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Tuesday, December 29, 2009


moving toward a new basel consensus

via alea -- patience wheatcroft in the wall street journal on the reform of the basel rules.

The backlash was inevitable, and what is now being advocated is the full Taliban approach, with exposure kept to the minimum. Much more stringent capital requirements will be imposed, with strict limitations on what will qualify as Tier One capital. The capital requirements for counterparty risks arising from derivatives and securities financing will be strengthened. Liquidity minimum standards will be introduced.

Leverage will be much more strictly limited and, in a move that could have wide-ranging consequences, there will be a requirement to use the good times to build up capital buffers for when the (inevitable) bad times come.

The U.K.'s prime minister, Gordon Brown, may have regularly proclaimed that he had done away with boom and bust, but the foolishness of his rodomontade is now painfully clear and regulators will want to be prepared for the turning of the economic cycle.

That will mean that, as the committee foreshadowed in the autumn, pay outs to staff and investors will be firmly sublimated in favor of shoring up the business.

However unjust the bankers and their investors might feel this to be, the taxpayers who have been forced to provide so much to prop up otherwise bankrupt financial institutions are unlikely to be sympathetic, even though many of their pension funds have in the past been beneficiaries of dividends from bank shares. Now the call is for caution.

There is still time for the banks to continue their current fling since the Basel recommendations are only aimed for implementation at the end of 2012, and then with some element of phasing. But a new, much tougher, regime is on its way.

much of what has been going on since march last has been the desperate effort of governments to not only keep western banking afloat but to construct a temporary paradigm in which banks can accrue capital at the expense of savers, borrowers and investors in order to aid in the necessary recapitalizing of large insolvent banking institutions before the absence of once-expected cash flows renders the (hopefully) temporary suspension of prudential accounting moot. perhaps the easiest of these steps to appreciate is the use of liquidity in the reflation of asset prices -- both of equities so as to allow titanic dilutive floats of common equity, and of securitizations and lower-quality debt instruments so as to prevent large writedowns on asset books as well as provide massively profitable opportunities in trading. (junk debt, it should be noted, is completing its best year ever by a wide margin.)

such helpful extensions of the government balance sheet will surely if quietly continue. for example, perhaps the most notable development of the holiday season was the quiet removal of treasury bailout caps on fannie mae and freddie mac.

The government's decision to provide unlimited support to Fannie Mae and Freddie Mac probably presages more aggressive action to prop up the U.S. housing market.

The government may put a mortgage-modification effort, called the Home Affordable Modification Program, or HAMP, into overdrive in coming years, pushing for reductions in the principal outstanding on home loans overseen by Fannie and Freddie, Bose George, an analyst at Keefe, Bruyette & Woods, wrote in a note to investors Monday. ...

KBW's George initially found the extra support "perplexing," he said, because Fannie and Freddie are unlikely to need more than $200 billion of government money each.

During the depths of the recession in March 2009, the Government Accountability Office estimated that the bailouts of the two companies would cost taxpayers $389 billion, the analyst noted. Since then, house prices have stabilized and have begun to creep up in some areas.

Instead, unlimited taxpayer support will give the government "more flexibility in potentially taking more aggressive action to support the housing market," George wrote.

HAMP has so far had little effect on foreclosures. So the government may push for an enhanced version of the program that includes reductions in the principal outstanding on mortgages, the analyst said.

Principal reductions are controversial because they leave banks and other major mortgage lenders with bigger losses and lessened capital. The industry prefers modifications that lower interest payments in other ways, such as extending the maturity of home loans.

