at Harris Private Bank, was downright euphoric:

This is critical, this is the most important data that we have seen this cycle. This is going to get people’s attention. This confirms that most of the negativity we have seen in the market is derived from the market itself and not the data.

Never mind that nearly half of the 103,000 new jobs “created” in September were accounted for by the return of thousands of striking Verizon workers to their jobs. Brian Dolan, chief strategist at Forex.com, didn’t let that caveat tamp his enthusiasm:

 We're getting a lot of good feedback on our special report on cozy ties between Wall Street and the Fed. As one Wall Street economist put it: "I've never seen the 'Fed Alumni Association' used more extensively for back-channel communications with the Street than has been the case since June."

The story pulls back the veil on the privileged access that Federal Reserve officials give to big investors, former Fed officials, money market advisers and hedge funds.

Another economist from a European bank thanked us for the report, saying: "I hate the idea that monetary policy is communicated through non-official channels, be it old friends or newsprint."

This picture was making the rounds on Wall Street on Thursday, after President Obama proposed limiting big banks'  financial risk-taking.

Five things to think about this week

TUSSLE FOR DIRECTION
- The tussle between bullish and bearish inclinations -- with bears gaining a bit of ground so far this month -- is being played out over both earnings and economic data. Alcoa got the U.S. earnings season off to a good start but a heavier results week lies ahead and could toss some banana skins into the market's path. Key financials, technology bellwethers (IBM, Google, Intel), as well as big names like GE, Nokia, Johnson and Johnson will offer more food for thought for those looking past the simple defensive versus cyclical split to choices between early cylicals, such as consumer discretionaries, and late cyclicals, such as industrials, based on the short-term earnings momentum. Macroeconomic data will need to confirm the picture painted by last week's unexpectedly German strong orders and production figures to give bulls the upper hand.

FINANCIAL FOCUS
- The heavy financial results slate (Goldman, JP Morgan, Bank of America, Citi) will show the extent to which balance sheets are being cleansed of toxic assets and the health of, and outlook for margins, trading revenues, etc. The relative performance of the firms reporting could put the spotlight on the split between investment banking and retail exposure. In Europe, Swedbank's results will be watched for Baltic exposure while clarity is still being sought on what banks plan to do with the large chunk of ECB one-year money which they continue to park back at the ECB in the form of overnight deposits.

JAPANESE DILEMMA
- The BOJ's policy meeting poses thorny questions on quantitative easing (QE), with the policy debate complicated by sharp gains in the yen. The yen has risen as much as 10.5 percent in three months against the dollar and is nearing the 90 threshold which is viewed by the foreign exchanges as the point at which the Japanese authorities start ratcheting up the rhetoric. Further sustained yen gains will fuel market debate about the fallout for carry trades and for exporters -- and by extension economic activity.

George Alogoskoufis is a hardly a household name outside Greece and EU financial circles. But the newly sacked Greek finance minister could yet become a poster child for politicans struggling to fight off economic decline and banking industry collapse. His demise was in large part due to a public perception that he was helping out the banks but ignoring rising joblessness.

Greece, of course, is a special case at the moment, still recovering from riots over the police shooting of a teenager. But finance ministers, central bankers and other responsibles are probably not immune from Alogoskoufis Syndrome. Balancing the need to bail out the finance industry with rising economic misery among everyday people is not easy. Fat cats are not exactly in favour at the moment.

This could, indeed, come to a head later in the year. Investment cycles tend to recover before economic ones. So what happens when Wall Street, the City and the like start bringing in the money again just as unemployment lines start getting even longer?

JPMorgan economist Michael Feroli is getting that sinking feeling.

He is out with a bold forecast calling for the Federal Reserve to drop its benchmark interest rate to zero by January.

“We believe the Fed then continues to conduct a zero-interest rate policy (ZIRP) for the remainder of 2009,” he wrote in a note to clients. “The change in our call is motivated in large part by the risk that deflation becomes more likely in an environment where labor market slack is building, and ongoing financial tightening is delaying the prospect that slack begins to get worked down.”

Ugly economic data and growing concern about a deep U.S. recession has prompted a flurry of aggressive — and gloomy — calls from the big Wall Street firms. At Goldman Sachs, economist Andrew Tilton has built two scenarios for the fourth quarter that he calls “worst case” and “just awful”.

It probably isn’t a big surprise that banks are cracking down on consumer loans, but the Federal Reserve’s latest survey of senior loan officers turns up an interesting twist: consumer demand for loans is also falling dramatically.

The headline-grabbing figures read like a classic credit contraction. Nearly 60 percent of banks said they had tightened lending standards on credit card loans in the past three months, and 70 percent had done so on mortgages to “prime” borrowers with good credit histories.

Half of domestic banks said they had become either somewhat or much less willing to make consumer installment loans, up from 35 percent in the previous survey, for the largest percentage in more than two decades.