Of Trust and Time

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Central Bankers, economy, Federal Reserve Board, Fiscal Crisis, Floyd Norris, Global Crisis, Monetary Policy, New York Times

Floyd Norris is a business journalist who writes for the New York Times. His articles are interesting and insightful. His article in the April 26, 2013 Business Section of the Times was no less. In fact, it was rather chilling.

The article was about a proposed change in Federal Reserve policy the intent of which is to better insulate the U.S. banking system from other systems, particularly Europe. His point being that Central Bankers, and in particular, the Federal Reserve, no longer trusted other Central Bankers to effectively regulate their monetary system, and banks subject to it. In effect, the Fed would require higher standards. The European’s have objected and the Fed has not formally put the policy in place, but the message is clear. There is a lack of trust.

In a crisis there are two important assets. Capital requirements, liquidity requirements all are in important, but when they cannot stem a tide, when rules need to be bent or broken, it is trust and time that are critical. These are off balance sheet assets. There is no IFRS, GAAP, or STAT accounting policy for them. You only see them in legal documents when they have failed: default clauses; offsets; collateral; bankruptcy.

When there is less trust, you need more time. This was evident in the 2008 crisis, as first trust evaporated and contagion let time cascade away. The connectedness and speed of transactions became a nightmare. The game of quick trades and derivatives could not be unwound as the notional amounts were devoid of relative value. Regulation subsequent to the crisis was supposedly going to address institutions that were too big to fail, but they have only gotten bigger, and then our government leveraged themselves. Tier 1 capital- sovereign capital for the most part- which was supposed to be the most secure capital supporting these institutions (which by regulation banks and insurance companies must hold certain percentages of) became weak capital. Despite excessive debt, which temporarily can be managed, the U.S. has once again become the currency of choice. The Fed is now playing on this for competitive reasons and other countries have been compelled to play along.

The problem now is that economies are unraveling, because too many people are unemployed or under-employed. On a micro-economic basis corporations have temporarily protected themselves. This is not a long term solution for them. The finance ministers in Europe have belatedly realized the macro-economic effect of austerity is destablizing their continent, with spill-over effect. China, still a derivative economy, will not be a white knight, as they are leveraged and cannot withstand internal upheavel.

We are increasingly captivated by models, program trades and financial engineering in the hope that we can earn that little extra margin. It is time we forgot about momemtum, moved away from dark pools, and recognized once again that value is long term rather than immediate. We have a lot more time, and with more time, mistakes can be corrected; trust can be restored. In the end, what Germany practiced in 2008 must be absorbed globally. Corporations need to take a micro hit and retain and hire full time workers in there own country. This is particularly true for the U.S., because its consumer economy still drives the world, particularly when Europe has pulled off the road. China’s rising middle class will get there, but it is not there yet.

The truth is that most large businesses do not need tax breaks to do this. Their effective rates are not substantial and they have sat on piles of cash. For those who redomesticated to more tax efficient havens, they should start to bring the funds back to the U.S. regardless of the tax implications. They will ultimately recapture it in revenue as the world economy revives. The equities markets are a fiction of current unsustainable monetary policy. Trust and time is running out.

Rollover- Without Jane Fonda

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banking, business, China, currency, economy, Euro, financial crisis, foreclosures, Jane Fonda, mass marketing, pareto principle, politics, reinsurance, Rollover, U.S.

In 1981 Jane Fonda, Kris Kristofferson and Hugh Cromyn were in a so-called financial thriller about the collapse of the world monetary system due to Arab oil monetary fears and self-preservation. Apart from the fact that I was younger and Jane Fonda was in it, the movie’s theme has haunted me for years. Looking on the web there are a few others like me, and if you do a search there is an interesting juxtaposition on youtube between the movie and the U.S. recent financial crisis. I don’t subscribe to the economic/political views of the producer’s of that video, although there is truth in everything. My prior post on contagion clauses reflects my view that in any crisis the most important element is time.

This brings me to the so-called pareto principle of 80/20; that which is important and worthy of attention is in the 20% cohort. In fact, the 20% group may be too large, as which is catastrophic, is often 1% or less, is most important, and is remote (or at least unpredictable). Life intervenes before the catastrophe, so other choices are made in lieu of catastrophic planning. When the catastrophe comes, there is little time to react; obligations in place often accelerate the catastrophe; those who have knowledge of the subject and are most capable of responding often have conflicts in doing so; rules must be broken; and the solution is generally to bide for time, by rolling things over long enough until normalcy returns.

I read in the papers each day about the financial crisis. In Europe apart from it being a political-fiscal crisis which needs time to resolve, sovereigns and the capital markets are in a dance of debt with no one who wants to cut in. Sovereign debt is Tier I capital for banks under Basel regardless of quality. There is no legal cap on country borrowing (although there is an economic cap), so the dance can continue.

In the U.S. the foreclosure problem is also a dance between the government (including Fannie/Freddie) and the banks and the secondary markets. They hope to run this out as long as possible to permit the capital base of the banks to improve and so continue the no effective interest borrowing from the Fed without corresponding macro usage of the funds (this would be Cat planning if they were not rewarding their internal and external stakeholders, even on a deferred basis). While there is some haircut due to unpaid interest, more often the obligations are being deferred through a balloon payment. In a low interest, volatile investment market the opportunity cost is relatively low, compared to a true haircut by the banks. When the interest rate/investment climate changes there will be a lot more foreclosures. The government is pushing State Attorney Generals to come on board, at the same time that the Obama administration’s low hanging fruit proposals don’t stand a chance in Congress. Look for 2013.

A number of years ago I spoke on a panel at a Reinsurance conference, where my topic was emerging issues in reinsurance. Reinsurance is insurance of insurance companies, and is one of the ways insurance companies finance themselves and protect their balance sheets. It impacts the premiums you pay. The issue I wanted to bring up was currency. In part because currency is hedged outside of reinsurance and in part because these were mostly property & casualty insurers, they did not understand why I wanted to talk about this. Since then the Euro crisis ensued, which has aggregated interest in the U.S. dollar in the short term. My talk was more long term, particularly for long tail risks. Given that China may become the dominant economic country, and that the Yuan could be the world’s currency in the future, long term commitments in dollars needed to be qualified. To get there there is likely to be a basket of currencies as in Singapore.

China’s domestic market will grow, making it the more dominant consumer economy on a mass marketing basis-  contrary to the pareto principle. As such, U.S. wages and its standard of living will decline, as the benefit of globalization is macro rather than micro. In order for China to sustain this they need to continue to follow their labor, rather than capital oriented economic policy unless that choose a more totalitarian political policy based on economic disparity. As U.S. companies have belatedly learned, every country supports their own and they will not share as much in China’s rise, unless they have know-how to share. Accordingly, the US will not be able to rollover debt to China.

The rollover period continues, but it is coming to an end.