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SECRETARIA DE ESTADO DE ECONOMÍA,

MINISTERIO SECRETARÍA GENERAL DE POLÍTICA ECONÓMICA DE ECONOMÍA Y ECONOMÍA INTERNACIONAL Y HACIENDA SUBDIRECCIÓN GENERAL DE ECONOMÍA INTERNACIONAL

CUADERNO DE DOCUMENTACION

Número 88º ANEXO II

Alvaro Espina Vocal Asesor 12 de Junio de 2009

BACKGROUND PAPERS:

1. Blue Double Cross by Paul Krugman … 13 2. Actually existing Minsky. The Conscience of a Liberal … 14 3. Tax on Medical Benefits Gains Traction by Lori Montgomery … 16 4. Golden State Bailout by Joe Mathews … 18 5. S&p warns of a rating downgrade for the UK by Eurointelligence … 20 6. UK Credit Rating Outlook Downgraded: Sovereign Debt Crisis Ahead? by RGE Monitor … 23 7. Why public private plan has bankers squirming by Gillian Tett …25 8. Asset Class Labels, by Vega... 27 9. Redistribution through the Geithner Plan by Dennis J Snower … 28 10. ¿Es la deflación una seria amenaza? By Finanzas e Inversión … 33 11. Unidos por la cartera: La delicada relación financiera entre EEUU y China Finanzas e Inversión … 37 12. U.S. Weighs How tol et Banks Give Money Back by Louise Story and Eric Dash … 42 13. Assset classes and the inadequacy of labels by RGE Monitor … 44 14. Derivative Dribble by Charles Davi … 47 15. The Flight to Simplicity in Derivatives by Rick Bookstaber … 50 16. How to Grade the Stress Tests and PPIP by Adam S Posen … 51 17. Big setback for US housing market by Eurointelligence … 53 18. Japan’s Economy Shrank Record 15.2% Last Quarter (update2) by Jason Clenfield … 56 19. German “bad bank” schme criticism rejected by James Wilson 57 20. Housing: Recovering or Not? by Ben Steverman … 59 21. This crisis is a moment, but is it a defining one? By Martin Wolf... 61 22. Architecture Billing Index Stedy in April by CalculatedRisk … 64 23. Are Commodity Prices Getting Ahead of Fundamentals? By RGE Monitor … 66 24. Some Bankruptcies Are Worth It by Lee C Buchheit and David A. Skeel Jr. … 70

1 25. Wall St. Firm Draws Srutiny as US Adviser by and Michael J de la Merced … 71 26. Bos says stability pact may be useless in crisis by Eurointelligence … 75 27. Berlin forced to dilute bad bank scheme by Bertrand Benoit … 76 28. Three Month Dollar LIBOR Falls to 79 basis points by CalculatedRisk … 78 29. Vote on Fas 140 Requires the Reintermediation of at least $900bn in off –balance sheet vehicles starting in 2010 by RGE Monitor … 79 30. The perfect, the good, the planet by Paul Krugman … 80 31. As Detroit Crumbles, China Emerges as Auto Epicenter by Kendra Marr … 82 32. Weber opposes EU stress tests by Eurointelligence … 84 33. needs more than an accounting trick by Wolfgang Münchau … 87 34. Housing bubbles around the world by New N Economics … 89 35. From a Theory to a Consensus on Emissions by John M. Broder.. 90 36. BIS Report: Central Banks May Be on Cusp of Change by Joellen Perry … 93 37. El concurso de Martinsa es trágico para muchos pequeños acreedores by Julián Rodríguez … 95 38. Otro modelo, pero en serio by Michele Boldrin … 98 39. Desgravar se va a acabar by José García Montalvo … 99 40. La primavera de los zombis by Joseph E. Stiglitz … 102 41. ¿Cambiar o mejorar el modelo económico? By Antón Costas … 104 42. El Dorado no estaba en el Este by Lluis Pellicer … 106 43. El papel del ICO en la crisis by Aurelio Martínez Estévez … 108 44. La máquina del dinero divide al BCE by Claudi Pérez … 110 45. El necesario debate sobre las pensiones by César Molinas … 113 46. Hedge Fund Manager’s Farewell by …116 47. The Machinery Behind Health-Care Reform by Robert O’Harrow Jr. … 119 48. Empire of Carbon by Paul Krugman … 124

2 49. TRIBUNA: Economía global Paul Krugman. El Imperio del carbono by Paul Krugman ,,, 122 50. China Is Said to Plan Strict Gas Mileage Rules , by Keith Bradsher... 127 51. China and the liquidity trap by The Conscience of a Liberal … 129 52. Forgotten snark by Brad DeLong … 130 53. There's Something About Macro, by Paul Krugman... 131 54. Progress in Macroeconomics? By Grasping Reality with Both Hands … 133 55. Visiones “Krugmaniáticas” contra el euro by José Luis Feito … 136 56. Exchanges sense bonanza in OTC overhaul by Aline van Duyn and Anuj Gangahar … 138 57. The eurozone’s terrible recession …140 58. ECB favours using monetary policy as asset-price tool by FT.com …141 59. Bad Bank Proposal in Germany: Internal Memo Puts Toxic Assets At €800 bn by RGE Monitor … 142 60. Obama Urges Rules on Investments Tied to Crisis by Stephen Labaton and Jackie Calmes … 144 61. AIG Could Repay US in 3 to 5 Years, Chief Tells Congress by Brady Dennis … 147 62. US Pusches Ahead With Derivatives Regulation by David Cho and Zachary A Goldfarb … 149 63. A bad proposal for bansk by Eurointelligence … 151 64. Slow Start to Federal Plan for Modifying Mortgages by Tara Siegel Bernard … 154 65. China’s Heart of Gold by Victor Zhikai Gao … 157 66. The Almighty Renminbi? by Nouriel Roubini … 159 67. IMF demands stress test for EU banks by Eurointelligence… 161 68. IMF urges stress tests on European banks by Scheherazade Daneshkhu and Tony Barber and Peter Thal Larsen … 163 69. Berlin backs toxic assets plan by Bertrand Benoit … 164 70. Alarm Sounded on social by Amy Goldstein … 166 71. Recession Drains Social Security and Medicare by Robert Pear … 168

3 72. The State of Housing Markets Around the World: Not Bottoming Yet? … 171 73. 2008 in review: the downtourn accelerated at year end by Global Property Guide … 172 74. A simpler way to solve the “dollar problem” and avoid a new inflationary cycle by Domingo Cavallo & Joaquín Cottani … 177 75. Whay Obama’s conservatism may not prove good enough by Martin Wolf … 179 76. Poland is thinking abour delaying euro entry by Eurointelligence … 182 77. Is Larry Summers The Next Gordon Brown? By Simon Johnson … 184 78. Fed Watch: Turning Which Corner? By Tim Duy …185 79. Bank Stock Sales Add Billions in New Capital by Binyamin Appelbaum … 189 80. We’re Dull, Small Banks Say, but Have Profits by David Segal … 191 81. In German Suburb, Life Goes On Without Cars by Elisabeth Rosenthal … 193 82. Iceland’s new pushes EU accession by Eurointelligence … 196 83. A Return to Trend Growth in 2010? By CalculatdRisk … 198 84. Administration Plans to Strengthen Antitrust Rules by Stephen Labaton … 199 85. Investment Outlook by Bill Gross …202 86. Hacia un Nuevo capitalismo by Timothy Garton …205 87. Ten Reasons Why the Stress Tests Are “Schemess” Test and Why the Current Muddle-Through Approach to the Banking Crisis may Not Succedd by Nouriel Roubini … 208 88. Bernie ’s Secretary Spills His Secrets by Vanity Fair … 214 89. Trichet se sube al helicoptero by Claudi Pérez … 217 90. Entrevista: Economía global Jacques de Larosière coordinador del informe europeo de regulación bancaria by Alicia González … 221 91. Fine Line for Obama on How to Convey Hope on Economy by David E Sanger …224

4 92. Fannie Loses $23 Billion, Prompting Even Bigger Bailout by Zachary A Goldfarb …226 93. The Dynamically-Hedged Economy II by Doug Noland … 229 94. Employment: Comparing Recessions and Diffusion Index by CalculatedRisk … 232 95. Stressing the Positive by Paul Krugman …234 96. Hacer hincapié en lo positive by Paul Krugman … 236 97. Did dinner with Obama pay off for the White House? By salon.com…237 98. Obama’s dinner with Stiglitz and Krugman by salon.com …238 99. Prisioner of the White House by Newsweek … 240 100. Ailing Banks Need $75 Billion, US Says by Edmund L Andrews … 242 101. Stress Tests Results Split Financial Ladscape by Louise Story and Eric Dash … 245 102. US to Wind Down Help for Some Banks by Binyamin Appelbaum and Neil Irwin … 248 103. Friedrich Hayek as a Teacher by Mises Daily … 251 104. A few surprises from the ECB by Eurointelligence … 254 105. Lessons of the Global Financial Crisis: 3. Built to fail by Eurointelligence …257 106. Stress Test Result Watch: Banks Scramble To issue Common … 263 107. ECB Adopts Active Credit Easing and Extends Term Loan To 1 Year … 266 108. April Junk Return Highest In 22 Years: Are Investors Over-Optimistic? … 267 109. La reforma de la Ley Concursal by Diario juridico.com Derecho y Noticias Jurídicas … 270 110. President Obama, Cut Corporate Taxes Instead by Michael Mandel … 273 111. How Private Could Rev Up the U.S. Economy by Peter Carbonara and Jessica Silver Greenberg … 275 112. The Perils of Global Banking by David Henry and Matthew Goldstein … 287

5 113. Virtual Currencies Gain in Popularity by Olga Kharif … 287 114. Fed Sees Up to $599 Billion in Nank Losses by David Enrich, Robin Sidel and … 290 115. Barack Obama and the carmakers by Claudio Munoz … 294 116. Capitalism in Crisis by Richard A. Posner …296 117. Stress Test Finds Strength in Banks by Binyamin Appelbaum … 299 118. As Stress Tests Are Revealed, Markets Sense a Turning Point by Erich Dash and Louise Story …302 119. Grading the Bank’s Stress Test by The Editors … 305 120. More Stress Test Leaks: , JP Morgan, AmEx all Pass by CalculatedRisk … 309 121. Senate Passes Expanded FDIC Credit Line by CalculatedRisk … 310 122. Czech Senate approves Lisbon Treaty by Eurointelligence … 311 123. “Ecomafia”, 20.500 millones de beneficio by Miguel Mora … 314 124. Fomc 2003 Transcripts: Bernanke Willing to Lower Rate to Zero by Brian Blackstone … 316 125. Assessing Stress Test Methodology And Results: Faces $35bn Capital Shortfall? By RGE monitor … 317 126. FAS 140 Consolidation of Variable Interest Entities (VIE) and QSPES: “Stress Test” Metohodlogy Envisions $900 bn by RBE Monitor … 319 127. Time For Basel III? EU Adopts Higher Capital Requirements And Charges For Structured Securities by RGEMonitor … 320 128. EU Revamps Bank Capital, Asset-Backed Rules in Crisis (Update1) by John Rega … 321 129. Regulators’ new blueprint for bank supervision avoids the trickiest bits by Economist.com … 323 130. RGE Monitor’s Newsletter: The Impact of the Bankruptcy by RGEMonitor … 324 131. U.S. Says Bank of America Needs $33.9 Billion Cushion by Louise Story and Eric Dash … 327 132. As Investors Circle Ailling Banks, Fed Sets Limits by Eric Lipton … 330

6 133. Bank Tests Yield Early Progress by Binyamin Appelbaum … 334 134. Obama Targets Overseas Tax Dodge by Lori Montgomery and Scott Wilson … 336 135. Obama Calls for New Curbs on Offshore Tax Havens by Jackie Calmes and Edmund L Andrews … 338 136. Obama Plan leaves One Path to Lower Taxes Wide Open by Lynnley Browning … 341 137. What’s left of central bank independence? by Willem Buiter … 343 138. Where Home Prices Crashed Early, Signs of a Rebound by David Streitfeld … 354 139. Bailout Justice by John Ashcroft … 357 140. Distressed Debt Investors Dictate The Terms: How Big An Issue Are “Empty Creditor” With CDS Hedges? By RGEMonitor … 359 141. “Big Bang” In The CDS Market: Industry Group Adopts Standardized Rules “Plain Vanilla” CDS by RGEMonitor … 361 142. “Empty Creditors” and the Crisis by Henry T.C. Hu … 363 143. Inflation Nation by Allan H Meltzer … 1365 144. Falling Wage Syndrome by Paul Krugman … 368 145. Bank capital hocus-pocus … 369 146. Geithner’s New Bank Fix Is Bogus, Too by Henry Blodget … 370 147. Basel II: International Convergence of Capital Measurement and Capital Standards: A revised Framework-Comprehensive Version Part. 2 …373 148. Lessons of the Global Financial Crisis 1. The End of Ponzi Prosperity by Satyajit Das … 374 149. Lessons of the Global Financial Crisis: 2. Whatever it takes by Satyajit Das … 378 150. Tests of Banks May Bring Hope More Than Fear by David Leonhardt … 382 151. Las inmobiliarias bajan precios para contener la competencia de la banca by Lluis Pellicer … 385 152. El PP pide que el Estado no pueda emitir deuda opaca by Agencias … 386 153. La crisis de nuestros principales clientes dificulta la recuperación por la vía del sector exterior by El Pais … 387

7 154. La revuelta de la desigualdad by Ulrich Beck … 388 155. The recession and the return of taxes by FT.com … 391 156. must learn from Japan’s experience by FT.com … 392 157. La locomotora europea entra en vía muerta by Juan Gómez … 394 158. La era de Gordon Brown se desvanece by Walter Oppenheimer … 398 159. Dilema en las pensiones privadas latinoamericanas by Carmelo Mesa-Lago … 400 160. As a Profesor, a Pragmatist about the Supreme Court by Jodi kantor … 403 161. Chrysler’s fall may help administration reshape GM by David E.Sanger and Bill Vlasic … 406 162. The Swiss and Their Secrets by The Times … 409 163. How Got Its Real Estate Fix by Devin Leonard … 410 164. Tres mujeres sin piedad by Miguel A. Noceda … 417 165. El Banco de España desvela múltiples irregularidades en la gestión de CCM by Miguel Angel Noceda … 418 166. OP-ED Columnist by Paul Krugman … 421 167. La banca ya no quiere más viviendas by Yolanda Duran … 423 168. The Lenders Obama Decided to Blame by Zachery Kouwe … 426 169. Obama Brings a Hans-On Style to Detaoñs. Big and Small by Peter Baker … 428 170. The Chrysler Bankruptcy by New York Times … 429 171. Chrysler to File Bankruptcy, Obama Unhappy with “Money People” by Rolfe Winkler … 431 172. Chrysler Bankruptcy: Were CDSs the culprit? By Alex Salkever … 432 173. Does the U.S. Need an Auto Industry? By Room for Debate … 434 174. Banks Exposure to the Declining Commercial Real Estate: Whro Holds Toxic CMBSs? By RGEMonitor … 438 175. Chrysler headed for bankruptcy by Eurointelligence … 440

8 176. Lenihan on the ECB and the Guarantee by Karl Whelan … 441 177. Shifting ownership of Irish banks by Patrick Honoban … 442 178. Chrysler Bankruptcy Looms as Deal on Debt Falters by Zachery Kouwe and Michlines Maynard … 445 179. Shareholders Oust Bank of America Chief as Chairman by Louise Story … 446 180. As Detroit is Remade, the UAW Stands to Gain by Micheline Maynard and Nick Bunkley … 449 181. For inmediate release by press release …451 182. The credit crunch is coming by Eurointelligence … 452 183. Is 2009 the new 1929? Current Crisis Shows Uncanny Parallels to Great Depression by Spiegel Staff … 455 184. Talking the Downturn on the Chin, Why is Germany so calm? by Juan Moreno … 470 185. Navigating Towards Bretton Woods 3? By RGEMonitor … 474 186. Running a Current Account Deficit of 10% of GDP: is a Sudden Stop A Real Possibility? By RGE Monitor … 478 187. Intra-EMU Spreads: Will There Be a Sovereign Default in Europe by RGEMonitor … 479 188. The Last Temptation of Risk by Barry Eichengreen … 481 189. European Socialists: barroso will stay on even if we win by Eurointelligence … 487 190. Export reliance not sustainable for Germany by Chris Bryant …487 191. fears hedge fund “” by Peggy Holliger … 489 192. Europe’s banking crisis is much worse than we thought by Wolfgang Muchau … 492 193. Assessing Stress Test Methodology and Results: and Bank of America Told To raise More Capital by RGEMonitor … 495 194. AIG acts to avoid default riske by Francesco Guerrera …499 195. Italy Seizes Millions in Assets From Four Banks by Claudio Gatti … 500 196. Morgege Modification Bill Faces Trouble in Senate by Renae Merle … 502

9 197. The Ethical Executive: Becoming Aware of the Root Causes of Unethical Behavior: 45 Psychological Traps That Every One of Us Falls Prey To by Robert Hoyk and Paul Hersey … 503 198. Money for Nothing by Paul Krugman … 504 199. Geithner, as Member and Overseer, Forget Ties to Finance Club by Jo Becker and … 508 200. German toxic waste totals over €800 bn by Eurointelligence … 519 201. IMF says national deficits to remain Sky -high by Chris Giles and Krishna Guha … 305 202. IMF says existing stimulus could suffice by Chris Giles … 520 203. Eurozone banking needs a co-ordinated strategy by Wolfgang Munchan … 521 204. The case for a European rescue plan by Wolfgagn Munchan … 522 205. Internal paper of the Bafin by Sueddeutsche.de … 525 206. Appears strange about the occurrence by Guido Bohsem, Martin Hesse and Claud Hlversscheidt … 526 207. Union aims at 90-per cent solution Hypo real Estate by Piously … 527 208. Government is responsible for scrap papers The Bad bank comes by G Bohsem u S Holl … 529 209. Bank Balance Sheet: Liquidity and Solvency, part 1 by CalculatedRisk … 531 210. Krugman Worries about L-Shaped Recession by CalculatedRisk … 534 211. With Stress Test Results in Hand, Banks May Need to Boost Capital by Binyamin Appelbaum …535 212. Labour’s affair with bankers is to blame for this sorry state by FT.Com … 537 213. Reclaiming America’s Soul by Paul Krugman … 539 214. U.S. to Tell Big Banks the Results of Stress Test by Eric Dash … 542 215. Bank Stocks Slid After Blogger Gave His Scoop on Stress Tests by Tim Arango … 544

10 216. Plight of Carmakers Could Upset All Pension Plans by Mary William Walsh … 546 217. Tracking Loans Through a Firm That Holds Millions by Mike McIntire … 549 218. Credit Card Reforms Pressed by Obama by Michael A Fletcher and Nacy Trejos … 553 219. Is Fiat buying Chrysler or Opel or both? By Eurointelligence …556 220. Catastrophic to Awful the Banking Spin Cycle by Satyajit Das … 559 221. Methods to identify systemic financial risks by Brenda González- Hermosillo, Christian Capuano, Dale Gray, Heiko Hesse, Andreas Jobst, Paul Mills, Miguel Segoviano y Tao Sun … 563 222. How to Undestand the Disaster by Robert M Solow … 567 223. Fundamentally Different by John B Judis … 575 224. As Housing Market Dips, More in US Are Staying Put by Sam Roberts … 578 225. Accounting Change Boosts Wels Fargo by Binyaming Appelbaum … 581 226. Forget global imbalances, it is now a Sino-American imbalance by bsetser … 582 227. A Chancellor flying on a wing and a prayer by Martin Wolf … 585 228. For Housing Crisis, the End Probably Isn’t Near by David Leonhardt … 588 229. IMF says crisis will last many years by Eurointelligence … 591 230. Weber hist out at Brussels by James Wilson and Ralph Atkins … 592 231. Transcript of FT interview with Axel Webel, president of the Bundesbank by Ralph Aftins … 593 232. How economics lost sight of real world by John Kay … 603 233. Why the green shoots of recovery could yet wither by FT.com … 605 234. Banks in Europe Lag in Recovery by Anthony Faiola … 608 235. How the US will Save GM and Chrysler by Steven earlstein … 610

11 236. Quadrangle is Facing Questions Over Pension Funds by Louise Story … 612 237. Nabk tests we should get stressed about by Mohamed El-Erian … 615 238. IMF Boosts Global Loss Estimate to $4.1 Trillion: $2.7 T US Originated, $1.2T in EU; $150bn in Japan by Rge Monitor … 617 239. Stress Tests Underway: IMF Says US Banks Need $275-500 bn Caital Injections For Tangible/Asset Ratio of 4-6% by RGE Monitor … 619 240. Germany Ponders Bad Banks Toxic Waste urgently Seeking Dump by Beat Balzli … 623 241. Socialists want to turn hedge fund regulation into election issue by Evro Intelligence … 626 242. Bank Aid Programs Are Seen as Open to by Edmund L Andrews … 631 243. Back to 1960 by Izabella Kamiska … 633 244. With son in remission, family looks for coverge by Kevin Sack … 634 245. Civil Lawsuit Over Katrina Begins by Jon Schwartz … 637 246. The central bank panif of 2008 by bsetser … 639 247. A crisis of Ethic Proportions by John C Bogle … 642 248. Turnaround Lesson by Barry Riholtz … 644 249. End of Economic gloom? Not as Early as you wis. Roubini’s latest article for project Syndicate by RGE Monitor … 645 250. Judge Richard Posner Questions his free-market faith in “A failure of Capitalism” by Marcus Baram .. 648 251. Steve Forbes interviews Nouriel Roubini The Roubini Recovery by RGE Monitor … 651 252. Sifting through past FDIC troubled asset auctions: average 56 cents on dollar value implies additional $1 trillion writedowns by RGE Monitor …660 253. Bernanke is fighting the last war by Anna Schwartz … 662