Aggressive reductions in principal on mortgages overseen by Fannie and Freddie could leave the companies with significant losses and cut further into their waning capital bases. But Treasury can pump more money into the institutions to make up for that, George said.

debt forgiveness is in the end just another avenue for debt reduction, and an overdue one at that. i don't imagine it will have much salutary effect on home prices, which are in the process of returning to historical discounted cash flow relations to incomes and rents -- indeed acquiescing to principal writedowns is an implicit acknowledgment that house prices cannot be returned to anything like their former level. to the extent that mortgagor might be subsequently be free to relocate without creating a credit event, it may even increase housing supply and pressure prices further.

this should impair bank balance sheets mightily, as in most cases banks have (much like fannie and freddie) avoided marking real estate loan portfolios to loss expectations which will be realized in debt forgiveness. but this can be seen as the other side of the bailout coin -- the massive 2009 government aid in recapitalization and the continuing use of the fed, treasury, FDIC and GSEs to lighten the blow by transferring debt and debt guarantees to the government balance sheet is groundwork preparing banks for the losses to come. it seems the major banks will be nursed through this transition and slowly recapitalized on the other side to comport with more pragmatic and robust post-basel-2 standards. at least, that would seem to be the plan.

but will it hold? that's the real question, and it depends very much on whether the assessment of the federal reserve, treasury and administration about the nature and depth of the problems afflicting the capital markets -- particularly of cash flows and the leverage applied to them -- are accurate. if the impairment of the banks is being underestimated (and indeed even if it isn't) the tail risk of precipitating a currency event with a debt issuance shock looms -- one that, while not constituting an event of default, may nevertheless impair american access to internationally traded commodities.

the public remarks of government officials very likely do not betray the fullness of their comprehension of the issues, given the nature of what j.k. galbraith famously called "incantation". but neither is it likely that ben bernanke grasps how inefficacious monetary policy is and will remain for so long as net loan demand is negative and banks are deleveraging, building investment portfolios or even retiring wholesale funding rather than making new loans.

i suspect the fed hopes to have kickstarted in early 2009 with very easy monetary policy a self-sustaining if mild and fragile growth cycle akin to those sparked by his predecessor, increasing incomes and thereby creating the cash flows needed to sustain asset prices and retire debt out of earnings without a massive series of deflationary writedowns. such an invention would allow both the fed and treasury to, perhaps gently and incrementally, withdraw their monetary and fiscal support without relapse.

but i fear that's probably wrong. instead, i think they are misreading a strong inventory correction which followed a near-full-stop in late 2008, one which is probably closer to its end than beginning, as growth in real retail sales is yet to be observed. indeed the most recent retail figures from the fed show flat-to-slightly-down year-over-year through november -- and this in spite of the augmentation of a series of fiscal stimuli (including the quasi-fiscal stimulus of permanent fed asset purchases) and a significant weakening of the dollar from the crisis peak, in comparison to a post-crash economy of late 2008 which had already been in recession for a year.

and here again we return to the linchpin of the entire construction -- fiscal stimulus. the household balance sheet is profoundly damaged; any foray into debt forgiveness would indicate that the government understands and accepts that. loan growth to the consumer sector is highly unlikely for some time to come. corporate cash flows depend much on household spending, and so the reduced flows that result from the move to balance sheet repair necessitate a corporate deleveraging in kind. and the banks, for their part, are eager to deleverage themselves and willing to buy riskless government debt for the purpose to retracting from risk and avoiding capital charges. into this paradox of thrift only government spending can prevent a fall in incomes, therefore deposits, therefore leverage, therefore asset prices, therefore again incomes and so forth.

without any further action, the impact of the ARRA fiscal stimulus package will be waning in all future quarters as it continues to disburse but with reduced intensity. as has been repeated ad nauseum, this will mean a diminishing impact on GDP growth reverting to a drag on GDP growth in 2h2010. so too between now and the end of the first quarter will planned fed asset purchases trail off to zero. if my presumptions above are correct, this will mean a return to the deflationary dynamics of the paradox of thrift as 2010 progresses -- which means negative GDP growth, deepening negative change in real sales, decreased employment and lower asset prices (in the case of the most leveraged assets, much lower) in a double-dip that should definitively end any semantic argument about whether or not the current economic process constitutes a depression. and that would shatter the outlook and plan of the fed to marshal the financial system back to health, incurring huge further losses in the banks and GSEs alike.

in the event, as i don't see the political will for further fiscal stimulus, i don't expect the adoption of anything like more stringent capital rules for the banks would be welcome anytime soon -- perhaps its just as well that implementation isn't until 2012, and i imagine it might be delayed more still.

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