12 Opinion

May 22, 2009 OP-ED COLUMNIST Blue Double Cross By PAUL KRUGMAN That didn’t take long. Less than two weeks have passed since much of the medical- industrial complex made a big show of working with President Obama on health care reform — and the double-crossing is already well under way. Indeed, it’s now clear that even as they met with the president, pretending to be cooperative, insurers were gearing up to play the same destructive role they did the last time health reform was on the agenda. So here’s the question: Will Mr. Obama gloss over the reality of what’s happening, and try to preserve the appearance of cooperation? Or will he honor his own pledge, made back during the campaign, to go on the offensive against special interests if they stand in the way of reform? The story so far: on May 11 the White House called a news conference to announce that major players in health care, including the American Hospital Association and the lobbying group America’s Health Plans, had come together to support a national effort to control health care costs. The fact sheet on the meeting, one has to say, was classic Obama in its message of post- partisanship and, um, hope. “For too long, politics and point-scoring have prevented our country from tackling this growing crisis,” it said, adding, “The American people are eager to put the old Washington ways behind them.” But just three days later the hospital association insisted that it had not, in fact, promised what the president said it had promised — that it had made no commitment to the administration’s goal of reducing the rate at which health care costs are rising by 1.5 percentage points a year. And the head of the insurance lobby said that the idea was merely to “ramp up” savings, whatever that means. Meanwhile, the insurance industry is busily lobbying Congress to block one crucial element of health care reform, the public — that is, offering Americans the right to buy insurance directly from the government as well as from private insurance companies. And at least some insurers are gearing up for a major smear campaign. On Monday, just a week after the White House photo-op, reported that Blue Cross Blue Shield of North Carolina was preparing to run a series of ads attacking the public option. The planning for this ad campaign must have begun quite some time ago. The Post has the storyboards for the ads, and they read just like the infamous Harry and Louise ads that helped kill health care reform in 1993. Troubled Americans are shown being denied their choice of doctor, or forced to wait months for appointments, by faceless government bureaucrats. It’s a scary image that might make some sense if private health insurance — which these days comes primarily via HMOs — offered all

13 of us free choice of doctors, with no wait for medical procedures. But my health plan isn’t like that. Is yours? “We can do a lot better than a government-run health care system,” says a voice-over in one of the ads. To which the obvious response is, if that’s true, why don’t you? Why deny Americans the chance to reject government insurance if it’s really that bad? For none of the reform proposals currently on the table would force people into a government-run insurance plan. At most they would offer Americans the choice of buying into such a plan. And the goal of the insurers is to deny Americans that choice. They fear that many people would prefer a government plan to dealing with private insurance companies that, in the real world as opposed to the world of their ads, are more bureaucratic than any government agency, routinely deny clients their choice of doctor, and often refuse to pay for care. Which brings us back to Mr. Obama. Back during the Democratic primary campaign, Mr. Obama argued that the Clintons had failed in their 1993 attempt to reform health care because they had been insufficiently inclusive. He promised instead to gather all the stakeholders, including the insurance companies, around a “big table.” And that May 11 event was, of course, intended precisely to show this big-table strategy in action. But what if interest groups showed up at the big table, then blocked reform? Back then, Mr. Obama assured voters that he would get tough: “If those insurance companies and drug companies start trying to run ads with Harry and Louise, I’ll run my own ads as president. I’ll get on television and say ‘Harry and Louise are lying.’ ” The question now is whether he really meant it. The medical-industrial complex has called the president’s bluff. It polished its image by showing up at the big table and promising cooperation, then promptly went back to doing all it can to block real change. The insurers and the drug companies are, in effect, betting that Mr. Obama will be afraid to call them out on their duplicity. It’s up to Mr. Obama to prove them wrong.

May 19, 2009, 7:13 am Actually existing Minsky So I’m actually reading Hyman Minsky’s magnum opus, here in Seoul. (Yay Amazon Kindle; boo its habit of crashing every hour or so, and having to be reset. Are other people having that problem?) And I have to say that the Platonic ideal of Minsky is a lot better than the reality. There’s a deep insight in there; both the concept of financial fragility and his insight, way ahead of anyone else, that as the memory of the Depression faded the system was in fact becoming more fragile. But that insight takes up part of Chapter 9. The rest is a long slog through turgid writing, Kaleckian income distribution theory (which I don’t think has anything to do with the fundamental point), and more.

14 To be fair, it took me several decades before I learned to appreciate Keynes in the original. Maybe a reread will make me see the depths of Minsky’s insight across the board. Or maybe not. I guess the point is that you can be a bad writer and a great economist. And I really am gravitating toward a Keynes-Fisher-Minsky view of macro, although of the three I’d much rather read Keynes.

May 17, 2009, 7:59 pm The night they reread Minsky Brad DeLong offers a neat little model of speculative fluctuations in asset prices, based on the idea that investors gradually switch strategies based on what seems to work for other people: if people buying stocks seem to be doing well, more people move into stocks, driving up prices and making stocks look even more attractive. It’s very close to Shiller’s notion of bubbles as natural Ponzi schemes. And Brad’s version is very much what I was saying in this piece written in 1999 — one I had a lot of fun writing. What’s missing, as Brad himself points out, is the asymmetry of booms and crashes. What he doesn’t say is that what we really need is a model that can produce a Minsky moment — the point at which margin calls force deleveraging. I’ll be giving the Robbins Lectures at the LSE next month. The title of this post is also the title of my third lecture. I hope I actually have a model by then …

15

Tax on Medical Benefits Gains Traction Health-Care Overhaul Could Be Funded by Levy on Employer-Paid Insurance Premiums By Lori Montgomery Washington Post Staff Writer Friday, May 22, 2009 A new tax on employer-provided health insurance is emerging as a likely option to finance an overhaul of the nation's health-care system, key Democrats say, despite opposition from organized labor and possibly the Obama administration. Critical details have yet to be resolved, including whether to tax the benefits of all workers regardless of income and what portion of their employer-paid insurance premiums to tax. But the idea won a surprising degree of acceptance during a closed- door meeting of the Senate Finance Committee this week, according to several people present. And once-fierce opposition among House Democrats is softening as lawmakers confront their limited options for raising the estimated $1.2 trillion that will be needed to pay for reform over the next decade. "There's a strong sentiment that still exists in the House" against taxing employer- provided benefits, said Rep. John B. Larson (D-Conn.), a member of House leadership who sits on the tax-writing Ways and Means Committee. "But we understand how important it is to get a package through." Implementing such a tax would create a tricky political situation for President Obama, who last year spent millions on campaign ads that harshly criticized a similar idea advanced by his Republican opponent, Sen. John McCain of Arizona. But while continuing to express opposition to the proposal, White House officials have repeatedly stated that all financing options are on the table. And some Democrats are already calculating how to explain a reversal. That task may have been made easier this week when congressional Republicans proposed using the tax to finance their own health-reform blueprint, lending the idea a bipartisan stamp of approval. Excluding employer-provided benefits from taxation "is one of the distortions in the health-care marketplace that needs to be fixed," said Rep. Paul D. Ryan (R-Wis.), one of the plan's authors. "It was put in place in the mid-20th century when everyone had the same jobs for most of their lives. And we don't live like that anymore." According to U.S. Census data, 177 million Americans received health insurance from their employers in 2007, the most recent year for which data are available. Nearly two- thirds of people under 65 have at least some of their insurance premiums paid by their own employer or that of a family member. Under current law, those benefits are not taxed as income, one of the largest loopholes in the U.S. tax code. If the loophole were eliminated, congressional tax analysts estimate that the IRS would have collected an extra $133 billion last year alone.

16 Senate Finance Committee Chairman Max Baucus (D-Mont.), who expects to unveil health-reform legislation next month, has said he is not interested in closing the loophole, but in establishing limits. Among the options: Taxing only the benefits of high-earning individuals who make at least $200,000 a year ($400,000 for families). Or taxing benefits for all workers above some pre-set amount. One figure under discussion is $13,000, the national average value of employer-provided coverage for families. Both options have disadvantages. Taxing only wealthy families, for example, "doesn't make sense," said Sen. John F. Kerry (D-Mass.), because it would raise too little money -- only about $160 billion over 10 years, according to Finance Committee aides. But "you've got to be very careful how far you go" down the income ladder, Kerry said. "If you come down too low, you're impacting workers and threatening the employer-based system." Some Democrats are particularly concerned that the tax would fall heavily on union members, who tend to have generous health packages sometimes derided as "Cadillac" plans. But those plans are expensive because they include dental and vision benefits, large provider networks and low co-payments -- "things every American wants and should have," said Richard Kirsch, national campaign manager of Health Care for America Now, a coalition of unions and community organizations. Kirsch yesterday endorsed an alternative tax plan drafted by Citizens for Tax Justice that would target corporations and the wealthy for $1 trillion in tax increases over the next decade. Capping employer-provided health benefits would generate around $500 billion over the next 10 years, by various estimates, and key Democrats say it may be the only politically viable option for raising that kind of cash. "Everyone hates it," said a member of the House Ways and Means Committee, speaking on condition of anonymity because he has yet to discuss the issue with his colleagues. "But where else do you go?" http://www.washingtonpost.com/wp- dyn/content/article/2009/05/21/AR2009052104184_pf.html

17 Opinion

May 22, 2009 OP-ED CONTRIBUTOR Golden State Bailout By JOE MATHEWS Los Angeles IS California too big to fail? That’s the question President Obama and Congress will soon face. While many states have severe fiscal problems, the depth and unusual persistence of California’s budget problems — the state has run deficits for most of the decade — has emptied Sacramento’s till. On its current path, California will run short of the cash it needs to pay its bills in late July. It’s highly unlikely that the state’s political leaders will be able to fix the problem themselves. Typically, states build up a cushion of tax revenues in the spring to pay expenses through the fall, when little cash comes in. But enormous drops in tax revenue have left California without the savings to meet even one month’s worth of expenses. The other methods of cash management — transfers to the general budget from other state accounts and short-term borrowing in the credit markets — are no longer enough to address the problem. California’s leaders have drawn so deeply in recent years on the state’s hundreds of special funds that there is little cash left to repurpose. And selling short-term notes in the credit markets is difficult because of California’s credit rating, the lowest of any state. Even if the state could pay high interest costs, California may require more cash — more than $20 billion by some estimates — than it can plausibly acquire in the markets. It is true that California’s Legislature and governor, Arnold Schwarzenegger, could take bold action to conserve cash. But the size of the deficit and the state’s governing system make such action next to impossible. A two-thirds vote of the Legislature is required to pass any budget or raise any tax in the state, and compromise has become a dirty word. A legislative deal reached in February to address part of the budget problem came under such fierce attack from the left (for its spending cuts) and from the right (for its tax increases) that voters rejected five of its major components in a special election on Tuesday. The state Republicans, egged on by right-wing talk radio hosts, have started campaigns to recall two Republican lawmakers who voted for the compromise. California is not a patient that can heal itself. What to do? Bankruptcy would appear to be out. Federal law authorizes only local , not states, to seek bankruptcy protection. Yet in California, irresponsible voices on the right (and a few on the left) have suggested testing the limits of the law and forcing the state to begin to delay or default on its obligations. That would be a disaster, not only for California, but also for the country. Financial analysts fear that the failure of California’s government could further damage the state’s economy (and by extension, the nation’s) and shake confidence in the bond markets,

18 making it difficult for cities and counties to borrow and perhaps sending some local governments into real bankruptcy. Others in Sacramento — including the Assembly speaker, Karen Bass, and the state treasurer, Bill Lockyer — are investigating the possibility of federal assistance. This could take several forms. The Treasury could offer guarantees on any short-term bonds that California sells to raise cash. Or money from the Troubled Asset Relief Program could be used to backstop such notes. Or Washington could speed up some of the stimulus money earmarked for the state. Each of those ideas, or a combination of the three, offers hope. However, as a condition of any assistance, the federal government should charge the state a fee that includes penalties if it fails to make major changes in its budgeting process. At a minimum, California should be required to submit for federal approval a multiyear plan to meet its obligations and to eliminate its structural deficit. Washington might also require the establishment of a board to oversee state finances. (Federal loan guarantees to in the 1970s provide one model.) There would be fierce resistance to federal aid. Other states may wonder why California deserves special attention — it’s a fair point, and it might be wise for the government to offer similar guarantees to other states in distress. California officials might worry about the loss of sovereignty. And Democrats in the administration and Congress, many of them Californians, may be tempted to help a Democratic state without conditions. But they shouldn’t. By attaching strings to any aid, the federal government would give the state its best chance at saving itself. Most important, President Obama should press California’s elected officials and its voters — 61 percent of whom supported him last November — to make constitutional changes. Among these would be the elimination of the gridlock-creating two-thirds vote for budgets and tax increases, and new curbs on ballot initiatives that mandate spending for popular programs without identifying new tax dollars to pay for them. Federal officials may resist intervening at first, out of misplaced caution. But the combination of the state’s size and its dysfunction means that Washington will probably have to intervene sooner or later. There can be no American recovery if California collapses. Joe Mathews is a senior fellow at the New America Foundation. http://www.nytimes.com/2009/05/22/opinion/22mathews.html?th&emc=th

19

22.05.2009 S&P warns of a rating downgrade for the UK

As the UK is heading for a debt-to-GDP ratio of 100%, S&P has warned of a possible downgrade. The news had big effects in financial markets yesterday and send the euro higher. The news also affected the US, where dollar and US bonds came under pressure amid expectations that the same could happen over there too, given that the US in a similar position (among others Bill Gross of Pimco apparently thinks so). The FT quotes S&P as saying that such high levels of debt in the UK were not consistent with a triple A rating. The article also said that France and Germany may also be subject to a credit downgrade, given their evolution of debt levels. Martin Wolf on the UK’s obsession with finance Martin Wolf notes that the UK’s tragedy consists of having a competitive advantage in an irresponsible industry – finance. The long-term solution for the UK is to reduce its dependence on finance. He says the financial sector produces strong and negative externalities, and one should deal with finance as one deals with polluters – one should tax it. Another of his recommendations is to create a much more diversified business environment. Why it is going to get tougher for the US Writing in Vox, Christian Broda , Piero Ghezzi, and Eduardo Levy-Yeyati, write that In a new financial landscape in which leverage is limited by worldwide regulation and the gradual digestion of toxic assets will weigh on bank’s balance sheets, the US will face tougher terms to finance its external imbalance. Perfectly at odds with the global imbalance premonitions of the early 2000s, the dollar’s weakness will likely be the best gauge of the turnaround of the global crisis.

German banks pass on interest rate cuts FT Deutschland looks at the Bundesbank’s monthly report which says that German banks pass on interest rate cuts after all. Of the interest rate cuts, 80% were passed on to customers in the normal credit business, and 60% for mortgages, which is about an average figure – though these still jar with warnings from consumer organisations and

20 even central bankers who said those were not sufficiently being passed on. The Bundesbank report also made the point that the same applies to other euro area member states. Towards a new global currency FT Deutschland has a long report today about the recommendations of the Stiglitz committee, which has kickstarted a discussion process that might lead to a new global currency. The committee has published its recommendation ahead of the UN summit early June in which the future global monetary system is on the agenda. One of the frequently discussed options is the use of special drawing rights, but this is not yet feasible. The article concluded with a quote from Stiglitz who said that the question is not whether the dollar will be abandoned as the dominant global currency but whether this will happen in an orderly or chaotic manner. An ingenious way to solve the crisis: Just ignore it El Pais leads its economics section with a story that the Bank of Spain is considering proposals to relax the provisions under which banks have to account for bad or doubtful loans. At present, certain categories of loans have to be provisioned if pay arrears reach 90 days. The immediate consequence of a rule change would be to raise banks profits – although nothing will have changed in reality. (This is one of those now-you-see-me- now-you-don’t accounting exercises which are getting more popular in Europe).

European elections watch A Le Monde Editorial condemns the European elections as a missed opportunity for Europe, a result of many factors: hardly known candidates; an evaluation process that is more of a recycling of national politicians instead of an attempt to define future leaders for Europe; nation-centric debates based on the popularity or otherwise of national governments; and the failure, so far, to ratify the Lisbon Treaty that would have give the European Parliament greater powers in the nomination of the next European Commission.

Munchau about the social market economy Writing in FT Deutschland in the series on the 60th anniversary of the Federal Republic, Wolfgang Munchau says that Germany’s Social Market Economy is not a model for the rest of the world, not even today in the midst of the crisis. One of the big features of the system is the Landesbanken, semi-state-owned banks through which politicians exercise influence. Yet, it was those LBs that were among the biggest buyers of credit market securities during the crisis, and which are now most in trouble. Of the many institutions the Social Market Economy has created, none would have helped another country in this crisis. However we define the problem of Anglo-Saxon capitalism, the Social Market economy is not the solution.

Comments on Bank Rescue Tett on the public-private partnership to buy up toxic assets The US bank bailout plan is unlikely to fly, according to Gillian Tett in the , because the auctions are likely to come in at much lower than the rates at which banks are prepared to sell. In this case, the banks would have to account for large losses in the short-run which they are not prepared to. She said that some of the larger banks

21 have adopted a policy of “quiet footdragging”, quoting one bank’s agreement to participate in a pilot scheme as a matter of goodwill, but not to continue thereafter. There seems not much optimism about whether the Geithner plan can work. Snower on the same Dennis Snower, writing in Vox, says that under the threat of the financial crisis, US banks have received, without much controversy, huge bailouts. This column argues that the rescue plan ought to act as an automatic stabiliser, providing large bailouts to those institutions whose toxic assets turn out to be worth little and smaller bailouts to those whose toxic assets are worth more. But that is precisely what the Geithner Plan doesn’t do. Ahearne on the Irish banking scheme Writing in the Irish Times, Alan Ahearne says the approach of the Irish government (which he now advises) is to establish an asset management company (NAMA), to buy property and development loans from the banks at a discount through the issue of government bonds to the banks. These bonds will add to the gross stock of public debt, but so long as the valuation of loans is roughly correct, there will be no change in net public debt. Nama’s assets and liabilities will roughly match. He explains why this is a better scheme than Germany’s idea to freeze the debt.

22 May 21, 2009 UK Credit Rating Outlook Downgraded: Sovereign Debt Crisis Ahead? • May 21: S&P put UK's AAA sovereign debt rating on negative watch as it foresees UK public debt rising to 100% of GDP in medium-term, which is more characteristic of an AA rating than the UK's current AAA. Gilt yields have risen on concerns of increased supply as government spending increases to boost the ailing UK economy. Analysts believe actual public borrowing will exceed official forecast in UK Budget report Rating Outlook o Britain will have a deficit of 11% of GDP in 2010, the highest in the Group of 20 o Fitch: One of the fastest rates of increase in government debt will be in the UK partly reflecting the size of the underlying fiscal deficit before the crisis. UK government gross debt will reach the Maastricht guideline of 60% of GDP by 2010, highest level since mid-1970s. The potential for sovereign rating downgrades over the medium term has therefore increased, especially if government fails to put in place credible medium term fiscal strategies to restore public finances to health once an economic recovery is underway early in the next decade o ML: Recent rises in government CDS spreads could be unwarranted. In the short term, there will be large impacts upon public sector net borrowing and debt potential. But medium-term costs to the government from the various banking- system support schemes should be relatively small, particularly in relation to their aggregate size of hundreds of billions of pounds o See related Spotlight Issue: The Rating Agencies' Take on Sovereign Risk in the G7 Performance o May 21: After S&P put UK debt rating on negative watch, 10-year Gilt yield rose to 3.71% before dropping back to 3.63% on a successful auction of 5yr gilts. The on 10yr Gilts over German Bunds widened to 24bp - still narrower than on Jan 20. 5yr CDS premium rose to ~80bp - still below all-time high on Jan 21 o Apr 22: 5yr CDS on British debt reached 95bp, much higher than chocolate giant Cadbury's 50bp, after government said its net borrowing will reach 1/8 of GDP in 2010 o Apr 1: U.K. successfully auctioned off all 3.5 billion pounds ($5 billion) of six-year notes

23 o Mar 25: 40yr gilt auction failed for the first time since 2002 due to buyer shortage for GBP1.75bn (US$2.55bn) of bonds. Investors bid for 93% of bonds offered. Confidence boost from QE was not enough to attract investors o Mar 11: BoE began purchasing gilts to push down yields. 10-year gilt yield fell to 3.08% o Jan 21: 5yr credit default swaps on British debt reached an all-time high of 148bp o Jan 20: U.K. government bonds slumped after Chancellor Darling announced the second bank rescue in three months, raising the specter of more public borrowing. The yield spread on 10yr Gilts over German Bunds doubled to 53bp Supply Outlook o Oil n Gold: For 2009-10, the government will issue a record volume of new gilts - perhaps up to 260 billion pound ($377bn) - resorting to 'syndicated sales' through commercial banks in a bid to avoid a buyers' strike o Nomura: The 2009-10 Budget implied a £220bn DMO Gilt issuance remit. The authorities are loading a good proportion of the additional issuance into the BoE buyback sweet spot on the curve and signaling their intentions to use syndication as an alternative. o BNP: The Chancellor's budget projections remain overly optimistic – pointing to the risk of even higher borrowing than the official estimates as of April 2009. The official estimate for government spending growth this year was revised up from <5% y/y to 7.7% y/y. However, the early 1990s recession showed that with unemployment surging, the pace of increase in government outlays is likely to be between 10% y/y and 15% y/y. Furthermore, the Chancellor is premature in his assumption that borrowing as a percent of GDP begins to shrink as soon as 2010 Yield Outlook o Citigroup: We remain somewhat bearish on gilts, on the grounds that the bulk of growth downgrades are past, inflation probably will remain sticky, the fiscal deficit is on an unsustainable path, and policy is underpinning risk assets. o (not online): Gilts 2-10-yr slope is too steep. The market is pricing in steeper curves than what is warranted by macroeconomic fundamentals in the countries where policy rates have not approached the zero bound, while countries that have effectively hit the zero bound are priced in line with fundamentals. From a practical standpoint, 2-10-yr flatteners look attractive in the Gilts term structure, both from a valuation standpoint, as well as because of the exposure to direct purchases of Gilts by the BoE o Dresdner: Gilt market returned around 8% in 2008 in the face of UK recession and sharply lower rates. In 2009, low rates and the deflationary forces of the downturn are likely to outweigh record levels of Gilt issuance. Yields are set to fall further http://www.rgemonitor.com/475/United_Kingdom?cluster_id=4970

24 COLUMNISTS: Gillian Tett Why public private plan has bankers squirming Published: May 21 2009 20:04 | Last updated: May 21 2009 20:04 Cometh the hour, cometh the acronym. Thus might run the unspoken motto of American financial policy these days. As the banking saga has unfolded in the past two years, a string of US initiatives have tumbled out, with titles so lengthy I will not attempt to list them in full. Remember the M-LEC programme that was launched to reorganise the shadow banks (but quickly died)? Then came Talf, TSLF and Tarp, which aim to provide liquidity, restart the securitisation machine and recapitalise the banks. Now a new focus is emerging. This week Tim Geithner, US Treasury secretary, said that a PPIP – or public-private investment plan – would start in early July to use $75bn- $100bn of state funds to encourage the sale of up to $1,000bn of toxic assets by banks. Part of the programme will cover loan sales and be run by the Federal Deposit Insurance Corporation; the other half, relating to securities, will be organised by the Treasury. In both schemes, asset managers will be given state finance to encourage bids. So will this latest acronym-filled endeavour work? (Or, at least, avoid the fate of the ill-starred M- LEC?) If you listen to some senior US bankers, it is easy to feel pretty doubtful that the PPIP can really fly. The key sticking point is price. The PPIP plan will work if banks take part to sell assets. But right now, no banker wants to participate in an auction that produces asset prices lower than those on bank books. After all, if that were to happen, banks would face pressure to make more writedowns – which they can ill afford. The Treasury and FDIC hope to avoid this scenario by encouraging asset managers to place high bids for the bank assets, by offering non-recourse leverage of up to five times (or far higher than non-recourse leverage available in the market). Some politicians hate that, since the details of the deals mooted so far appear to leave taxpayers with little embedded upside. That political scrutiny, in turn, makes asset managers nervous. As a result, it is still unclear whether enough asset managers will produce bids that are high enough to make the banks happy with an auction price. So some large banks are – unsurprisingly – adopting a policy of quiet footdragging. A senior official at one large bank observed this week that his group would participate in a pilot scheme, as a gesture of goodwill. But after that token gesture, this bank will probably stop. And while the government wants to set a minimum lot size of $1bn, this bank is lobbying for a figure nearer $250m to limit the auction to a few choice (token) assets. Unsurprisingly, this banker – like others – concludes that he is “not optimistic” about PPIP, not least because the urgent pressure to sell assets is receding as banks raise capital. That view may not be entirely representative: another bank tells me it is preparing to get properly involved (not least because it has the financial strength to have written many assets down). Government officials running the PPIP scheme insist there is strong

25 overall interest from potential buyers and sellers. They also point out that it need not matter if the scheme ends up being limited in size. After all, what PPIP is trying to do (like Talf and much else) is reignite market activity, not replace it. Think of it as a chunk of firelighter on a pile of wet wood. Thus, the sheer act of talking about PPIP – and then staging a few sales – may be enough to kickstart a private sector trading toxic assets again. Or so the hope in Washington goes. “Success is what happens to the market overall,” says one. They have a point, given that there is some evidence that schemes such as Talf are contributing to a market thaw. But, almost irrespective of whether PPIP “succeeds” in delivering many deals (and personally I have doubts that it will), there may be another reason to welcome it. Most notably, irrespective of the complexities of arranging deals, the PPIP has already served one extremely valuable function by highlighting the sheer insanity that has bedevilled the financial world in relation to asset prices. Most notably, if large American banks had previously marked their assets at a realistic market-based price, they would not be so scared of engaging in auctions with PPIP now. Better still, they might have spotted earlier the degree to which their assets were deteriorating – and taken action to address it. But precisely because the supposedly “” western financial system has become stuffed with complex assets that were rarely traded – even during the credit boom – banks have been able to use fantasy prices for their assets for years. Hence their continued horror at the idea of open trading. That is the real scandal that bedevils the PPIP idea. That in turn points to a wider lesson for the future: namely that to avoid a similar credit disaster, it is crucial that financiers are forced to place as much financial activity as possible on transparent trading arenas. Better still, they need to do that well before a bubble bursts – or there is any need to start fighting over whether a PPIP can truly fly.

http://www.ft.com/cms/s/0/dd321aa0-4637-11de-803f-00144feabdc0.html

26 Risk Over Reward A blog about how to think about investing, markets, economics, macro forces, industries, securities, etc. Alpha is an investor at a large buy-side firm; Vega is a trader at a major trading house. Wednesday, May 20, 2009 http://riskoverreward.blogspot.com/2009/05/asset-class-labels-vega.html Asset Class Labels - Vega The traditional classification method looks at the asset itself (commodity, equity etc). Alpha’s method looks at the investor’s claim on the asset (real, fixed, residual, or derivative). Both are important to understand the nature of an investment. For example, physical ownership of crude oil behaves very similarly to a collateralized oil future, so the traditional method does a fine job. On the other hand, a derivative claim on real estate (like a highly leveraged CDO) behaves nothing like real ownership of real estate; Alpha’s investor claims method is much more accurate in this case.

I’d like to add yet a third dimension to classifying investments that will hopefully clarify rather than complicate. That third dimension is strategy. By “strategy” I’m not referring to the strategy of the fund or portfolio (e.g. long/short), but rather the reason for purchasing a specific asset. We can categorize the purchase of any asset as arbitrage, market making, value investing, growth investing, macro, or pattern. I’m using these terms a little differently than they are usually applied to portfolio strategies. Arbitrage is strictly zero risk trading (e.g. buying a contract on one exchange and selling an identical contract on another exchange at a higher price.). I’m using “market making” to refer to an asset purchase motivated by the belief that the price has been temporarily depressed by order flow (e.g. a customer faces a margin call and is forced to sell a stock to you). Value investing means purchasing an asset below its current intrinsic value. Growth investing is purchasing an asset as a bet that its intrinsic value will increase. Macro refers to betting on political factors like interest rate changes and other systemic factors. “Pattern” refers to any kind of quantitative trading whether based on mean reversion or trend following. This third dimension is sometimes the most revealing about the risks and expected returns from an investment. For example, if you learn that a class of hedge funds are facing investor redemptions and must liquidate their portfolios, you may buy many classes of assets and investor claims from them in the belief that prices are temporarily depressed from the forced selling (market making). This strategy may be coupled with fundamental analysis that the assets are undervalued (“value investing”). The same analysis and many similar pitfalls apply whether you are buying equity derivatives or physical silver from the distressed sellers.

I think each classification method adds value, and there’s no reason to limit ourselves to just one. As an investor, I evaluate any purchase by all these criteria. We should ask the same of anyone managing our money. What type of assets are they buying? What claim to those assets do they have? Finally, why are they buying those assets? Together, the answers to these questions can help us answer the real question: what is our expected return and what are our risks?

27 vox

Research-based policy analysis and commentary from leading economists

Redistribution through the Geithner Plan

Dennis J Snower 20 May 2009

Under the threat of the financial crisis, US banks have received, without much controversy, huge bailouts. This column argues that the rescue plan ought to act as an automatic stabiliser, providing large bailouts to those institutions whose toxic assets turn out to be worth little and smaller bailouts to those whose toxic assets are worth more. But that is precisely what the Geithner Plan doesn’t do.

Under the threat of the present economic crisis, US financial institutions have received huge bailouts and guarantees. This support is leading to large increases in the national debt, which will need to be financed through taxes in the future. In the process, a massive redistribution of income is under way (Sachs 2009). The public is vaguely aware of this redistribution and is angry about it. Why, people are asking, are we giving such generous payouts to the financiers who got us into this mess? How large might this redistribution turn out to be? Is this redistribution necessary to restore the financial industry to health? These questions are tough to answer since the banks’ toxic assets, along with the resulting bailouts and guarantees, are fiendishly complicated and opaque. Not surprisingly, strategies that are complicated and misguided receive far less public scrutiny than those that are uncomplicated and misguided. This is one reason why the financial crisis was permitted to occur – the financial instruments were too complicated for their buyers, sellers, or regulators to understand. By the same token, the complexity of Geithner Plan also contributes greatly to its chances of political success, for now most voters don’t understand the terms of the bailout. (This, I will argue, is the strongest point in its favour.) To grasp what is going on, let’s start with a simple question – what sort of policy do we need when the task is bailing out financial institutions with toxic assets? The distinguishing feature of toxic assets is that we don’t know how to value them. This lack of knowledge is what makes them “toxic.” This means that we don’t know in advance how large a bailout the institutions with toxic assets will need to enable them to survive. To deal with this sort of a problem, needless to say, we need a policy that acts as an “automatic stabiliser” – institutions whose toxic assets turn out to be worthless will need larger bailouts than institutions whose toxic assets turn out to be valuable. Consider an analogy. We don’t know what the external temperature will be when we install a heating system in our house. And we don’t need to know, provided that we have a thermostat, so that the internal temperature adjusts automatically to whatever the external temperature happens to be. Along the same lines, we now need a financial

28 rescue package that automatically adjusts to the problem at hand. The Geithner Plan pretends to be an automatic stabiliser. The official line, after all, is that the plan permits the free market system to price the toxic assets, and thereby enables the government to provide the appropriate amount of bailout. As we will see in a moment, the truth looks different. The Geithner Plan is more like a thermostat that is stuck at one temperature, so that we might freeze in the winter, but boil in the summer. Specifically, I will show that the plan can be fabulously wasteful when the banks need only modest bailouts. Then far too much money may be redistributed from the taxpayer to the financial sector. And when the banks need big bailouts, the plan may turn out to be completely ineffective. In short, this is precisely the sort of policy we want to avoid when we are faced with toxic assets. A frightening scenario To see why this is so, let’s take a simple example (for more, see Krugman 2009, Stiglitz 2009, and Young 2009). Consider an asset that has a 50% chance of being worth $100 and a 50% chance of being worthless. So the asset’s value is $50, the average of $100 and $0. (I leave you to add enough zeros to each dollar figure so that the example looks realistic to you.) Suppose that the asset is toxic, which means that we don’t yet know how to value it, since we aren’t yet aware that the asset has a 50-50 chance of yielding $100 or $0. Now let’s work out how US Treasury Secretary Geithner’s plan would deal with this asset, and how much income would be redistributed in the process. Although the arithmetic is boring, I assure you that the outcome of our calculations won’t be. They show that there is something fundamentally wrong with the Geithner Plan – it generates a potentially gigantic amount of redistribution and, furthermore, the redistribution is completely unnecessary, since it is completely irrelevant to the job of bailing out the banks. To keep my explanation simple, I will assume, in agreement with the Geithner Plan, that the right way to deal with the financial institutions that are too-large-to-fail is to bail them out with taxpayers’ money. Then all I will ask is whether the plan gives them the bailouts they need. (As a matter of fact, however, I think this assumption is wrong. In my opinion, (i) the burden of bailout out these institutions should be shared among the taxpayer, the bondholders, and the stockholders of these institutions and (ii) the appropriate instrument is debt-for-equity swaps. They, incidentally, could be made to work as an automatic stabiliser, but that is a different story.) Since the asset is toxic, its current valuation is inevitably somewhat arbitrary. So suppose that the bank currently values the asset at $55 – which is $5 more than the asset is actually worth – and if the bank were to receive $55, it would return to financial health. Moreover, suppose that a private-sector bidder indeed offers $55. Under the Geithner plan, the government finances 92% of the asset, the private bidder finances the remaining 8%, and the private bidder and government each receive the same amount of equity. If the asset costs $55, then the private bidder contributes $4.4 in equity (8% of $55). The government also contributes $4.4 in equity. So the government loan is $46.2 ($55 - $4.4 - $4.4). Recall that the asset has a 50% chance of being worth $100. If that happens, then the government loan can be repaid. The remaining profit is $53.8 (which is $100 minus the loan of $46.2). Since the private bidder and government have the same amount of

29 equity, this profit gets shared equally between them. So each gets $26.9. The private bidder’s yield is $22.5 (which is $26.9 minus the $4.4 that the private bidder paid for the asset). The asset also has a 50% chance of being worth $0, and if that happens, then the government loan can’t be repaid. So the private sector loses $4.4 (its equity stake) and government loses $50.6 (its loan of $46.2 plus its equity stake of $4.4). Let’s take stock. On average, the private sector’s gain is $9.05 (which is the average of its $22.5 gain in good times and the $4.4 loss in bad times). So the private bidder winds up with the fabulous rate of return of 205.68 % (namely, its $22.5 average gain relative to its initial investment of $4.4)! But the government, on average, makes a loss of $14.05 (which is its $22.5 gain in good times and its $50.6 loss in bad times). This means that the government is left with a horrifying rate of return of -319.32 % (namely, its average loss of $14.05 relative to its initial investment of $4.4)! Observe that the government’s average loss ($14.05) is higher than the private sector’s average gain ($9.05); the government and private sector together make a loss of $5. This is the amount they overpaid for the asset. It’s now easy to see what redistribution has taken place. $5 gets redistributed from the private bidder to the bank (since the bidder paid $55 for an asset worth $50) and $9.05 gets redistributed from the taxpayer to the private bidder. The really sad thing is that only the first payment is necessary if we wish to return the bank to health through a bailout. But under the Geithner plan, the taxpayer winds up paying $14.05. That is 181% more than was needed to save the bank! But that, unfortunately, is not the end of the story. Since the private-sector bidder made a rate of return of 205.68 % on his equity investment, the other bidders may be expected to bid up the price of the asset. The following table shows what will happen.

Table 1. Private sector bidding scenarios

Average Average Price Private Rate of Government Rate Excess Private-Sector Government Offer Return (%) of Return (%) Redistribution Gain Gain 55 9.05 -14.05 205.68 -319.32 181 60 7.6 -17.6 158.33 -366.67 252 65 6.15 -21.15 118.27 -406.74 323 70 4.7 -24.7 83.93 -441.07 394 75 3.25 -28.25 54.17 -470.83 465 80 1.8 -31.8 28.13 -496.88 536 85 0.35 -35.35 5.15 -519.85 607 As the price of the asset is bid up (from $55 to $60 to $70), the private-sector rate of return gradually falls (from 205.68% to 158.33% to 118.27%…). Eventually, once the offer price has reached $85, this rate of return has declined to 5.15%. At this point, there is little to be gained from bidding the price up further and so the price of the

30 asset may be expected stabilise at around $85. At this price, as you can see, the government’s rate of return is an eye-popping - 519.85%. Now $35 gets redistributed from the taxpayer to the bankers (since $85 was paid for an asset worth $50) and $0.35 gets redistributed from the taxpayer to the private-sector bidder. But since the bank just needed $5 to be restored to health, the taxpayer is paying in excess of 600% more than is required. Other frightening scenarios The exercise above is just one of many possible frightening possibilities. So far our calculations were based on the premise that only $5 – the equivalent of 10% of the true value of the bank’s toxic assets – is required to save the bank. But suppose that more money were required, say 20% or more of the value of the toxic assets. How would the Geithner Plan perform then? The next table shows the amounts of excess redistribution corresponding to different amounts of bailout. Table 2. Excess redistribution for different bailouts

5 10 15 20 25 30 35 55 181 60 252 76,00 65 323 111,50 41,00 70 394 147,00 64,67 23,50 75 465 182,50 88,33 41,25 13,00 80 536 218,00 112,00 59,00 27,20 6,00 85 607 253,50 135,67 76,75 41,40 17,83 1,00

The numbers in the first row are the size of the bailout. So if a bailout of $10 is required (which is 20% of the true value of the toxic asset), then the bank will accept at least $60 for the asset and thus the excess redistribution is 76%. But, as we saw in the previous table, the private rate of return is high and so the price of the asset will get bid up to $85, corresponding to excess redistribution of about 135%. In this way, the table shows clearly that as the size of the required bailout rises, so the amount of excess redistribution falls. If it should turn out – by coincidence – that the required size of the bailout ($35) is about equal to the amount by which the Geithner Plan induces the private bidders to overpay for the asset ($85 - $50 = $35), then there will be virtually no excess redistribution. But this, as noted, could only happen by accident. But what happens if even an overpayment of $35 – corresponding to 70% of the true value of the toxic asset – is insufficient to return the bank to health? Specifically, suppose that $40 (amounting to 80% of the value of the toxic asset) is required. What then? The first table gives the answer. At $40 overpayment, the asset must be valued at $90, and then the private rate of return would be about -15%, that is, the private

31 bidders would be making a loss. So clearly no private bidders would be willing to offer $90. This means that the Geithner Plan would not work, since the banks would require an overpayment in excess of what the bidders would be willing to offer. There would be no takers, and the government’s offered loan would remain unused. Then, in the absence of any further rescue package, the bank would have to default. What is the upshot of this woeful portfolio of frightening scenarios? Which one is likely to apply? The answer is as simple as it is important. We don’t know. It’s the essence of a toxic asset that we don’t know. If we knew what the asset was worth, it wouldn’t be toxic. If we knew how large a bailout each financial institutions needs, the policy response would hardly be a challenge. It is for this reason that we need a rescue plan that acts as an automatic stabiliser, providing large bailouts to those institutions whose toxic assets turn out to be worth little and smaller bailouts to those whose toxic assets are worth more. But that is precisely what the Geithner Plan doesn’t do. As the exercise above shows, far too much money is transferred from the taxpayer to the banks when these banks need only modest bailouts, whereas none might be transferred when they need large bailouts. Only through a massive coincidence could it happen that the plan transfers the right amount of equity to the banks. In short, this is a hopeless plan. Of course, it’s true that some of the redistributed money will probably make its way back to the taxpayer through pension funds, mutual funds, and other institutions that invest in the financial sector. But is this redistribution sensible? Do we want to take potentially huge amounts of money from the taxpayer and give them to the financiers, just as the economy slides deeper and deeper into recession? Do we want to rely on a policy that we know will become ineffective as soon as the banks are in really big trouble? I find it hard to believe that the American public would have accepted the Geithner plan if these possibilities had been presented to them. No, I think that the main appeal of the plan lies in its complexity, enabling voters to retain the hope – for the time being – that the banks will get the funds they need through the capitalist system, free of government control. References Krugman, Paul (2009). “Geithner plan arithmetic” 23 March. Sachs, Jeffrey (2009). “Will Geithner and Summers Succeed in Raiding the FDIC and Fed?” VoxEU.org, 25 March. Stiglitz, Joseph (2009). “Obama’s Ersatz Capitalism” New York Times, 31 March. Young, Peyton (2009). “Why Geithner’s plan is the taxpayers’ curse” Financial Times, 1 April.

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Boletín de Universia-Knowledge@Wharton http://www.wharton.universia.net 20 Mayo - 2 Junio, 2009 Publicado el: 20/05/2009 ¿Es la deflación una seria amenaza? Cuando los ordenadores y los televisores de pantalla plana bajan de precio la mayoría de la gente se alegra. Pero la deflación real, esto es, un descenso generalizado de los precios y de los ingresos, es otra historia. De hecho, la deflación fue uno de los desastres de la Gran Depresión. Desde que los economistas detectaron ciertas tendencias deflacionistas en Estados Unidos, la mayor parte de Europa y algunas partes de Asia, esta primavera el término ha aparecido en diversas ocasiones en las noticias. ¿Tendremos deflación? Y en caso de tenerla, ¿será realmente grave? Los expertos no acaban de ponerse de acuerdo en relación con la primera cuestión; algunos sostienen que la deflación podría ser generalizada mientras otros insisten que la recuperación económica y los programas de estímulo del gobierno disipan prácticamente toda probabilidad de deflación. Entre aquellos que creen que la deflación ya ha llegado –o está a las puertas-, pocos esperan que vaya a ser un problema realmente serio. Muchos admiten que sus predicciones podrían ser erróneas, concediendo excesiva importancia a las enormes incertidumbres sobre la situación económica actual; otros parecen estar menos preocupados por la deflación que por un posible repunte de la inflación. “Creo que vamos a evitar la deflación”, dice el profesor de Finanzas de Wharton Jeremy J. Siegel señalando que la caída en picado del precio del petróleo y otras materias primas del pasado año ya ha finalizado. Informes recientes muestran que en Estados Unidos los salarios se están manteniendo; la caída de los salarios es uno de los factores que podría provocar deflación, añade Howard Pack, profesor de Políticas Públicas y Empresa en Wharton. Japón, Estados Unidos y España han registrado recientemente ligeras caídas en los precios de consumo. Pero todos han sido descensos de menos del 1%; durante los años de la Gran Depresión en Estados Unidos (1929-1933), los precios cayeron casi un 25%. El 11 de mayo, China informaba de una caída del 1,5% en su IPC para abril, lo cual supone el tercer mes consecutivo de descenso en los precios de consumo; los precios al por mayor caían un 6,5%. Pero a la mayoría de los economistas no les asombran estas caídas de los precios y señalan la existencia de otras señales de recuperación económica. Muchos sostienen que dichos descensos eran esperados porque las cifras del año anterior reflejan los altos costes del petróleo y los alimentos. “La economía está empezando a recuperarse”, dice el profesor de Finanzas de Wharton Marshall E. Blume, el cual menciona el bajo ritmo de crecimiento de nuevas prestaciones por desempleo como evidencia de que la deflación no es una amenaza seria. La reciente caída del producto interior bruto (PIB) fue debida principalmente al recorte en la producción a medida que los suministradores echaban mano de los inventarios en lugar de

33 producción nueva, sostiene Blume. Con los inventarios por los suelos, la demanda debería empujar de nuevo los precios al alza. Otros creen que la deflación es bastante probable. “Me sorprendería que Japón no experimentase ningún problema deflacionario”, dice Franklin Allen, profesor de Finanzas y Economía en Wharton. “Creo que es bastante probable en Europa y en Estados Unidos”, añadía citando la rápida caída de la inflación. Allen interpreta el descenso en el PIB como una señal de que los fabricantes tienen un “enorme exceso de capacidad”, lo cual equivale a un exceso de oferta que puede contribuir a la caída de los precios. Junto con la caída de la demanda debido al incremento del desempleo, estos factores podrían convertir a la deflación en un serio problema en Estados Unidos y Europa, sostiene Allen. Mauro F. Guillén, profesor de Gestión Internacional de Wharton, espera una deflación bastante generalizada, pero no cree que vaya a ser realmente seria. La mayoría de las caídas en precios han sido bastante suaves, señala, y los elevadísimos gastos gubernamentales en Estados Unidos y otras partes del mundo al final deberían animar suficientemente la demanda como para que los precios suban. Algunos informes muestran que los economistas esperan una caída de los índices de precios al consumo –en relación con el año anterior- en los próximos meses en Estados Unidos, el Reino Unido, la zona Euro y Japón. Pero durante una conferencia del 11 de mayo, el presidente de la Reserva Federal Ben Bernanke afirmaba que la amenaza de deflación está “decayendo”, aunque añadía que aún debíamos seguir vigilantes. El círculo vicioso La caída de precios puede ser, hasta cierto punto, algo bueno. Pero cuando hablamos de una caída generalizada de los precios, los consumidores y las empresas posponen sus compras porque esperan menores precios en el futuro, les preocupa un posible descenso de sus ingresos o no quieren adquirir activos cuyo valor va a bajar. Una menor demanda obliga a su vez a los vendedores a bajar los precios, lo cual nos conduce a un círculo vicioso. “Se retroalimenta y es muy difícil detenerlo una vez se pone en marcha”, dice Pack. La deflación es especialmente grave para aquellos que están endeudados, ya que sus ingresos podrían disminuir, pero no su deuda. El colapso de los precios de la vivienda en Estados Unidos constituye un excelente ejemplo; millones de propietarios han acabado debiendo más que el propio valor de sus viviendas. Incapaces de vender sus casas por una cuantía suficiente como para cancelar sus deudas, los propietarios que pierden su empleo tampoco pueden adquirir una nueva vivienda. Aunque la deflación fue devastadora durante la Gran Depresión y en los 90 se convirtió en un serio problema para Japón, Pack cree que la amenaza para Estados Unidos y otras economías desarrolladas es limitada, ya que las manufacturas y la agricultura tienen un menor peso relativo que en el pasado. “En Estados Unidos en la actualidad las manufacturas suponen un pequeño porcentaje relativo del gasto”, añade. La economía estadounidense está dominada por los servicios, y los salarios constituyen su mayor gasto, explica Pack explicando que es más complicado para los empleadores recortar salarios que para las empresas manufactureras recortar precios. Blume añade que una de las causas de la Gran Depresión fue la mala gestión del estándar oro, que gobernaba los valores de las divisas. El estándar oro fue abandonado hace bastante tiempo. Otros expertos consideran que los programas de estímulo económico del

34 gobierno deberían mantener a raya la deflación. No obstante, en su vertiente académica Bernanke es un experto en la Gran Depresión y parece estar dispuesto a hacer cualquier cosa para borrar toda sombra de deflación. Efectivamente, una gran parte de los expertos entrevistados señalaron la inflación como una de sus principales preocupaciones, ya que el dinero inyectado por el gobierno para estimular la economía permite a los consumidores y empresas empujar al alza los precios. La Reserva Federal ha manifestado claramente su intención de revertir la política monetaria cuando se den las condiciones adecuadas, pero la realidad política podría cruzarse en su camino cuando la lucha contra la inflación obligue a aumentar los tipos de interés, afirma el profesor de Finanzas de Wharton Richard J. Herring. “Cuando sea el momento de subir los tipos de nuevo, seguramente el desempleo todavía esté creciendo”, dice. “Si la Reserva Federal sube los tipos en el momento adecuado se encontrará de bruces con la oposición del Congreso y de los acreedores”. El peor escenario sería repetir la excesivamente prolongada política de bajos tipos de principios de esta década, cuando Estados Unidos se recuperaba de la burbuja punto.com, advierte Herring. La “asimetría política” –esto es, la preferencia política por los bajos tipos-, “es parte del motivo por el que ahora nos encontramos en este lío”. En opinión de Guillén, la situación óptima sería un nivel bajo de inflación en lugar de no tener inflación alguna. “La tasa ideal sería una consistente con un crecimiento económico sostenido”, afirma. El nivel de inflación óptimo depende de la tasa de crecimiento de la economía, pero normalmente se consideran buenas tasas entre el 3 y el 5%. “Para poder crecer es necesario detectar qué productos o servicios tienen una demanda elevada, y los síntomas de una alta demanda son el crecimiento de los precios”. Este mecanismo ayuda a la economía a distribuir su capital eficientemente, ya que los productos y servicios cuyos precios crecen atraen inversión procedente de aquellos cuyos precios caen, señala. Consumidores y empresas se benefician –hasta cierto punto- del aumento del precio de los activos. Por ejemplo, los propietarios de una vivienda pueden destinar los préstamos hipotecarios al gasto en consumo. “Esto va a estimular el consumo y contribuir al crecimiento económico”, dice Guillén. Obviamente, la cosa tampoco puede ir demasiado lejos, señala. La burbuja inmobiliaria de hace unos años proporcionó a los propietarios de viviendas grandes cantidades de dinero para consumo pero tuvo consecuencias negativas cuando la burbuja estalló. “La inflación de los precios de los activos es algo positivo, pero si se convierte en burbuja al final acabará llegando el día del Juicio Final, y eso es exactamente lo que está ocurriendo ahora”. El gobierno federal está luchando contra las tendencias deflacionistas manteniendo bajos los tipos de interés e inyectando dinero en la economía para animar a los consumidores y empresas a gastar. Aunque Guillén cree que esta estrategia al final acabará dando resultado, conseguir una rápida recuperación es tarea bastante complicada. Estado de la situación: “Extraña”. “En estos momentos, en el corto plazo la situación es muy extraña”, observaba Guillén señalando que los individuos y las empresas prefieren destinar el dinero extra al pago de deuda en lugar de gastar. Preocupados por el riesgo de los potenciales acreedores, los bancos han acaparado el dinero de los programas de estímulo del gobierno en lugar de dejarlo prestado, tal y como era la intención del gobierno. “Si no lo dejas prestado, si te lo quedas, entonces no se genera más demanda”. Para la Reserva Federal, ajustar los tipos de interés es “una decisión muy, muy

35 complicada; hay que encontrar el equilibrio perfecto”, dice Guillén, ya que un acceso excesivo al dinero puede actuar como detonante de la inflación. En dicho caso, la Reserva Federal probablemente incrementaría los tipos de interés, aunque aumentarlos demasiado supone cerrar el grifo de un dinero que la economía necesita para crecer. “No nos gusta la situación actual, en la que tenemos deflación y también recesión”, dice Guillén. “Nos gustaría que la recesión se transformase en crecimiento económico, y nos gustaría cambiar la deflación por una inflación suave que fuese sostenible con el crecimiento económico”. Preocupada por la deflación tras la explosión de la burbuja punto.com a principios de esta década, en 2003, 2004 y 2005la Reserva Federal mantuvo los intereses bajos, recuerda Richard Marston, profesor de Finanzas y Economía en Wharton. En su opinión, se trató de una reacción desmedida basada en la creencia errónea de que una desaceleración económica estaba empujando los precios a la baja siguiendo un patrón típicamente deflacionario; pero la causa real eran las importaciones baratas de países como China. Mantener los tipos demasiado bajos durante demasiado tiempo alimentó el boom inmobiliario, lo cual condujo a la crisis financiera, dice Marston. Ahora, los esfuerzos del gobierno para inyectar dinero en la economía deberían preparar el terreno para la recuperación, añade Marston prediciendo que en caso de tener deflación será en todo caso muy moderada. “Creo que son los consumidores los que van a sacarnos de la recesión”, dice Marston. “La mayoría de las familias estadounidenses ha recortado su gasto en consumo, pero no todas han podido hacerlo porque sus ingresos también han caído”, dice señalando la preocupación de los consumidores sobre el futuro. En opinión de Marston, la gente que cuenta con un buen nivel de ingresos aflojará el bolsillo cuando se empiecen a ver señales de recuperación, las cuales ya empiezan a ser evidentes. “Empezarán a salir y a cenar de nuevo en restaurantes. Empezarán de nuevo a comprar ropa, y empezarán a comprar coches … Empiezo a sentirme mucho más optimista”. http://www.wharton.universia.net/index.cfm?fa=viewArticle&id=1714&language=spanish

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Unidos por la cartera: La delicada relación financiera entre EEUU y China Durante casi dos décadas, EEUU y China se han mantenido unidos en un extraño, y sin embargo beneficioso, abrazo económico. A pesar de las diferencias políticas entre los dos países, el consumidor americano ha consumido ávidamente los productos chinos, mientras China acumulaba miles de millones de dólares en transacciones comerciales con EEUU. El acuerdo ha funcionado durante años. Recientemente, sin embargo, bajo la fuerte presión de la crisis económica global, la relación financiera entre China y EEUU empieza a parecer una situación de mutua dependencia poco saludable. Los chinos tienen un volumen de reservas extranjeras tan grande en activos basados en dólares que hoy en día es vulnerable a los cambios en la economía americana. EEUU, por su parte, ha permitido que China comprara buena parte de su deuda, hasta tal punto que actualmente los americanos dependen de los intereses chinos. “Las inversiones de China en EEUU son de tal magnitud que hoy en día dependemos mutuamente”, observa Richard J. Herring, profesor de Finanzas de Wharton. “Ellos tendrían serias pérdidas financieras si hicieran algo que pudiera causar la devaluación del dólar. En realidad, a estas alturas, los chinos parecen asustados con el descontrol de nuestra política monetaria y fiscal y con lo que eso puede causar”. Las reservas cambiarias chinas han aumentado sustancialmente en las últimas décadas, pasando de US$ 216.000 millones, en 2001, a US$ 1.520 billones en 2007 y, luego, a US$ 1.950 billones en 2008, según datos publicados en el informe de marzo del Servicio de Investigaciones del Congreso (CRS, en la siglas en inglés). Algunas estimaciones calculan que el valor actual de esas reservas es de US$ 2.300 billones. En términos de porcentaje del PIB, las reservas cambiarias chinas pasaron del 15,3%, en 2001, a un 45% en 2008. Algunos economistas estiman que cerca de un 70% de esas reservas corresponden a activos basados en dólares. China tiene actualmente US$ 1.360 billones en títulos americanos y en títulos de la deuda del Gobierno. Hay quien teme, en EEUU, que las inmensas reservas en dólares de los chinos puedan causar problemas a la economía americana si China un día decidir deshacerse de esas inversiones. “Para EEUU, es una situación de fragilidad”, observa Franklin Allen, profesor de Finanzas de Wharton. “Nosotros somos la parte vulnerable, porque si China decide liquidar sus reservas, podría haber una fuerte presión sobre el dólar, lo que sería muy malo para EEUU”. Pérdidas doblemente garantizadas Precisamente para evitar un desastre económico de ese orden China no venderá los títulos de la deuda americana en su poder. Los chinos necesitan que EEUU compre sus productos, y no tiene interés alguno en que la economía americana o el dólar colapsen. Además de eso, si China vende parte de los títulos del Tesoro que posee, el valor del

37 resto de sus reservas basadas en dólares también caerá. “Si ellos comenzaran a deshacerse de los títulos del Tesoro, o si se desacelera el ritmo de las compras de los títulos, el impacto sobre el dólar será enorme, y ellos no quieren eso”, dice Todd Lee, economista jefe para China de la consultoría IHS Global Insight. “A fin de cuentas, EEUU es el destino más importante de las exportaciones chinas”. De momento, EEUU se siente feliz de vender títulos del Tesoro a los chinos porque eso ayuda a financiar la deuda nacional del país, que es de US$ 11.000 billones. El enorme apetito chino por los títulos de la deuda americana mantiene los precios elevados y los tipos de interés bajos. Los especialistas no coinciden, sin embargo, acerca de la razón por la cual China habría optado por adquirir tantos títulos de EEUU, y discrepan también sobre la posibilidad de que China se deshaga de ellos un día. Los chinos son dueños de buena parte de los títulos del Tesoro de largo plazo y de la deuda de entidades del Gobierno, como Fannie Mae y . El país sobrepasó a Japón en septiembre del año pasado y se convirtió en el mayor dueño de títulos del Tesoro americano. A finales de febrero, de acuerdo con cifras del Gobierno americano, China tenía aproximadamente US$ 744.000 millones en títulos del Tesoro, cerca de un cuarto de todas las reservas cambiarias. El país es también, de lejos, el mayor dueño de títulos de órganos del Gobierno, que corresponden a cerca de un 36% de todas las reservas extranjeras, según datos de finales de junio de 2008. Hay quien dice que China ha acumulado a propósito activos basados en dólares para manipular el valor de la moneda local, el yuan (o renminbi). Al comprar dólares, los chinos mantienen el valor del yuan en niveles bajos, dicen algunos expertos, abaratando las exportaciones chinas. Otros dicen que China necesitaba simplemente un lugar seguro para colocar sus dólares. Decidió entonces invertirlos en títulos del Tesoro americano, porque son considerados las inversiones más seguras. “Durante mucho tiempo, no hubo inversión mejor en el mundo que los títulos del Tesoro”, observa Philip M. Nichols, profesor de Estudios Jurídicos y de Ética en los negocios de Wharton. “No se trata sólo de un lugar seguro; es también cómodo”. El Gobierno chino es “fundamentalmente prudente, ya que es fruto de una época que sólo puede ser descrita como cruel y brutal”, dice Nichols en alusión a las guerras civiles y a la ocupación extranjera que culminaron con la llegada al poder por los comunistas en 1949. “Por lo tanto, el raciocinio de ellos va más por el lado de la cautela que por posibles riesgos. Para mí, eso es una razón aún más fuerte para que inviertan en títulos del Tesoro, más fuerte inclusive que la preocupación en mantener el renminbi bajo”. Aunque China ya ha hecho inversiones arriesgadas anteriormente, ha decidido volver a los títulos del Tesoro después de sufrir pérdidas considerables en 2008. Su fondo soberano, China Investment Corp. —creado en 2007 con la misión de administrar mejor las reservas cambiarias del país— invirtió en Blackstone, un grupo de , y en Morgan Stanley, un banco de inversiones, poco antes de caída del mercado americano. En junio de 2007, el fondo había comprado US$ 3.000 millones en acciones de Blackstone LP a US$ 31 cada una. El valor de esas acciones cayó a menos de US$ 8 en octubre de 2008. Posteriormente, en septiembre y octubre de 2008, China compró US$ 44.500 millones y US$ 65.900 millones de títulos del Tesoro en septiembre y octubre, respectivamente, según un informe de la CRS. “Eso tal vez refleje, en parte, un distanciamiento de China y de otros inversores extranjeros en relación a la adquisición de títulos basados en activos de entidades americanas, como los de Fannie Mae y Freddie Mac, prefiriendo títulos más

38 ‘seguros”, como los del Tesoro americano”, observó el autor del informe, Wayne M. Morrison, experto de CRS en comercio y finanzas asiáticas. China tal vez esté también acumulando montantes enormes de reservas extranjeras a consecuencia de la crisis económica asiática de 1997, cuando el FMI impuso condiciones severas a los beneficiarios de la ayuda ofrecida por la institución. “En mi opinión, eso contribuyó de forma decisiva” al crecimiento de las reservas cambiarias de China, dice Allen. “Creo que la mayor parte de los países asiáticos vio lo que estaba sucediendo y llegó a la conclusión de que no habían sido tratados con justicia. Por eso es por lo que han estado acumulando desde entonces billones de dólares en reservas”. El superávit comercial de China puede llegar a US$ 325.000 millones este año, según dijo un economista de ING Group a Bloomberg el 23 de abril. De acuerdo con Bloomberg, las reservas cambiarias chinas cayeron US$ 32.600 millones en enero, US$ 1.400 millón en febrero y, luego, subieron hasta US$ 41.700 millones en marzo. ¿Una estrategia de manipulación? Pero buena parte de los observadores de China afirma que las compras de títulos del Tesoro por parte de los chinos es una forma de manipular la moneda local. “Los chinos gestionan el valor del yuan comprando y vendiendo dólares”, observa Howard Pack, profesor de Negocios y Políticas Públicas de Wharton. “Ellos producen a propósito superávits de exportación, por lo tanto tienen un exceso de moneda extranjera. Cuando compran títulos del Tesoro, el valor del yuan se queda bajo en relación al dólar. Eso permite que los exportadores chinos vendan a precios relativamente bajos a EEUU”. China necesita mantener su moneda en niveles bajos para dar respaldo a una economía enfocada en la exportación, observa Marshall Meyer, profesor de Gestión de Wharton. “China es extremadamente dependiente de las exportaciones”, dice él, y manipula el valor de su moneda acumulando grandes cantidades de dólares. “La estrategia deliberada de crecimiento por medio de la fabricación a bajo coste es señal de que China quiere mantener el valor del yuan en un nivel modesto, razonable —algunos dirían ‘artificialmente bajo’— para hacerlo competitivo en el mercado global”. Las exportaciones netas de China (exportaciones menos importaciones) contribuyeron a un tercio del crecimiento del PIB en 2007, según otro informe del Congreso. El sector de comercio exterior del país emplea a más de 80 millones de personas. De acuerdo con Meyer, las reservas cambiarias extranjeras aumentaron, no sólo a causa del comercio, sino también debido al “hot Money” —dinero que entra en China por medio de gente que especula con la moneda y que apuesta por la apreciación del yuan—, además de las inversiones directas de compañías extranjeras, muchas de ellas americanas. Desde el comienzo de la crisis económica, el hot money está saliendo de China. Meyer observa que China no puede reinvertir su riqueza en dólares en el país porque “tendría entonces que convertirla en RMB (renminbi), lo que revaluaría la moneda china. Por lo tanto, ésa es una de las paradojas que enfrenta el país. Los chinos tienen mucho dinero, pero no pueden invertirlo internamente”. Las alegaciones de manipulación de la moneda han llevado al Congreso americano a amenazar con imponer sanciones comerciales a China, pero a pesar de mucha discusión, no se ha aprobado ninguna ley. La Ley de Combate a la Manipulación de la Moneda China, de 2008, murió en el Congreso a finales del año pasado. De 1994 a julio de 2005, China mantuvo el cambio con el dólar americano en 8,28 yuanes. En 21 de julio de 2005, el Gobierno chino anunció que el yuan se haría

39 “ajustable con base a la oferta y demanda del mercado en relación al movimiento cambiario de una cesta de monedas”. El yuan se ha apreciado más del 20% en relación al dólar desde 2005, sin embargo muchos dicen que la moneda china continúa depreciada. “Los chinos niegan vehementemente la manipulación del yuan, y la posición oficial del Tesoro americano es que China no manipula la tasa de cambio —a pesar de la confirmación del secretario del Tesoro americano, Timothy Geithner, de que habría manipulación”, dijo Kent Smetters, profesor de Seguros y de Gestión de riesgo de Wharton. China dice, “oficialmente, compra títulos del Tesoro porque quiere títulos seguros, y admite que nuestras economías están entrelazadas: compramos los productos baratos de los chinos mientras ellos compran nuestra deuda. En la práctica, los chinos intentaron mantener el RMB devaluado para promover sus exportaciones. Sin embargo, es muy probable que ellos valoren también las inversiones más seguras. Por lo tanto, las dos cosas van juntas”. Avery Goldstein, profesor de Ciencias Políticas de la Universidad de Pensilvania, dice que ha habido teorías de conspiración tanto del lado chino como americano, en que uno culpa al otro por los reveses económicos actuales. Goldstein no cree en esas teorías. “Creo que la situación actual se ha desarrollado a lo largo del tiempo porque tenía sentido, en el plan económico, para ambos países. Estamos satisfechos de ver a los chinos comprando títulos del Tesoro americano y los chinos apreciaban el hecho de que tenían un puerto seguro donde invertir”. Esa maraña financiera mantiene unidos a los dos países en una camisa de fuerza política incómoda. “En el actual escenario de crisis, creo que los dos lados son más conscientes de cómo el destino de ambos está entrelazado”, dice Goldstein. “Ellos están unidos de una forma que no permite una separación fácil”. Las negociaciones entre EEUU y China en torno a cuestiones candentes como las de Corea del Norte, el calentamiento global, los derechos humanos, el terrorismo y las ventas de armas a Taiwan, pueden estar cada vez más marcadas por preocupaciones económicas como la del desequilibrio de la balanza comercial y la manipulación de la moneda, dice Goldstein, principalmente después de que el Gobierno Obama optara por la convergencia del diálogo económico y político. “Eso genera oportunidades de asociaciones explícitas o implícitas entre las cuestiones políticas y económicas, que sería mejor mantener separadas”. Una herramienta política Nichols dice que es difícil creer que China no haya usado sus reservas como herramienta política en algún momento. Lee, de Global Insight, prevé que China use sus reservas como medio de presionar políticamente a EEUU. A fin de cuentas, sin embargo, “es posible que ellos digan una cosa, pero no van a llevar a cabo sus amenazas. Es todo un juego”. La “amenaza” consistiría en que China redujera de forma significativa sus compras de la deuda americana, o, en un escenario más extremo, dejar de invertir en ella de una vez por todas. Cualquiera de esos escenarios obligaría a EEUU a ofrecer tipos de interés más altos por sus títulos, dificultando o haciendo imposible la financiación de su déficit. De acuerdo con los expertos, es improbable que China se deshaga de un golpe de sus reservas, porque nadie las compraría y podría haber pérdidas financieras para el Gobierno chino. Además de eso, cualquier crisis de la economía americana podría, en última instancia, perjudicar a la economía china basada en exportaciones. Pero los chinos dejaron claro, recientemente, su preocupación por la economía

40 americana. “Hemos hecho enormes cantidades de préstamos a EEUU”, dijo Wen Jiabao en una rueda de prensa inmediatamente después del cierre de la sesión legislativa anual, en marzo. “Está claro que estamos preocupados por la seguridad de nuestros activos. Para ser sincero, estoy un poco preocupado. Nos gustaría que EEUU honrara su palabra, continuara siendo una nación confiable y garantizaran la seguridad de los activos chinos”. Lo que realmente preocupa a los chinos, dice Allen, es que “vamos a pedir prestado un valor tan alto que la inflación será muy alta. No creo que ellos teman que podamos incumplir los pagos”. Pero si EEUU toman demasiado prestado, hasta el punto de que el valor del dólar comenzara a caer, será como si China “nos hubiera dado US$ 2.000 billones y nosotros devolviéramos, al final, US$ 1.000 billones”. Pack concuerda. “Los chinos, por primera vez, están preocupados. Ellos temen que el déficit de EEUU lleve a la inflación a los americanos. Con eso, el valor de los títulos en su poder caerá. Por lo tanto, ellos están diversificando sus inversiones en otras monedas. De momento, no es nada significativo”. La cuestión, dice Pack, es saber lo que China hará los próximos años. En relación al futuro, los expertos dicen que una de las cuestiones más fundamentales consiste en saber cómo va a controlar EEUU su voraz apetito por el endeudamiento. “A largo plazo, EEUU va a querer que el patrón de crecimiento sea un poco más equilibrado”, dice Lee. “No se puede permitir que el consumidor continúe engordando la deuda del consumo y mantenga los menores índices posibles de ahorro indefinidamente”. Si China consigue llevar su economía a un plan más doméstico, tendría menos que perder con el desmoronamiento de la economía americana en el momento en que decidiera deshacerse de la deuda de aquel país. “Si los déficits presupuestarios persisten, si no redujéramos nuestros problemas y si los BRIC (Brasil, India, China y Rusia) continúan su desarrollo y dependen menos del consumidor americano, necesitaremos a los chinos más que ellos nos necesitarán a nosotros dentro de 15 años aproximadamente”, dice Smetters. “Está claro que todo eso es más o menos libre. Pero la cuestión es que la mala política fiscal de EEUU y el crecimiento económico continuo de los BRIC hará a EEUU tan interesante financieramente como Roma”. Publicado el: 20/05/2009

41 Business

May 20, 2009 U.S. Weighs How to Let Banks Give Money Back By LOUISE STORY and ERIC DASH It began on Oct. 13, in an atmosphere of panic, with an ultimatum from Washington. Now, the nation’s largest banks see a chance to bring an end to the bailout era. After so much bad news, it scarcely seems possible. But having regained a financial footing as well as a bit of their old swagger, major banks are racing to pay back billions of taxpayer dollars. Many insist they will do so by year-end. Few in Washington or on Wall Street expected such a quick reversal. Many said they believed banks would rely on the government for years. Banks, the thinking went, would need help coping with bad subprime mortgages and other troublesome assets that led to the financial crisis. But now that big banks seem to have stabilized, regulators are trying to determine how and when these institutions should be allowed to return their bailout money — and whether such a step might leave banks vulnerable to another crisis should the economy turn for the worse. Two weeks after the results of the federal stress tests, several banks, among them Bank of New York Mellon, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street and U.S. Bancorp, have begun formal discussions with regulators about repaying their portion of the $700 billion rescue, said banking executives and a federal official. New details emerged Tuesday about the repayment plans, including word that regulators would refuse to let a single major bank exit first, which might have given that institution considerable bragging rights. Instead, around June 8, the Federal Reserve expects to identify a group of banks that are ready to leave the bailout program, according to a Federal Reserve official, who was granted anonymity because of the Fed’s policy against speaking publicly on such matters. The Treasury Department will handle the timing of the payments, this person said. Many ordinary Americans, angered by multibillion-dollar bailouts and what they see as excessive pay in the financial industry, might welcome news that taxpayers will get their money back sooner rather than later. But repaying the bailouts is not without risk. While many big banks have, for the moment, stanched crippling losses, the banking industry still faces significant challenges. New troubles loom in commercial real estate and credit cards. By letting banks return bailout money, the government would cede some power over institutions that were at the center of the financial crisis. Banks, for their part, are eager to extricate themselves from heightened government oversight, including restrictions on their employees’ compensation. “If a given bank repays the money and then in October, it needs the money again, that is going to be very scary,” said Douglas J. Elliott, a fellow at the Brookings Institute and a former banker at JPMorgan Chase.

42 Bank chiefs have said for months that they would like to repay the money, provided through the Troubled Asset Relief Program, or TARP. But it is only recently that several large banks entered into formal conversations with regulators. Executives at five banks discussed the issue for this article, but they were granted anonymity because they were not allowed to share their conversations with regulators. Rumors and leaks about prospective repayment plans seem to emerge almost daily. Some observers say banks may be trying to force the government’s hand into allowing the repayments. “You’re seeing more public tension between them,” said Andrew Goldberg, the chairman of the corporate and financial practice at Burson-Marsteller, a public relations firm. “This is a dialogue between two very different constituencies that operate with two different mind-sets — the banks and the government — and they intersect in the zone that we call TARP.” The tension also reflects old Wall Street rivalries that are once again coming to the fore — if they receded at all. Goldman, for instance, has long been viewed as the most likely to pay off the money first. But rivals insist such a decision might be viewed as favoritism, given Goldman’s ties to important federal officials, including the head of the Federal Reserve Bank of New York, William C. Dudley, who once worked at Goldman. While several small banks have repaid their bailout money, no large bank has done so. Citigroup is the only large bank so far that has decided to make the government a long- term shareholder. In deciding which banks can repay bailout money, the government will potentially draw a line between winners and losers. One sticking point is whether to allow banks that return bailout money to continue using a government program that guarantees bank debt. Some banks might not be able to operate without that program. Regulators said recently that that before companies could return the money, they must demonstrate that they could issue debt without the government program. A person briefed on regulators’ thinking said they were leaning toward allowing banks to continue using the debt program through October. Another issue is taxpayers’ investment in the banks. The government owns warrants that give it the right to buy shares in the banks, and must now decide how much banks will have to pay to buy those warrants back. Stronger banks like Goldman favor a hefty price. Banks with less cash on hand want to expunge the warrants cheaply. Strong or weak, most big banks want to repay the money before the end of this year, so that they can pay out bonuses as they see fit. Louise Story and Eric Dash, “U.S. Weighs How to Let Banks Give Money Back” 20/Mayo/2009 http://www.nytimes.com/2009/05/20/business/20repay.html?th&emc=th

43

May 20, 2009 Asset classes and the inadequacy of labels Alpha | Labels and bad jargon can lead to cloudy thinking and poor investing. Or as Orwell wrote: “the slovenliness of our language makes it easier for us to have foolish thoughts.” The institutional investment world, by consensus, labels asset classes such: -Absolute Return - -Equities -Private Equity -Real Assets (Real estate and commodities) See the investment report for the Yale Endowment and its chief Dave Swensen’s book “Pioneering Portfolio Management.” I posit that the traditional scheme of labels is an unhelpful way to view the investible universe. A better way would be to look at the economic and legal structure of investments, and draw out broader, more conceptual categories. Basically, there are four types of claims: real, fixed, residual, and derivative. All stocks, bonds, absolute return strategies, and other financial instruments can be viewed as being in these buckets. Real claims: This is direct ownership of, and often physical possession of, tangible assets. This means owning hard assets like gold, land, oil fields, oil barrels, wheat, etc. Most homeowners have a real claim on their home; they both own it and reside in it. Physical ownership and control is important for unstable societies (e.g. owning oil fields, pipelines, and ports in Nigeria, with one’s own security forces to guard these assets since the government and police are weak and unhelpful). Value comes from using up an asset: selling the land, drilling for oil and depleting the field, etc. Fixed claims: This is a fixed monetary claim on the earnings of an asset or entity. Bonds are fixed legal claims against a company or government entity’s earnings or balance sheet. The debtor must pay a certain amount (interest) periodically to the creditor, and when the period is over the whole sum (principal) must be returned. Sometimes fixed assets are secured with real assets, sometimes not. When owning fixed assets, a strong legal framework and rule of law is important. If a creditor can’t trust the court system to collect from a defaulted debtor, this asset class becomes much riskier. Very safe real estate that pays out a steady annual income falls between a real claim and a fixed claim. Residual claims: This is a residual monetary claim on the earnings of an asset or entity, coupled with some sort of ownership of the asset or entity. Often residual claims are in common stock or partnership interests. Preferred stock and convertible bonds are hybrids between fixed and residual claims. The distinction between public equities and private equity both is and isn’t important (we call that a paradox). Public equity owners have little control over a firm’s residual resources, a small ownership stake, and a liquid market for their stake. A private equity owner has much control over a firm’s residual resources, a large ownership stake, and an illiquid market for their stake. Derivative claims: This is a structured contractual claim whose payout depends on the price or level of another “reference” entity from point 0 to point 1 in time. Futures,

44 options, and structured products are derivatives, and the underlying reference entity can be real assets like gold, bonds, stocks, interest rates, commodities, indexes, and pretty much anything (weather, political outcomes, catastrophes, etc.). This is raw betting, sometimes hedging. My thesis is that an investor must have a different skill set for each of the asset classes above. For real claims, the productive or final sale value of the asset is key. At the purest, non- speculative level, investors in real assets are like 19th century entrepreneurs, attempting to turn land into cities, forests into timber products, and deserts into productive oil fields. The premium skill set here is resource conversion. Can the real claim owner turn silk fibers into textiles people want, or trees into furniture? For fixed claims, coverage and security are key. That is, does an entity have the earnings to “cover” both the interest and principal payments? Analyzing the factors behind earnings, like profitability, firm size, return on assets, etc. is important. And as extra security, if the payouts are missed, can the fixed claim owner recover some value through secured real claims on hard assets? The premium skill set here on engineering analysis and character appraisal. What is the margin of safety on cash flow variation, and can the fixed claim owner trust the debtor to not default? For residual claims, growth prospects and final payouts are key. Common stock holders want to know if they will ever get any of the residual cash generated by an entity. Of course, investors can sell their shares, but at some point, some final investor must get cash flows or a distribution of hard assets. Otherwise, the whole thing has been a sham, a game of musical chairs with no prize at the end. For a residual claim, there is no obligation for an owner to ever get anything. The premium skill set here is on economic analysis and character appraisal. What are the growth prospects for a business over time, and can the residual claim owner trust management to act in her best interest in distributing cash before doomsday? Value stock investors do more of a fixed claim analysis (is the stock trading for less than its assets?). Growth stock investors do more of a residual claim analysis (will enough cash be generated in the future to elevate the stock?). Distressed debt investors do a complicated mixture of fixed and residual claim analysis: fixed when they look at liquidation values and collateral; residual when they look at the worth of a business over time, and their potential future ownership share. For derivative claims, a keen understanding of both the underlying security and the technical features of the derivative contract are key. To trade natural gas, one needs to understand the underlying supply and demand in the market (like a real claim owner), along with the quirks of the trading environment and the features of the contract (the roll date of the contract, its liquidity, etc.). Also, knowledge of a counterparty’s solvency is important, as a derivative claim owner could win on a trade and lose when the other side goes bust and fails to pay. In the end, this classification scheme really gets to the heart of investing. In comparison to the conventional wisdom above, it combines “equities” and “private equity” into one class. It eliminates “absolute return,” which is a marketing buzzword that sells the idea that any investor or class can always be up and never down. And this scheme unmasks derivatives as their own world, a separate asset class which must be handled carefully or completely avoided. One final note, which Vega points out: “There's also the problem that the asset categories [describe above] can be manipulated: fixed claim investments can act as

45 derivatives if they're at a deep enough discount and bought with leverage; then they effectively become call options. Investors in real estate in 2006 were more similar to equity speculators (looking to sell at a better price rather than collect any cash flow), than ‘19th century entrepreneurs.’” Vega has a point. An equity position in a near-bankrupt company is more like a call option, a derivative claim. Likewise, distressed debt in an over-levered company is more like equity, a residual claim. For capital structure arbitrage, an investor is arbing the perceived relative value differential between a fixed claim and a residual claim (or fixed to fixed, fixed to derivative, etc.). A final example: when investors borrow much money to buy any hard asset, with the goal of flipping the assets months later, their position is more like a derivative claim than a real claim. The point is to look at the substance of a security/asset and its situation, not the outward label (bond, stock, real estate, etc.).

Originally published at Risk Over Reward and reproduced here with the author's permission. http://www.rgemonitor.com/financemarkets- monitor/256819/asset_classes_and_the_inadequacy_of_labels

46 Derivative Dribble How NPR Mangled Geithner’s Plan For OTC Derivatives Charles Davì, May 18, 2009 at 10:45 pm Also published on the Atlantic Monthly’s Business Channel. Timothy Geithner has released his proposal on how to regulate the OTC derivatives market. The proposal is broad in its scope and the regulations proposed would have a profound impact on market practice if implemented. Despite this, the sleuths at NPR claim to have discovered a “huge loophole” in the plan. I’ve also been studying both Geithner’s proposal and the NPR article on the subject, and the only holes that I found were in NPR’s understanding of the OTC market. In order to fully understand the earthly implications of Geithner’s policies and the gargantuan errors made on Planet Money, we should probably understand what the OTC derivatives market is. So, let’s begin with a brief overview of what the OTC market is and what it isn’t. What Is An OTC Derivative? A derivative is a contract that derives its value by reference to “something else.” That something else can be pretty much anything that can be objectively observed and measured. That said, when people talk about derivatives, the “something else” is usually an index, rate, or security. For example, an option to purchase common stock is a fairly well-known and ubiquitous derivative. So are futures for commodities such as pork belly and oil. However, these are not the kind of derivatives that Geithner is talking about. Geithner is talking about OTC derivatives, or “over the counter” derivatives. This category of derivatives includes the much maligned “” market, as well as other larger but apparently less notorious markets, such as the interest rate and foreign exchange derivatives markets. The key defining characteristic of an OTC derivative is that it is entered into directly between the parties. This is in contrast to exchange-traded derivatives, such as options to purchase common stock. Highly bespoke OTC derivatives are often negotiated at length between the parties and involve a great deal of collaboration between bankers, lawyers, and other consultants. For other, more standardized OTC contracts, commonly referred to as “plain vanilla trades”, contracts can be entered into on a much more rapid and informal basis, e.g., via email. For the limited purpose of wrapping your head around the world of derivatives, think of all derivatives as being in one of three broad categories: (1) exchange-traded derivatives (e.g., options on common stock and futures on pork belly); (2) standardized OTC contracts (e.g., your basic credit default swap); and (3) bespoke OTC contracts (transaction specific, often more complex instruments). The “Huge Loophole” NPR claims that Geithner’s proposal has a “huge loophole”, which they uncover through the following summary:

47 - Banks and other players have to tell the government when they buy and sell these derivatives. That means the government can know how many are out there and who has them. - If banks and others are buying and selling standardized derivatives, they must trade them on an exchange, sort of like how stocks are traded on an exchange. That way it’s more transparent and the prices should more accurately reflect the market sentiment. - But — and here’s the big but — banks and others are perfectly free to continue trading custom-made derivatives as private transactions between two parties. In case you didn’t catch it, that last part was supposed to be the clincher. But before we can appreciate why it’s not a clincher, we need to do a bit more homework on the OTC market. In Geithner’s proposal, there’s a lot of talk about CCPs, or “central counterparties.” These are often incorrectly equated with exchanges. CCPs are not exchanges. They are exactly what their name suggests: a central counterparty for swaps of a particular type. After two parties enter into an OTC trade together, they novate, or more colloquially, move their trades to the CCP. So unlike trades executed on an exchange, CCP trades are entered into directly between the two parties, but later shifted over to the CCP. There are a lot of reasons why this is done, and they’re beyond the scope of this article. But if you’re interested in reading more about CCPs, go here. The key take-away is that CCPs are not exchanges, but more like risk repository/management systems where trades get moved to after they’re executed. So, NPR believes that because OTC market participants are not forced to trade on exchanges, their trades will continue to be unnoticed and unregulated. This is completely false for two reasons: first, trades that are capable of being moved to a CCP would be required to be moved to a CCP under Geithner’s plan; second, even if they weren’t, Geithner’s plan calls for all OTC trades, including those in the third bespoke category, to be recorded in what are known as “trade repositories,” such as DTCC’s Deriv/SERV. Here is the relevant language from Geithner’s proposal: [I]f an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared. [A]ll trades not cleared by CCPs [are] to be reported to a regulated trade repository. This is in contrast to NPR’s second point above, which asserts that all such trades would be traded on an exchange. That is wrong. What this says is: all trades that can be moved to a CCP (not an exchange) should be, and it will be assumed that this is required; and if they’re not moved to a CCP, they have to be recorded in a trade repository. So, by definition, this proposal would make regulators aware of every single trade in the OTC market since every trade is either on a CCP, in which case the CCP will record its existence, or not on a CCP, in which case the trade repository will record its existence. But how do we explain NPR’s blunder in their third point? That blunder comes from yet another equivocation between a CCP and an exchange. The relevant language from Geithner’s proposal is as follows: [Relevant laws should be amended to impose] the encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives. NPR hones in on the “encourage” language, taking this to mean that market participants will have a choice between using an exchange or being unregulated financial pirates. Of

48 course, those swashbuckling financiers will choose the latter. As I’m sure you’re starting to see, this is a false dilemma. What Geithner is suggesting here is that regulated institutions avoid the OTC market altogether, and make use of derivatives from the first category above (the exchange traded ones). Of course, such a policy should be suggestive and not prescriptive, because contrary to popular belief, OTC products serve legitimate needs that exchange traded products don’t meet, at least not yet. Customized Misinformation No finance bashing story is complete without a kooky conspiracy theory, and so in order to fulfil the meme, NPR offers us an explanation as to why those crazy credit default swaps are so darn complex: It seems reasonable to expect that every single sales team on Wall Street will work very hard to convince their customers that they have Very Special, One-Of-A-Kind Credit Derivatives that are far better than the boring old ones traded on the exchange. Unfortunately for NPR, this is complete nonsense. The vast majority of credit default swaps are completely standardized and have been for a while. Recent changes to how CDS are priced has increased fungibility even further. In fact, one of NPR’s commenters actually pointed this out. The NPR commenter writes: Virtually ALL CDS contracts are standardized. Which is to say that I can open a position with Goldman Sachs and unwind that position at Citigroup. These instruments will be covered under the Obama proposal and are well suited to being exchange traded. Are there bespoke products available in the derivative market place? Absolutely. But they account for a minuscule portion of the overall business. But NPR doesn’t stop there. Acknowledging the possibility (fact) that they are wrong about standardized CDS, they go on to claim that: [Even assuming the commenter] is right (he probably is) and most currently-traded CDS would qualify for a new exchange or clearinghouse; it seems fair to guess that lots of CDS operations will be looking for ways to avoid that clearinghouse and all the extra regulation and transparency and lowered commissions it brings with it. Yet again, unfortunately for NPR, that is more nonsense. The major swap dealers have already set up a CCP on their own, before regulators required them to do so, and are currently moving trades to it. Swap dealers do not make money by over-complicating products and duping trillions of dollars worth of capital. They make money by creating a market. That is, they buy and sell swaps, creating a market, and pocket the difference between the prices at which they buy and sell. If you want to use jargon, you would say they create “liquidity” for swaps. That’s their business. Making complicated products that aren’t fungible does not advance that business model. Even more importantly, as we noted above, Geithner’s proposal wouldn’t let them off the hook simply because they used bespoke products. If the trade is accepted on a CCP, it is presumed to be required to go there. And even if it’s not, it gets reported anyway.Clearly Planet Money doesn’t think it’s a very good proposal. But in my humble opinion, it’s at least a reasonable proposal for the residents of planet Earth. http://derivativedribble.wordpress.com/2009/05/18/how-npr-mangled-geithners-plan- for-otc-derivatives/

49 Rick Bookstaber Friday, May 15, 2009 The Flight to Simplicity in Derivatives Complexity is one of the demons that makes our financial markets crisis prone. Much of the complexity arises in the specter of derivatives and other “innovative” products. To reduce the risk of crisis we must exorcise this demon. We need a flight to simplicity. Geithner’s proposal for new derivatives regulations, which includes centralized clearing and exchange trading for standardized derivative products, moves us toward this goal. A stated objection to this proposal is that the door remains open for complex OTC versions of swaps and derivatives. Or worse, that having the standardized products out in the light of day will only accentuate the demand for the more shadowy and opaque versions of the products. I don’t think that is the way things will play out. More likely is that this proposal, properly executed, will be a major step forward in improving the transparency and efficiency of the market place, and will shore up the market against the structural flaws that derivative-induced complexity have created. Assume we get to the point of standardized swaps and derivatives instruments that are exchange traded and backed by a clearing corporation. These instruments will create a high hurdle for any non-standard OTC product a bank wants to put into the market. The OTC product will have worse counterparty characteristics, will not be as liquid, will have a higher spread (which helps explain why the banks will decry this proposal) and will have inferior price discovery. To overcome these disadvantages, the specialized OTC product will have to demonstrate substantial improvement in meeting the needs of the investor compared to the standardized products. Furthermore, the thought-leaders on the buy side will add their own hurdles to the more complex OTC products. I would not be surprised if many investors require derivatives taken on their behalf be of the standardized, exchange traded form, or that if an alternative is presented, it has to be approved by their firm’s CIO or risk manager. If this comes about, there won’t be too many instances where a complex OTC is pushed forward, because for most legitimate purposes the standardized products, on their own or in combination, will be found to do the trick. Which gets us to the illegitimate purposes. Many of the complex innovative products are used for what might charitably be called non-economic purposes. Like allowing firms to lever when they aren’t supposed to lever, take exposure in markets where they are not supposed to take exposure, or avoid taxes that they are supposed to pay. I have discussed this more in an earlier post, My “Non-testimony” on the Regulation of Swaps and Derivatives. If someone writes a history of innovative products, it will start with the golden era, when options and other derivatives were introduced to help investors better meet their investment objectives, allowing them to mold returns or, in the parlance of academics, to span the space of the states of nature. Then, somewhere along the line, an investor came to an investment bank and said, “Hey, I got a problem. You think you can help me out here.” His problem was something along the lines of, “My boss, he won’t let me trade mortgages, but I want to get my portfolio into these mortgages.” The ever- accommodating investment bank came back with an index amortizing swap.

50 Then – or maybe at the same time – the innovations went from "problem" solving to problem creating. Investment banks found clever ways to give their clients an extra twenty-five or fifty basis points by having them take on tail risks. These risks were subtle and infrequently occurring; most of the time things worked out. But every now and then, there were the blow ups; the likes of Orange County and P&G. http://rick.bookstaber.com/2009/05/flight-to-simplicity-in-derivatives.html

How to Grade the Stress Tests and PPIP by Adam S. Posen | May 4th, 2009 | 04:16 pm In school, usually one cannot postpone exams, and only real grubbers try to negotiate with their examining professors for better grades. In medicine, if one puts off one’s diagnostic tests, problems usually get worse. Whichever analogy the Treasury tries to use for explaining their stress tests, the drawing out of the process and the release of the results can hardly be seen as good news or good policy. The fact that by design the tests were to take several weeks, when ideally supervisors already had the data and just had to recalibrate the models, followed by six months for undercapitalized banks to fix their problems, only adds to the sense that this is all about forbearance. And as discussed in several posts on RealTime, as well as in my 2000 book, forbearance, keeping the banks open in hopes their balance sheets recover, is bad. Still, the Treasury and Fed may be doing the best they can, given that Congress has explicitly told them it will not provide more money for bank “bailouts” now. And the results of the stress tests leaked so far, notably that Bank of America and Citigroup will be asked to raise $10 billion each in new capital, are tougher than the cynics expected. Will that be tough enough to put the banking problems behind us? Clearly, no one is panicking about the US banking system, or even about particular banks, which makes sense since the government has guaranteed so much of the system. But given those guarantees, and the slow enforcement of the stress tests, it would seem to be kicking the problem down the road, whatever the intentions. How would we know if the stress tests are working, in the sense of being good policy leading to a good outcome? We have to consider them jointly with the Public-Private Investment Partnership (PPIP) put forward by Treasury Secretary Geithner, because the two programs are designed to work together in reducing the capital shortfalls of the major banks. The pressure from the stress tests is supposed to lead to greater willingness on the part of banks to sell their bad assets, and the sales of the bad assets are supposed to provide more private capital. I think this design is too clever by half [pdf], but we will soon find out. Here is what people should be looking for: • The combined amount of money going in to the toxic assets auctions and post- test capital injections—if it isn’t in the (low) hundred billions total, it probably is not enough; • Where the money for the toxic asset purchases and the capital injections comes from—if it is new money from private sources outside the banking system either bidding or injecting, that’s a good sign; if it is swaps of money between the banks buying each others’ fire-sale assets or conversion of US government preferred to common equity (with no additional conditions), that’s a bad sign;

51 • The creation of a secondary market, meaning sales by the initial purchasers to other smaller investors, of the PPIP auctioned assets—if such a market does not arise, then the initial purchases are likely solely driven by the government guarantees, and there will be no real “price discovery” to guide supervisors; and, • The flow of credit from the top 19 banks going to new or smaller customers—if the banks continue to sit on their funds or, worse, just roll over and extend loans to current big borrowers, then they still do not have enough capital. An additional vantage point from which to judge the entire exercise will be the reaction of international capital markets and other countries’ bank supervisors. I do not expect the stress tests and PPIP to have a first-order effect on the value of the dollar, or US long-term interest rates, since the government guarantees prevent any panic for now. But if most other governments view the as being too wimpy on the banks, we can expect either legitimate grousing about the United States’ subsidizing its banks unfairly for international competition, or more private capital flowing into bank stocks of countries where the situation is clearer. Of course, on these criteria, maybe we only need to worry about Canada, Spain, and Sweden being tough enough by comparison for the time being.

http://www.iie.com/realtime/?p=672

52

20.05.2009 Big setback for US housing market

So much for green shoots in the US housing market, which - by common consensus - needs at least to stabilise before the banking crisis can end. US housing starts hit a record low in April, at 458,000 (they were 2m during the boom). Calculated Risk, the best source on US housing, says that housing activity will bottom at some during this year (but this does not mean that prices will also bottom. Prices tend to fall for quite some time after housing starts and completions his their nadir. So it looks we are going the full 40-50% peak to through decline in this cycle, reached sometime in 2010.) Japan shrinks at 15.2% annualized in Q1 This is the curse of the export-led economy. Japan is doing even worse than Germany, with a fall in output of 4% in Q1, or 15.2% annualised. This follows an annualised contraction of 14.4% in Q4. Bloomberg reports that Japanese exports plunged an unprecedented 26% during the quarter, again annualised. But the single biggest contributor to the collapse was weak domestic demand (which has been relatively stable in Europe). The article also notes that the worst may be over, but analysts also note that consumer spending is likely to remain weak, given the expected rise in unemployment. Barroso wants a second mandatate In a talk with selected journalists, Jose Manuel Barroso spoke of his pride of having received the support of so many governments, Le Monde reports. Importantly he insisted that the Commission should be selected under the outgoing Nice Treaty, not the Lisbon Treaty, as Jean Quatremer points out in his blog, as this would require the Commission president to be confirmed by an absolute majority. He also made the incumbents’ perennial favorite argument that the crisis is so serious that political stability is now of utmost importance.

Massive Irish majority behind Lisbon

53 It is astonishing how quick a big financial and economic crisis can focus peoples’ minds. According to an Irish Times/TNS mrbi poll (hat tip Jean Quatremer), 52% were in favour, with only 29% opposed, a fall by 4pp from the previous poll. If you take out the undicideds, the tally is 64.5% in favour, and 35.5% against. The poll also asked people whether they are better of inside the EU than outside. A majority of almost 80% said yes. The poll also showed that the more educated you are, the more likely you are to vote Yes.

German regulator defends bad bank proposal Germany’s bad bank proposal comes in from criticism from all sides. Karl Whelan sets out his criticism in the Irish Economy blog, and says that the scheme is much worse than Ireland’s own. He asks who wants to invest in a bank whose SPV is going to make large and uncertain losses in the future? The FT has an article in which Jochen Sanio, the German banking regulator, defends the plan, saying that it would protect banks from the consequences of possible downgrades. European election watch In , the EU campaign of the radical right party FPÖ triggered a heated debate about extremism and antisemitism, when they published a EU campaign poster warning against EU accession of Turkey and Israel(!), reports Der Standard. Le Monde asks whether Austria is at risk of radicalisation. In the parliamentary elections of 2008, the two extreme right parties had together 37% of the votes among those under 30 year olds, and 29% of the whole electorate. Comeback of the Rhineland model Yves Leterme, former Belgian prime minister, believes that it is time for a comeback of the Rhineland model, reports De Tijd (hat Tip Flanders Today). In his latest book „The Rhineland model – for Sustainable and Social Prosperity’ he argues that the Rhineland model yields better results than its „neo-liberal“ counterpart in terms of equity and efficiency of its social insurance systems; it does not lack behind in terms of economic growth and is also sufficiently flexible to tackle the financial crisis. Leterme promotes the Rhineland model to become an option for Christian Democrats. Martin Wolf on the end of the recovery In his FT column, Martin Wolf asks the question how the crisis will pan out, and assumes that the world economy will kickstart with a Chinese/US driven economic recovery. But he says there are three open questions. The first is whether indebted households and falling net worth can generate a sustained increase in household savings? How long can fiscal deficits continue at their current rate? And can central banks engineer a non-inflationary exit? He is relatively pessimistic on our ability to reform the financial sector, but says that at least in the west, its glory days are over. But his overall conclusion is that capitalism will survive. Towards deflation and inflation Dieter Wermuth, in the German blog Herdentrieb, claims that consumer price deflation has already started in several western economies, and the situation is likely to deteriorate in the coming months. He warns of a self-reinforcing vicious cycle of deflation, a mirror image of an inflationary spiral. He supports the view of Kenneth

54 Rogoff and Greg Mankiw, who have argued in a recent article that the US should be heading for an inflation rate of 6% for two years. Wermuth makes the additional point that the US might also use the exchange rate to oil the wheels, as this would create a few domestic jobs and produce a bit of inflation. He concludes that the best way to solve the global deflation problem is not through a spiral of devaluations, but through international co-ordination. Lawrence Boone on Sarkozy Writing in Telos, Lawrence Boone write that Sarkozy’s economic reforms turned to out be both less ambitious in scope and more costly than estimated. As an example she cites the reform of the labour market, which should have involved the creation of a single work contract, but which ended up with a whimper of a procedural reform. The health care reforms, which should have cost next to nothing, however, ending up costs 1.4% of GDP. Please spare us a Stability Pact, Mark III Writing in FT Deutschland, Wolfgang Proissl agrees that the stability pact is an unsuitable instrument to bring down deficits in this crisis. Like its ill-fated predecessor, the second version of the stability pact remains inflexible, as it did not foresee this kind of crisis. But he concluded that yet another pact would not help the situation either, as such an exercise would have no credibility. He said the best strategy is to muddle through, and to define an exit strategy for each country.

55

Japan’s Economy Shrank Record 15.2% Last Quarter (Update2) By Jason Clenfield

May 20 (Bloomberg) -- Japan’s economy shrank at a record 15.2 percent annual pace last quarter as exports collapsed and consumers and businesses cut spending. The contraction followed a revised fourth-quarter drop of 14.4 percent, the Cabinet Office said today in Tokyo. Gross domestic product fell 3.5 percent in the year ended March 31, the most since records began in 1955, confirming that the recession is Japan’s worst in the postwar era. Exports plunged an unprecedented 26 percent last quarter, forcing companies from Toyota Motor Corp. to Hitachi Ltd. to cut production, workers and wages. Stocks have gained 32 percent since reaching 26-year low in March on speculation worldwide interest-rate reductions and spending by governments will halt the slide in the world’s second-largest economy. “There was a collapse across the board,” said Yoshiki Shinke, a senior economist at Dai- Ichi Life Research Institute in Tokyo. Still, he added that there’s “light at the end of the tunnel” and the economy will resume growing this quarter as companies replenish inventories and stimulus plans at home and abroad take effect. The yen traded at 95.71 per dollar at 11 a.m. in Tokyo from 96.16 before the report was published. The Nikkei 225 Stock Average rose 0.4 percent. The first-quarter contraction was the most severe since records started 54 years ago. Economists predicted the economy would shrink 16.1 percent. Worse Than U.S. GDP fell 4 percent on a non-annualized basis, more than double the U.S.’s 1.6 percent slide. It’s also worse than Europe’s record 2.5 percent contraction. Without adjusting for price changes, Japan shrank 2.9 percent last quarter. Weaker domestic demand was the biggest contributor to the decline, shaving 2.6 percentage points off GDP, the most since 1974. Net exports -- the difference between exports and imports -- was responsible for 1.4 percentage points of the drop.

56 Consumer spending slid 1.1 percent and business investment plunged a record 10.4 percent. Economists say companies will keep cutting spending because the decline in demand has left factories and workers underused. “There is a huge problem of over-capacity,” said Hiromichi Shirakawa, chief economist at Group AG in Tokyo. “That means capital spending is not likely to pick up.” Hitachi’s Losses Hitachi, a maker of nuclear reactors, home appliances and hard-disk drives, will trim costs by 500 billion yen ($5.2 billion) this fiscal year to minimize losses after a record 787.3 billion yen deficit last year. The Tokyo-based company said in January it plans to cut 7,000 jobs. Still, reports in the past month suggest the world’s second-largest economy may grow for the first time in a year this quarter, albeit from a low point, as exports stabilize and Prime Minister Taro Aso’s 15.4 trillion yen stimulus plan, announced in April, takes effect. Consumer confidence climbed to a 10-month high in April. Exports increased in March from a month earlier, and factory output rose for the first time since September. “While the economy will continue to be in a severe state, I expect less pressure from inventory adjustments and the stimulus package to provide support,” Economy and Fiscal Policy Minister Kaoru Yosano said after today’s report. Replacing Stockpiles Falling inventories accounted for 0.3 percentage point of last quarter’s contraction. Companies including Honda Motor Corp. have cut stockpiles at a quicker rate than sales have declined, giving them room to increase production. The automaker plans to boost output in Japan this quarter as dealerships clear inventories, reported last week. Honda Executive Vice President Koichi Kondo said last month that the worst for the U.S. is probably over. Still, the failure of export demand to do better than simply stabilize will probably limit the scope of Japan’s recovery. Toyota, Hitachi, and Panasonic Corp. all forecast continued losses in the current business year. Panasonic said last week it plans to close about 20 factories this year and proceed with the 15,000 job cuts announced in February. “We basically bottomed out,” said Jesper Koll, chief executive officer of hedge fund adviser TRJ Tantallon Research Japan. Even so, “on the consumer spending side you’ve got a very clear negative from the severe labor market adjustment.” http://www.bloomberg.com/apps/news?pid=20601087&sid=a_jsUBH352fg

German ‘bad bank’ scheme criticism rejected By James Wilson in Bonn Published: May 20 2009 01:54 | Last updated: May 20 2009 01:54

57 Germany’s financial regulator has rejected criticism of the country’s planned “bad bank” scheme and urged banks to take advantage of the chance to get rid of toxic assets before a possible wave of further hits to their capital. Jochen Sanio, president of BaFin, said there was a “concrete risk “ that sudden downgrades to some bank assets would dramatically raise the amount of capital needed by banks. “Freedom from this ... is the most important reason why German banks’ balance sheets should quickly be cleaned of toxic assets,” said Mr Sanio. His defence of Germany’s bad bank plan comes after analysts and bankers have said the scheme for dealing with about €200bn ($272bn) of toxic credits, announced last week by the government, is unappealing to banks and their investors and will do little to help recapitalise the financial system. The plans – heavily influenced by lawmakers’ reluctance to add to the burden on taxpayers – involve off balance sheet vehicles to stretch the time over which assets can be dealt with, while placing the costs of the scheme on the banks that own the assets. Participating banks face an immediate haircut on the value of assets spun off while dividends could be diverted to pay for further losses. Defending the plan, which is still to be approved by parliament, Mr Sanio said he understood the cross-party decision not to shield taxpayers from ultimate losses and said the scheme’ use was to free banks from further hits to their capital. “Whether and how far individual banks still need recapitalising is another question,” he said. He reinforced support for the bad bank scheme with a pessimistic view of the state of the economy, saying it was “more than improbable” that Germany would have a rapid, V-shaped recovery. “German banks need to go into the coming difficult economic phase with the strongest possible capital,” he warned. Any bank could be in for a “rude awakening” if it overestimated its capital strength, he said. Some German bankers believe the painful restructuring undertaken by the company’s corporate sector this decade has reduced the risk of loan defaults. However Mr Sanio said there was “no experience” of what the present recession could mean for banks. “We regulators are a long way from being able to estimate the amount of future defaults,” he said. Bafin also admitted its ability to supervise banks had been temporarily weakened because of the demands placed on it by a parliamentary inquiry into the near-collapse of Hypo Real Estate, the Munich-based property lender. Sabine Lautenschläger, Bafin’s head of banking supervision, said: “We have had to reduce certain areas of supervision for a certain time ... to provide for the inquiry ... there is a lot of work.” Her department was having to “borrow” staff from other Bafin departments, she said. Mr Sanio is among those expected to have to testify to the committee investigating the Hypo Real Estate bail-out, which began hearings this month. The bank has needed more than €100bn of support, mainly from the state. http://www.ft.com/cms/s/0/5f250790-4497-11de-82d6-00144feabdc0.html

58 News Analysis May 19, 2009, 6:53PM EST text size: TT Housing: Recovering or Not? Just as optimism began to bloom, U.S. housing starts hit a record low. The homebuilding sector may have to endure a long bottoming process By Ben Steverman Hopes are high that the deeply troubled U.S. housing sector has finally seen the worst of the recession and financial crisis. But new data on May 19 raised questions about that optimism. U.S. housing starts hit a record low, dropping 12.8% in April, to an annual pace of 458,000. Housing starts are down 79.8% from their peak in January 2006. A sharp drop in construction of multifamily dwellings drove the reading, with single- family starts actually up 2.8%. However, the overall record low disappointed economists and investors, who had seen signs in recent months that housing might have hit bottom. With housing starts at a record low, "it's early to pop the cork," says Michael R. Englund, chief economist for Action Economics. Yet, Englund and other economists told BusinessWeek, the data don't contradict hopes that housing might be near a bottom. "in the process of bottoming out" A drop in construction activity is certainly troubling for the overall economy and for unemployment trends. But a drop in housing starts might actually be good news for the sector's eventual rebound, says Gary Wolfer, chief economist at Univest Wealth Management (UVSP). One of the housing market's main problems is a glut of supply—too many homes for sale. Idle homebuilders mean fewer new homes coming onto the market, thus hastening a bottom for the market. "We're getting there in a brutal fashion," Wolfer says, but at least we're "in the process of bottoming out." Keith Hembre, chief economist at First American Funds, worries that further home foreclosures could continue to drive the proliferation of "for sale" signs across the country. However, he does see reasons to hope for a revival in demand. The government is helping: Low interest rates make mortgages more easily affordable (if you can qualify for one) and the federal government is providing an $8,000 tax credit in 2009 for first- time home buyers. "The signs are there that demand has generally hit bottom," Hembre says—and it may even be improving somewhat. A recovery start for homebuilders? First-quarter earnings reports from homebuilders have bolstered the case for guarded optimism. "For the homebuilding industry, we think that probably the worst is over," says Kenneth Leon, a Standard & Poor's equity analyst who covers the homebuilders. Key metrics seemed to improve in the homebuilders' first-quarter earnings reports, Leon says, including net orders, backlog, and the pace of homebuilder write-offs. Still, industry players continue to post quarterly losses.

59 Investors had a mixed reaction to the April housing starts data. Though the record decline was cited by some market observers as a troubling sign for the overall economy, shares of the largest homebuilders were mixed. On May 19, Pulte Homes (PHM) dropped 2.6%, to 10.03, but Toll Brothers (TOL) slipped just 0.7%, to 19.51, and D.R. Horton (DHI) gained 1.8%, to 9.96. Homebuilders: Not out of the woods After two very difficult years, homebuilders are trading solidly higher so far this year. The S&P Homebuilding index rose almost 19% in the first four months of 2009. S&P's Leon doesn't expect "a full sustained recovery" for the housing sector until the end of 2010. And several factors could derail or delay the housing market's recovery, experts say. Fresh foreclosures could flood the market with supply, even as homebuilders cancel new projects. Credit troubles could make it hard for buyers to get mortgages. Right now, "affordability is very attractive—if you can qualify and get a mortgage," Leon says. Even if activity returns to the housing sector, home prices could continue to fall for some time. "While we are well into the housing bottoming process, we are a long way from recovery," Stifel Nicolaus (SF) analyst Michael R. Widner wrote May 19. "Our math suggests we have a couple years to go before excess inventory clears and paves the way for significant housing sector improvement," he added. Watch "the broader financial crisis" Englund of Action Economics warns that there may be too much focus on foreclosures, government incentives, or individual data points. Those aren't the key drivers of a revival for housing, he says. As demonstrated by the "roller coaster of the last 2 1/2 years," he says: "It's the broader financial crisis that [is] really driving this process." While worries linger about the next potential financial disaster or an unforeseen economic meltdown, many home buyers are reluctant to take a risk on a major home purchase. "No one wants to jump headlong into this environment," Englund says. In other words, no matter what the data say from month to month, it's hard to imagine the housing sector bouncing back until the big picture significantly improves. Steverman is a reporter for BusinessWeek's Investing channel. http://www.businessweek.com/print/investor/content/may2009/pi20090519_897813.htm

60 COLUMNISTS This crisis is a moment, but is it a defining one? By Martin Wolf Published: May 19 2009 19:48 | Last updated: May 19 2009 19:48

Is the current crisis a watershed, with market-led globalisation, financial capitalism and western domination on the one side and protectionism, regulation and Asian predominance on the other? Or will historians judge it, instead, as an event caused by fools, signifying little? My own guess is that it will end up in between. It is neither a Great Depression, because the policy response has been so determined, nor capitalism’s 1989. Let us examine what we know and do not know of its impact on the economy, finance, capitalism, the state, globalisation and geopolitics. On the economy, we already know five important things. First, when the US catches pneumonia, everybody falls seriously ill. Second, this is the most severe economic crisis since the 1930s. Third, the crisis is global, with a particularly severe impact on countries that specialised in exports of manufactured goods or that relied on net imports of capital. Fourth, policymakers have thrown the most aggressive fiscal and monetary stimuli and financial rescues ever seen at this crisis. Finally, this effort has brought some success: confidence is returning and the inventory cycle should bring relief. As Jean-Claude Trichet, president of the European Central Bank, remarked, the global economy is “around the inflection point”, by which he meant that the economy is now declining at a declining rate. We can also guess that the US will lead the recovery. The US is again the advanced world’s most Keynesian country. We can guess, too, that China, with its massive stimulus package, will be the most successful economy in the world. Unfortunately, there are at least three big things we cannot know. How far will exceptional levels of indebtedness and falling net worth generate a sustained increase in the desired household savings of erstwhile high-spending consumers? How long can current fiscal deficits continue before markets demand higher compensation for risk? Can central banks engineer a non-inflationary exit from unconventional policies? On finance, confidence is returning, with spreads between safe and risky assets declining to less abnormal levels and a (modest) recovery in markets. The US

61 administration has given its banking system a certificate of reasonable health. But the balance sheets of the financial sector have exploded in recent decades and the solvency of debtors is impaired.

We can guess that finance will make a recovery in the years ahead. We can guess, too, that its glory days are behind it for decades, at least in the west. What we do not know is how far the “deleveraging” and consequent balance-sheet deflation in the economy will go. We also do not know how successfully the financial sector will see off attempts to impose a more effective regulatory regime. Politicians should have learnt from the need to rescue financial systems stuffed with institutions deemed too big and interconnected to fail. I fear that concentrated interests will overwhelm the general one. What about the future of capitalism, on which the Financial Times has run its fascinating series? It will survive. The commitment of both China and India to a market economy has not altered, despite this crisis, although both will be more nervous about unfettered finance. People on the free- market side would insist the failure should be laid more at the door of regulators than of markets. There is great truth in this: banks are, after all, the most regulated of financial institutions. But this argument will fail politically. The willingness to trust the free play of market forces in finance has been damaged. We can guess, therefore, that the age of a hegemonic model of the market economy is past. Countries will, as they have always done, adapt the market economy to their own

62 traditions. But they will do so more confidently. As Mao Zedong might have said, “Let a thousand capitalist flowers bloom”. A world with many capitalisms will be tricky, but fun. Less clear are the implications for globalisation. We know that the massive injection of government funds has partially “deglobalised” finance, at great cost to emerging countries. We know, too, that government intervention in industry has a strong nationalist tinge. We know, as well, that few political leaders are prepared to go out on a limb for . Most emerging countries will conclude that accumulating massive foreign currency reserves and limiting current account deficits is a sound strategy. This is likely to generate another round of destabilising global “imbalances”. This seems an inevitable result of a defective international monetary order. We do not know how well globalisation will survive all such stresses. I am hopeful, but not that confident. The state, meanwhile, is back, but it is also looking ever more bankrupt. Ratios of public sector debt to gross domestic product seem likely to double in many advanced countries: the fiscal impact of a big financial crisis can, we have been reminded, be as costly as a large war. This, then, is a disaster that governments of slow-growing advanced economies cannot afford to see repeated in a generation. The legacy of the crisis will also limit fiscal largesse. The effort to consolidate public finances will dominate politics for years, perhaps decades. The state is back, therefore, but it will be the state as intrusive busybody, not big spender. Last but not least, what does the crisis mean for the global political order? Here we know three important things. The first is that the belief that the west, however widely disliked by the rest, at least knew how to manage a sophisticated financial system has perished. The crisis has damaged the prestige of the US, in particular, pretty badly, although the tone of the new president has certainly helped. The second is that emerging countries and, above all, China are now central players, as was shown in the decision to have two seminal meetings of the Group of 20 leading nations at head of government level. They are now vital elements in global policymaking. The third is that efforts are being made to refurbish global , notably in the increased resources being given to the International Monetary Fund and discussion of changing country weights within it. We can still only guess at how radical the changes in the global political order will turn out to be. The US is likely to emerge as the indispensable leader, shorn of the delusions of the “unipolar moment”. The relationship between the US and China will become more central, with India waiting in the wings. The relative economic weight and power of the Asian giants seems sure to rise. Europe, meanwhile, is not having a good crisis. Its economy and financial system have proved far more vulnerable than many expected. Yet how far a set of refurbished and rebalanced institutions for international co- operation will reflect the new realities is, as yet, unknown. What then is the bottom line? My guess is that this crisis accelerated some trends and has proved others – particularly those in credit and debt – unsustainable. It has damaged the reputation of economics. It will leave a bitter legacy for the world. But it may still mark no historic watershed. To paraphrase what people said on the death of kings: “Capitalism is dead; long live capitalism.” Write to [email protected] More columns at www.ft.com/martinwolf http://www.ft.com/cms/s/0/beb9b7e8-449f-11de-82d6-00144feabdc0.html

63

Architecture Billings Index Steady in April by CalculatedRisk on 5/20/2009 09:00:00 AM From the AIA: Architecture Billings Index Points to Possible Economic Improvement After an eight-point jump in March, the Architecture Billings Index (ABI) fell less than a full point in April. As a leading economic indicator of construction activity, the ABI reflects the approximate nine to twelve month lag time between architecture billings and construction spending. The American Institute of Architects (AIA) reported the April ABI rating was 42.8, down from the 43.7 mark in March. This was the first time since August and September 2008 that the index was above 40 for consecutive months, but the score still indicates an overall decline in demand for design services (any score above 50 indicates an increase in billings). The new projects inquiry score was 56.8.

“The most encouraging part of this news is that this is the second month with very strong inquiries for new projects. A growing number of architecture firms report potential projects arising from federal stimulus funds,” said AIA Chief Economist Kermit Baker, PhD, Hon. AIA. “Still, too many architects are continuing to report difficult conditions to feel confident that the economic landscape for the construction industry will improve very quickly. What these figures mean is that we could be seeing things turn around over a period of several months.”

This graph shows the Architecture Billings Index since 1996. The index is still below 50 indicating falling demand.

64 Historically there is an "approximate nine to twelve month lag time between architecture billings and construction spending" on commercial real estate (CRE). So there will probably be further dramatic declines in CRE investment later this year.

Back in 2005, Kermit Baker and Diego Saltes of the American Institute of Architects wrote a white paper: Architecture Billings as a Leading Indicator of Construction

The following graph is an update from their paper.

This graph compares the Architecture Billings Index and year-over-year change in non- residential construction spending from the Census Bureau. This graph suggests the non-residential construction collapse will be very sharp, and although there isn't enough data to know if this is predictive of the percentage decline in spending, it does suggest a possible year-over-year decline of perhaps 20% to 30% in non-residential construction spending. http://www.calculatedriskblog.com/

65 RGE Monitor's Newsletter 20/05/2009 8:00 Are Commodity Prices Getting Ahead of Fundamentals? Greetings from RGE Monitor! Commodity prices seem to be getting ahead of fundamentals again. As of May 13, 2009, the Rogers International Commodity Index rose 7.6% since the start of 2009 on the belief that putative ‘green shoots’ around the world validated a V-shaped economic recovery in 2009. However, these 'green shoots' might still be a signal of the stabilization of economic activity at low levels, rather than a return to trend growth. Even if GDP growth around the world has bottomed, growth may continue to be negative or sluggish until 2011. As such, commodity price gains might reveal a false sign of economic recovery – and so might the recent spate of bear market rallies in stock markets and inflows into emerging markets. The strong uptrend in commodity prices since February has been propelled m ore by technicals (investment demand, opportunistic stockpiling at low prices) than fundamentals (real growth in physical demand and production). Commodity prices could snap back to reality before resuming a more moderate uptrend in line with a U-shaped global growth path. Base Metals Base metals posted the strongest rebound among the commodity groups. The S&P GSCI Industrial Metals sub-index rose 21.1% ytd as of May 13, 2009. Copper led the rebound as it had the smallest surplus (as a percent of supply) and China's copper imports reached an all-time high in March. China's import rebound was driven by strategic reserve buying and the re-stocking of depleted inventories to take advantage of low prices - not to reflect (as yet nonexistent) strong growth in global manufacturing or consumption. China’s infrastructure-heavy fiscal stimulus will provide some support to commodities as will the nascent stabilization of the property market, but other private demand may continue to be weak, suggesting that China’s commodity demands may level off at somewhat lower levels than recent trends. Although China's PMIs are the first and only ones globally to indicate expansion in the manufacturing sector, with external demand weak, they have a long way to go just to return to mid-2008 levels. Elsewhere, bankruptcy in the U.S. auto sector, dismal auto sales among Europe and Japan's carmakers and weak housing markets have obviated metal stockpiling. Non- precautionary metal demand has been flat globally, leaving the metal price uptrend without any real economic backing. Seasonality may also have beefed up metals prices temporarily: base metal demand tends to spike up in the spring as refiners stock up before metal producers – primarily in Europe – take their summer holidays. The opening of mines and refineries in Asia and Latin America have alleviated some of this precautionary demand for metals, but the 'spike' remains - albeit in milder form. For example, demand for aluminum by beverage

66 makers rises in the spring in anticipation of higher demand for canned beverages in the summer. After restocking ends, base metal demand will likely dip into a summer lull. Not even infrastructure-heavy fiscal stimulus packages may offset the fall in private sector demand for industrial metals. Already, some metal prices have begun to retreat as early as late April as physical buying waned and further pressure is likely. However, fundamentals may drive metal prices down only briefly before lower prices again attract opportunistic stockpiling and speculation. Metal prices may also be lifted by investor demand for metals as a hedge against the potential inflationary effect of quantitative easing or a weaker dollar. But technicals aside, metals will be hard pressed for a fundamentally sustainable rally until consumer demand growth revives. Moreover, higher average commodity prices might lead some of these green shoots to wither. Iron & Steel Meanwhile, contract bulks remain in limbo. Negotiations have already passed the April 1st start of the 2009 contract year yet benchmark iron ore contracts are still to be settled. With steelmakers demanding drastic price cuts (40-60% y/y) back to 2007 levels, sellers have been stalling for time in hopes that the market will improve. Negotiators plan to conclude negotiations by June 2009. Until then, major producers have offered iron ore in the spot market at temporary prices 20% below the 2008 contract levels. Iron ore spot prices have increased slightly since the start of 2009, but on higher freight costs not higher demand. As of May 15, 2009, the Baltic Dry Index was up 228% since the beginning of 2009. Iron ore contract prices will most likely end up lower than last year due to the global demand contraction. Analysts expect a 35%-65% correction. Steel contract prices should follow suit with one leg already down - the 2009 contract prices for metallurgical coal (a major steel input) have settled 60% lower than in 2008. The World Steel Association forecasts the world's apparent steel use will be lower in 2009 than in 2008. It expects only India to see an annual increase, thanks to construction for the 2010 Commonwealth Games. Precious Metals Gold is a special commodity in that the fundamentals of physical supply and demand are minor influences on its price. Gold’s price is most often driven by spe culative demand for a hedge against inflation or economic uncertainty. Many investors see gold as a substitute for fiat currencies. Consequently, gold prices sometimes track changes in central bank holdings of gold. Gold markets largely ignored China’s surprise revelation that it had increased its gold reserves as much of this had already been priced in by speculators. Moreover, China produces its own gold. The increase in China's gold holdings is just a mere drop in the bucket of its total $1.9 trillion in foreign exchange reserves. Gold's share in China's foreign exchange reserves remains much lower than the global average and well below the U.S. share. But China's interest in gold is consistent with its taste for real assets to gradually diversify from its U.S. bond-heavy portfolio. If other central banks followed suit, gold demand could increase sharply. IMF gold sales will likely have little impact on gold prices if it sells its gold to central banks rather than the free market. The European Central Bank Gold Agreement’s expiration in September 2009 may have more impact. The signatories are likely to renew the agreement and continue limiting central bank gold sales. Fears that

67 monetization of rising public debts will erode currency values may spark demand for gold as an inflation hedge.

Agriculture The commodity group trading closest to fundamentals has been agriculturals. S&P GSCI Agriculturals registered a small 1.77% ytd increase as of May 15, 2009 – a reasonable price gain in line with the subtle inflection in global consumer demand. Intra-group price performance has largely reflected differences in supply- demand situations: Sugar and coffee have outperformed grains, meat and dairy. Supply deficits due to cane crop failures in India and weather damage to coffee in Colombia have kept sugar and coffee prices at multi-year highs. According to the S&P GSCI, the sugar price has risen 19% ytd as of May 15, 2009 and coffee 10%. Grains (wheat, soybeans, corn) on average have fared less well, rising only 1% ytd as of May 15, 2009, commensurate with their looser supply/demand balance. Meat prices have fallen with the reduction in meat demand due to falling incomes around the world. The swine flu outbreak exacerbated the decline in pork demand and prompted bans on pork imports in Russia, China and other places. Dairy prices seem to have bottomed at the pre-boom levels of 2006 and stabilized at this lower balancing point for supply and demand. Oil WTI crude oil futures have risen sharply since March, touching $60 per barrel May 15 2009, despite the weak demand outlook. Preliminary data and economic forecasts suggest that 2009 will mark the second back-to-back annual oil demand decline since the 1980s as industrial and residential demand slows and commercial inventories are high around the world. As such, spot and futures prices are likely to face further pressure along with a return in risk aversion. OPEC’s cuts have contributed to tightening supplies somewhat but have yet to lead to much of an er osion of stockpiles, particularly in the U.S. where crude oil inventories are just off the highest levels since 1990 and well above the 5-year average. In Europe and Japan the supply overhang is less pronounced but stockpiles remain well above average levels, indicating no supply shortage. In the U.S., demand for gasoline has held up better than other fuel products as prices per gallon are well below year-ago averages and miles driven by Americans are on the increase on a year-on-year basis. However, with gas prices having inched up this year and the U.S. consumer under pressure, summer driving season may not add as much significant demand for gasoline as in the past. Meanwhile demand for crude oil products as a whole continue to fall sharply from last year, with the most recent data from the Department of Energy suggesting an 8% drop from early May 2008, with the decline in air traffic contributing to double-digit declines in jet fuel demand. Meanwhile, as with its metal demands, China's increase in oil imports in late Q1 and early Q2 might not be sustainable - reserve refilling and stockpiling may account for part of the increase. With the increase in refinery capacity, including a new refinery in Fujian which can process heavier, sour crude, China may also try to ramp up refined fuel exports without a short-term increase in fuel demand domestically. Moreover as energy prices rise, China- a price sensitive buyer- may well reduce purchases.

68 OPEC meets again at the end of May, but further cuts seem very unlikely now that oil prices have returned to a range where more OPEC members are fiscally comfortable (most GCC countries can balance their budget in the $50-55 range ). In fact data suggests that OPEC production has actually increased in April, with quota compliance falling to 77% down from the 81% from February of 2009. Compliance could well worsen. Meanwhile, non-OPEC production declines, especially from Russia, are reinforcing OPEC cuts. With a freeze on investment in most countries, supply shortages are a risk in the coming years, suggesting more volatile prices ahead.

Natural Gas The reduction in industrial demand and ample supply contributed to record buildup of natural gas inventories in and in Europe, pushing down on prices. As such, natural gas has been less infected by the renewed appetite for commodities. However with natural gas drilling activity having fallen sharply, there is a risk that the current glut could be followed by a supply shortage. With the manufacturing sector weak, industrial demand in advanced economies may be particularly slow to recover, limiting the revival of demand. Macroeconomic Implications There are several macroeconomic implications of this recent increase in commodity prices. Commodity exporting economies and their currencies are, like commodities, vulnerable to a reversal of risk appetite. The g reen shoots which prompted the in rush into commodities have likewise prompted inflows to commodity exporters like Russia, South Africa as well as Australia and other commodity exporters. The U.S. dollar’s weakness has contributed to strengthening of both G-10 and EM commodity currencies. However, with global exports weak, the upward pressure on currencies is not particularly welcomed and some emerging market economies like Russia are intervening in foreign exchange markets, adding to their reserves. At current oil prices, the outlook and liquidity conditions are improved in many exporting economies, many of which like Norway, Saudi Arabia and are deploying their past savings to meet current spending needs. However, even the current improvement in revenues may do little to avert the consumption slowdown in many of these economies. The generalized increase in commodity prices across the board and in transportation fuels in particular poses the risk of choking off any global economic recovery. And although current production cuts and delayed investment may have only limited effect on prices in 2009, they could raise the risk of a significant price shock in 2010 which could send the economy back into weakness. Swift increases in commodity prices as we saw in 2008, tend to exacerbate recessions as well as worsen external balances in the U.S. and key oil importers and adding to the amount of capital needed to finance fiscal and financial support packages http://www.rgemonitor.com/635

69 Opinion

OP-ED CONTRIBUTORS, MAY 19, 2009 Some Bankruptcies Are Worth It By LEE C. BUCHHEIT and DAVID A. SKEEL Jr. THE Treasury Department hopes that its recent stress tests on the country’s 19 largest banks have weeded out the capital-challenged ones. But many other large financial institutions are still groaning under huge burdens of debt and assets of dubious or uncertain value. Since the collapse of just over a year ago, the government has bailed out financial institutions whose failures threatened the broader financial system (with the exception of Lehman Brothers). In explaining this approach, federal regulators have said that they lack the tools to prevent disorderly failures of such institutions. Bailouts have been the only alternative to bankruptcy filings that can have dangerous effects on the rest of the economy. But why not adopt an approach that would, where necessary, allow the controlled failure of a major financial institution? To limit the disruption such an event might cause in the broader market, the government could announce that it would support the institution — for example, by guaranteeing its trading obligations — for, say, 60 to 90 days. During this period, the institution’s creditors and counterparties would not be permitted to cancel their contracts and demand immediate repayment, or force the institution to pony up additional collateral. (In the case of commercial banks, there would need to be arrangements to ensure that customers had continued access to their deposits.) In return, the institution requesting government assistance would be required to ask its creditors and counterparties to reduce or defer their claims in order to restore the institution to solvency. It would also be required to commence plans for a possible bankruptcy at the end of the support period; make all material information about itself available to prospective buyers; and cooperate with counterparties that wish to enter into arrangements among themselves that would smooth an eventual bankruptcy, if one cannot be avoided. If at the end of the support period enough creditors and counterparties have agreed to reduce or defer their claims so that the institution can stay afloat, or a third party has agreed to acquire it, then it would resume normal business. If neither of these happy outcomes occurs, then the institution would enter bankruptcy (or, in the case of commercial banks, insolvency) in the usual way. By this point, however, there would have been enough time to make preparations to ensure that the institution’s failure would not destabilize other companies or disrupt the financial markets generally. Of course, the prospect of an insolvency proceeding at the end of the support period, with no hope of further government help, ought to concentrate the minds of the stakeholders on finding a better solution. Lee C. Buchheit is a lawyer in New York City. David A. Skeel Jr. is a law professor at the University of Pennsylvania.

70 Business

May 19, 2009 Wall St. Firm Draws Scrutiny as U.S. Adviser By ERIC LIPTON and MICHAEL J. de la MERCED The financial crisis has ravaged many a Wall Street giant, but it has also produced a handful of winners. BlackRock, a money manager that is much admired but little known outside financial circles, is fast emerging as one of the nation’s financial powerhouses. BlackRock, which started in a one-room office 21 years ago, now manages $1.3 trillion in assets for big private clients, including hedge funds and foreign governments.

But it is the company’s highly prized role as a government adviser and contractor that is now drawing attention. By dint of its expertise and track record, it has won contracts to help the government manage the complex rescues of Bear Stearns, the American International Group and Citigroup.

71 It also won a bid to carry out a Federal Reserve program to stimulate the moribund housing market, and it has been hired to help evaluate Fannie Mae and Freddie Mac, the government-created mortgage finance giants. Other firms have been hired by the government to assist with the bailout, illustrating the increasingly symbiotic relationship between Washington and Wall Street. It makes sense for the government to turn to financial experts for help, but BlackRock has become so ubiquitous that some lawmakers, federal auditors and watchdog groups are now asking if the firm does too much, and if its roles as government adviser, giant federal contractor and private money manager will inevitably collide. Can a company that is being paid to price and sell troubled assets for the government buy the same kinds of assets for private clients without showing preference? And should the government seek counsel from a company whose clients stand to make or lose billions if those policies are enacted? “They have access to information when the Federal Reserve will try to sell securities, and what price they will accept. And they have intricate financial relations with people across the globe,” Senator Charles E. Grassley, Republican of Iowa, said. “The potential for a conflict of interest is great and it is just very difficult to police.” Without naming BlackRock, federal auditors have warned that any private parties that purchase distressed assets on the government’s behalf could use generous federal subsidies to overpay, artificially pushing up the price of similar assets that they manage for their own portfolios. “In other words, the conflict results in an enormous profit for the fund manager at the expense of the taxpayer,” Neil M. Barofsky, the special inspector general for the Troubled Asset Relief Program, wrote in a report last month. Some of BlackRock’s advice to the government has in fact helped the company. For example, in its role as an informal adviser, it urged the Fed to intervene in the markets in a way that made investors feel it was safe to put money back into money market funds, including BlackRock’s. The Federal Reserve will not reveal what it is paying BlackRock, disclosing only that on one of its five contracts, it will pay at least $71 million over three years to BlackRock and other firms to manage a portfolio of mortgage assets once owned by Bear Stearns. BlackRock says that rate is discounted and that the fees it collects on bailout-related work are only a tiny portion of its overall revenue. BlackRock has many admirers for the range and the quality of services it has provided to the federal government. James R. Wilkinson, who served until January as the chief of staff to the former Treasury secretary, Henry M. Paulson Jr., described BlackRock’s co-founder and chief executive, Laurence D. Fink, as a “patriot.” He added, “He is willing to help our country when we need it most.” Mr. Fink said he was proud that his company was helping pull the economy back from the brink, and he bristled at the suggestion of impropriety. Treasury and Fed officials have begun to take precautions. BlackRock’s dominance has prompted the Fed to seek an alternative partner as it prepares to expand its rescue efforts, a government official close to the situation said, requesting anonymity because the actions could affect the market.

72 And Treasury is holding off announcing the winning bidders for perhaps the most anticipated of all the bailout programs — the $1 trillion federally subsidized plan to purchase troubled assets from banks — in part to make sure the bidders cannot game the system. BlackRock is widely expected to win one of the contracts, in which the government would be a partner with private firms. Andrew Williams, a Treasury Department spokesman, said that BlackRock had no special status and was among a large group of industry players consulted about bailout programs. “We take this very seriously,” Mr. Williams said. “We talk to a lot of people — as we should.” Now 47 percent owned by Bank of America, BlackRock offers traditional services like managing other people’s money. But the unit that has grabbed most of the attention lately is BlackRock Solutions, whose sophisticated software, fine-tuned over many years, can take apart the thousands of loans in a mortgage-backed security to estimate what it is now worth and what it will most likely be worth in the future, helping investors decide whether to hold or sell the asset. During one frantic weekend in March 2008, when Bear Stearns was collapsing, BlackRock’s omnipresence became evident. On a Saturday, the firm was hired by JPMorgan Chase — which was considering buying Bear Stearns — to value one type of Bear Stearns security. The next day the Federal Reserve hired BlackRock, through a no-bid contract, to analyze and eventually sell off a $30 billion pool of risky mortgage securities that JPMorgan did not want. Those multiple roles created the potential for conflict, BlackRock’s own executives acknowledge. The company would be trying to sell assets on behalf of the government that were similar to assets it buys and sells for thousands of other private investors. For example, if BlackRock Solutions signaled to BlackRock’s asset managers the timing of a planned sale, that could benefit BlackRock’s investors, but harm taxpayers and the Federal Reserve. “We were very sensitive to it,” said Mark Wiedman, a managing director at BlackRock Solutions. To avoid this, BlackRock Solutions and BlackRock asset management employees are housed in separate buildings, working on separate computer networks. The firm also sells the Bear Stearns securities only through an independent broker, meaning BlackRock does not know who the buyers are. The Fed, in addition, has prohibited BlackRock from knowingly buying any of the Fed-controlled assets. But some remain skeptical that such firewalls really protect taxpayers. “How can one company have so much control over the process?” said Scott Amey, general counsel at the Project on Government Oversight, a Washington-based non- profit group. “Isn’t there somebody else they can turn to?” The concerns about BlackRock also extend to its role as an informal adviser. Mr. Fink has been known to call Treasury officials several times a day, Bush and Obama administration officials said, between occasional visits.

73 Last fall Mr. Fink urged the Fed to take action to unlock the frozen market for short- term lending to companies — a business that BlackRock’s money market mutual funds played a major role in. Investors had withdrawn $48 billion from those BlackRock funds, but once the Fed adopted the policy Mr. Fink was advocating, the money came pouring back. Mr. Fink said his advice was for the good of the economy, and that his was one of many industry voices calling for such a move. Still, Mr. Fink has not been shy in boasting about his access. “I mean it is a great seal of approval,” Mr. Fink told Wall Street analysts in December, as he simultaneously coached the Bush administration and the incoming Obama team. “We are asked to help navigate new policy. I’m running out of here to go meet with Treasury to talk about plans later this afternoon.” But it is clear that the income from fees is a lesser benefit than the buffing of its global reputation, a point Mr. Fink has made. “It gives comfort to our clients that we are being involved in some of the solutions of our economy, and it allows us to show our clients that we are being asked in these difficult situations to provide advice,” he said at the same event. BlackRock has not been immune to market turmoil, but its stock over the last year has held up better than its peers’. While BlackRock’s share price tumbled 33 percent, Federated Investors shares have lost 34 percent and Legg Mason, 65 percent. BlackRock ended 2008, a disastrous year for Wall Street, with $786 million in profit on $5 billion in revenue. Some lawmakers remain wary, even though they cannot cite any specific impropriety. “The very nature of what we are asking them to do almost guarantees that it is going to be to the benefit of BlackRock,” said Representative Darrell Issa of California, the ranking Republican on the House Committee on Oversight and Government Reform. “You can have separate pews, but if you go to the same church, it will cross over.” Edmund L. Andrews contributed reporting, and Kitty Bennett contributed research. http://www.nytimes.com/2009/05/19/business/19blackrock.html?th&emc=th

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19.05.2009 Bos says stability pact may be useless in crisis

The crisis is still raging, and the Europeans are already wondering about their exit strategy. FT Deutschland writes that the stability and growth pact is likely to lead to major disputes in the euro area about the exit strategy. The first warning shots came from Christine Lagarde, who called for a generous room for manoeuvre to reduce the deficits. Wouter Bos of the Netherlands said, perhaps uncharacteristically, that the stability pact is fairly useless to guide ministers in such a situation, as it was written for deficits of 4 or 5%, not 15%, according to one unnamed source. The pact stipulates that countries remedy excessive deficit within two or three years, while we are now talking about consolidation phases of 5 to 10 years.

Euro’s share in Russian reserves is rising at expense of dollar The Moscow Times (hat tip Brad Setser) reports that the euro’s share in Russia’s forex reserves increased to 47.5%, overtaking the dollar’s, which is now 41.5%. Setser says this would have been bigger news when Russia’s reserves were growing at the rate of late 2007, but Setser reminds his readers that the dollar is not the world’s reserves currency, only the world’s leading reserve currency. Bundestag has watered down German bank rescue plan The FT has an interesting article according to which the voluntary bad bank scheme, which will cost the taxpayer next to nothing, had been substantially watered down by the parliament. An earlier draft would have foreseen genuine debt relief, with potential losses to the taxpayer of several hundred billion euros, but the draft did not find a majority in the governing coalition ahead of the September elections.

European elections watch France In France, Francois Bayrou is the rising star, stirring up the campaign after he published his anti Sarkozy pamphlet 15 days ago. While he stands accused of using the European elections for his run to the French presidency in 2012 he himself refuses to distinguish between national and European vote. Le Monde quotes Bayrou saying: “We never constructed Europe to eliminate France.” He called on voters for a double protest vote –

75 against and Jose Manuel Baroso. Bayrou, careful not to be accused, as in 2007, of having no programme- announced a programme would be presented this weekend. In Belgium the campaign, if there is one at all, is intermingled with the regional elections and with it the central theme of good governance (see Le Monde). The trigger was an incident in francophone Wallonia, when one minister had to resign after revelations that he also received money as a consultant. More revelations followed about other socialist and liberal politicians. Some Flemish politicians used this incident to declare that Belgium is in fact ungovernable at the regional level. In Flanders this will benefit autonomist, populist and separatist parties. Verheugen’s last shot Gunter Verheugen has been criticising the German banking supervisors and the finance ministry over their failure to get to grips with the situation. He said that Germany was the world champion in risky bank deals. This was firmly denied by the finance ministry, whose spokesman said Verheugen had insufficient understanding of what happened. (The latter may be true, but Verheugen is still right in our view). One aspect of the credit crisis is truly over: the money market spreads are normal again The credit indicators are all looking good again. 3-month dollar Libor is now at 79 basis points, the TED spread, measuring the difference between 3-month Libor and 3-month Treasury bills is at 61.97 (it was at close to 500 after Lehman). For this and more spread updates, see Calculated Risk. Another reason for the crisis: Testosterone Anne Sibert has an interesting column in Vox, in which she asks the question why bankers were behaving so badly. She cites three reasons. They committed cognitive errors involving biases towards their own prior beliefs; too many male bankers high on testosterone took too much risk, and a flawed compensation structure rewarded perceived short-term competency rather than long-run results. Points one and three are known, but less so point number two. Here is more: “In a fascinating and innovative study, Coates and Herbert (2008) advance the notion that steroid feedback loops may help explain why male bankers behave irrationally when caught up in bubbles. These authors took samples of testosterone levels of 17 male traders on a typical trading floor (which had 260 traders, only four of whom were female). They found that testosterone was significantly higher on days when traders made more than their daily one-month average profit and that higher levels of testosterone also led to greater profitability – presumably because of greater confidence and risk taking.”

76 Europe Berlin forced to dilute bad bank scheme

By Bertrand Benoit Published: May 18 2009 23:43 | Last updated: May 19 2009 09:47 Germany’s voluntary “bad bank” scheme adopted by the cabinet last week is a substantially watered-down version of the original draft, amended because of a parliamentary revolt, the Financial Times has learnt. Berlin was forced to shelve the earlier draft, which would have saddled taxpayers with hundreds of billions of euros in risks associated with toxic assets held by the nation’s banks, because coalition legislators threatened to vote it down. The MPs’ show of force underlines how the looming general election in September is interfering with Berlin’s efforts to fix the ailing financial system and help German banks rid their balance sheets of toxic assets. “The Social Democrats [SPD] and the Christian Democrats [CDU] came together to have this bill changed,” one parliamentary official told the FT. “The SPD put pressure on the finance ministry, and the CDU on the chancellery, and we made it very clear that their plan was politically unmarketable.” Last week’s draft, which is now going through parliament for approval, would allow banks to transfer structured assets to a special-purpose vehicle (SPV) at 90 per cent of book value for up to 20 years in exchange for a state-guaranteed bond. That would reduce a bank’s need to raise capital in order to make up for constant writedowns on the value of its toxic assets. Yet the bank would remain liable for any loss incurred by the SPV when it is unwound and would agree to forgo dividends until this loss was repaid. The finance ministry added this post-liability provision under pressure from coalition MPs before sending the bill to cabinet. Its original blueprint foresaw taxpayers assuming a substantial part of the losses, not only freeing the banks’ balance sheets but boosting future profits too. The finance ministry refused to comment, but government officials privately confirmed the sequence of events and expressed concern that the final compromise could fail to raise interest from all but the most undercapitalised commercial banks. Economists and opposition politicians have given warning that a voluntary system that was likely to weigh on dividend payments for decades stood little chance of being adopted. “Bank directors answer primarily to their shareholders,” Alexander Bond, a Green opposition MP, said last week. “Participating in the bad bank scheme might in fact be against the interest of these shareholders.” Manfred Weber, chief executive of Germany’s private sector banking association, said the effectiveness of Berlin’s bad bank bill would depend on the details agreed in its passage through parliament. But he hinted that banks had doubts about the proposals and said it would be a “balancing act” for them to convince shareholders that part of future dividends should be paid to the state, as the plan proposes.

http://www.ft.com/cms/s/0/33b46514-43f8-11de-a9be-00144feabdc0.html c

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Three Month Dollar LIBOR Falls to 79 basis points by CalculatedRisk on 5/18/2009 11:51:00 AM From Bloomberg: Dollar Libor Drops Most in Two Months as Markets Thaw The London interbank offered rate, or Libor, for three- month loans slid four basis points to 79 basis points today, the biggest decline since March 19, according to British Bankers’ Association data. It decreased for the past 34 days, including a drop of 11 basis points last week, the most since January. Anyone with a LIBOR ARM is happy right now.

And a couple of other credit indicators:

There has been improvement in the A2P2 spread. This has declined to 0.47. This is far below the record (for this cycle) of 5.86 after Thanksgiving, and only slightly above the normal spread.

This is the spread between high and low quality 30 day nonfinancial .

Meanwhile the TED spread has decreased further over the last week, and is now at 61.97. This is the difference between the interbank rate for three month loans and the three month Treasury. The peak was 463 on Oct 10th and a normal spread is around 50 bps.

Last week, FDIC Sheila Bair said "the liquidity crisis is over for good". That might be a little optimistic (some ARS markets are still frozen), but it does appear the Fed has eased the liquidity crisis for now. The Treasury is still working on the solvency issues. Three Month Dollar LIBOR Falls to 79 basis points http://www.calculatedriskblog.com/2009/05/three- month-dollar-libor-falls-to-79.html

78 Vote On FAS 140 Requires the Re- Intermediation of At Least $900bn In Off- Balance Sheet Vehicles Starting in 2010 May 18, 2009 Overview: May 18 Bloomberg: FASB vote eliminates the so-called Qualifying Special Purpose Entity (QSPE), a type of trust that was exempt from balance-sheet treatment and capital requirements. Starting 2010, banks will have to re-intermediate these off- balance sheet vehicles on their balance sheets and provision with capital. • April 30: According to authorities' Stress Test methodoloy, the 19 banks subject to the tests would re-intermediate $900bn of off-balance sheet assets onto their balance sheets with according capital requirements. • Joseph Mason: Cliff Risk: One way to increase revenues and 'gains on sale' from securitization from period to period is to "sell" the loans for accounting purposes without really selling them in any true economic sense--> originators have always retained the economic risk in order to reap the ratings arbitrage benefit. This is why we're seeing high-flying companies seemingly falling off a cliff. • Ritholtz June 4: FASB has decided to “eliminate the concept of the Qualified Special Purpose Entity (QSPE)” in the revised financial-accounting standard, FAS 140-- > Banks have been using QSPEs to effectively boost their leverage and hence their return on capital by creating off-balance sheet assets to be sold later on--> Up to $5 trillion (with t) of dollars worth of derivatives buried on banks' QSPEs • July 2: Wall Street lobbying hard to delay FAS140 revision due by 2009 that could "prolong credit crisis" • CreditSights (via Blbg): Variable Interest Entities (VIE) include ABCP Conduits, Structured Investment Vehicles (SIV), CDOs, structured finance transactions, investment funds. Mandatory unwinding and firesales loom as the net asset value [(assets-liabilities)/#shares] of these asset-backed instruments declines with rising delinquencies/defaults among borrowers. • CPA Journal: A VIE must be consolidated on balance sheet if/when originator provides financial support at some point (i.e. must have a variable interest), or owns a controlling interest, or is the primary beneficiary. Conduits have $784bn in commercial paper outstanding as of March 08. • Hendler (CreditSights): " The securities in the VIEs may be worth as little as 27 cents on the dollar once they're put back on balance sheets" • Fitch: q3 Illiquid Level 3 financial assets (SFAS 157) over equity (times): BS 1.56; GS 1.84; LEH 1.68; MER 0.70; MS 2.74 (latter with some differences in inputs) • Structured Investment Vehicle SIVs (=subgroup of VIE) volume shrinks to $300bn from $400bn in August 07 ---> American Securitization Forum panel: market for so-called structured investment vehicles (SIVs) is effectively dead and likely to stay that way.

79

Opinion

May 18, 2009 Op-Ed Columnist The Perfect, the Good, the Planet By PAUL KRUGMAN In a way, it was easy to take stands during the Bush years: the Bushies and their allies in Congress were so determined to move the nation in the wrong direction that one could, with a clear conscience, oppose all the administration’s initiatives. Now, however, a somewhat uneasy coalition of progressives and centrists rules Washington, and staking out a position has become much trickier. Policy tends to move things in a desirable direction, yet to fall short of what you’d hoped to see. And the question becomes how many compromises, how much watering down, one is willing to accept. There will be a lot of soul-searching later this year for advocates of health care reform. (For me the make-or-break issue is whether the legislation includes a public plan.) But right now it’s the environmental community that has to decide how much it’s willing to bend. If we’re going to get real action on climate change any time soon, it will be via some version of legislation proposed by Representatives Henry Waxman and Edward Markey. Their bill would limit greenhouse gases by requiring polluters to receive or buy emission permits, with the number of available permits — the “cap” in “cap and trade” — gradually falling over time. It goes without saying that the usual suspects on the right have denounced Waxman- Markey: global warming isn’t real, emission limits will destroy the economy, yada yada. But the bill also faces opposition from some environmentalists, who are balking at the compromises the sponsors made to gain political support. So is Waxman-Markey — whose language was released last week — good enough? Well, Al Gore has praised the bill, and plans to organize a grass-roots campaign on its behalf. A number of environmental organizations, ranging from the League of Conservation Voters to the Environmental Defense Fund, have also come out in strong support. But Greenpeace has declared that it “cannot support this bill in its current state.” And some influential environmental figures — most notably James Hansen, the NASA scientist who first drew the public’s attention to global warming — oppose the whole idea of cap and trade, arguing for a carbon tax instead. I’m with Mr. Gore. The legislation now on the table isn’t the bill we’d ideally want, but it’s the bill we can get — and it’s vastly better than no bill at all. One objection — the claim that carbon taxes are better than cap and trade — is, in my view, just wrong. In principle, emission taxes and tradable emission permits are equally

80 effective at limiting pollution. In practice, cap and trade has some major advantages, especially for achieving effective international cooperation. Not to put too fine a point on it, think about how hard it would be to verify whether China was really implementing a promise to tax carbon emissions, as opposed to letting factory owners with the right connections off the hook. By contrast, it would be fairly easy to determine whether China was holding its total emissions below agreed-upon levels. The more serious objection to Waxman-Markey is that it sets up a system under which many polluters wouldn’t have to pay for the right to emit greenhouse gases — they’d get their permits free. In particular, in the first years of the program’s operation more than a third of the allocation of emission permits would be handed over at no charge to the power industry. Now, these handouts wouldn’t undermine the policy’s effectiveness. Even when polluters get free permits, they still have an incentive to reduce their emissions, so that they can sell their excess permits to someone else. That’s not just theory: allowances for sulfur dioxide emissions are allocated to electric utilities free of charge, yet the cap-and- trade system for SO2 has been highly successful at controlling acid rain. But handing out emission permits does, in effect, transfer wealth from taxpayers to industry. So if you had your heart set on a clean program, without major political payoffs, Waxman-Markey is a disappointment. Still, the bill represents major action to limit climate change. As the Center for American Progress has pointed out, by 2020 the legislation would have the same effect on global warming as taking 500 million cars off the road. And by all accounts, this bill has a real chance of becoming law in the near future. So opponents of the proposed legislation have to ask themselves whether they’re making the perfect the enemy of the good. I think they are. After all the years of denial, after all the years of inaction, we finally have a chance to do something major about climate change. Waxman-Markey is imperfect, it’s disappointing in some respects, but it’s action we can take now. And the planet won’t wait. http://www.nytimes.com/2009/05/18/opinion/18krugman.html?_r=1&th&emc=th

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As Detroit Crumbles, China Emerges as Auto Epicenter By Kendra Marr Washington Post Staff Writer Monday, May 18, 2009 America's auto titans are dismantling their global empires. But across the Pacific, it's as if the global economic forces that have pummeled Detroit never struck. Chinese auto sales are up, and this year China is projected to displace Japan as the world's largest car producer. Now, the auto world is buzzing that China's auto industry may try to pick up the pieces of Detroit -- at a bargain. Chinese companies have tried to dampen speculation, issuing regulatory filings that deny bids to buy Ford's Volvo or General Motor's Saab. But there's little doubt among analysts that Chinese automakers are interested in the United States and that Detroit's automakers are interested in them. Buying up iconic brands such as Hummer or Saturn could supply Chinese automakers with the technological expertise to help them leapfrog past long-established competitors, said Kelly Sims Gallagher, a lecturer at Harvard University's Kennedy School of Government, who wrote a book on Chinese automakers. "That's where Chinese firms are weakest," she said. "They have world-class business and manufacturing capabilities now. What they still lack is technological know-how, systems integration, being able to design new vehicles from scratch and get them to a manufacturing line." China still suffers from its reputation of being a copycat manufacturer. An acquisition could lend clout to some of the nation's 100 car companies that are largely unknown outside their home country. Such a deal would be "off-the-shelf legitimacy that you can purchase," said Aaron Bragman, an auto analyst with IHS Global Insight. The global auto industry is restructuring. Italy's Fiat is on the verge of taking control of Chrysler. Last year India's Tata Motors, already famous for its $2,000 Nano, acquired Jaguar and Land Rover. And China's auto sector has emerged as a threat to the long-standing pecking order. Earlier this year, Geely Automobile, one of China's largest private carmakers, purchased an Australian drivetrain transmission supplier, a leading gearbox manufacturer. Weichai Power, one of China's top diesel engine manufacturers, acquired a French diesel engine producer. Another Chinese company, BYD, which counts Warren E. Buffett as an investor, launched a mass-market plug-in electric car, ahead of GM's anticipated Chevrolet Volt. Detroit's annual auto show in January was somber, but Shanghai's show dazzled attendees with throngs of models, rock bands and light shows. This year, Nissan skipped

82 Detroit and attended the Chinese event in April. Mercedes-Benz, BMW and Porsche all unveiled new-vehicle models in Shanghai. "The center of gravity is moving eastward," Dieter Zetsche, chairman of Daimler, told reporters at the show. "When we look back 20 years from now, the year 2009 is likely to be viewed as the year in which the baton of leadership in the global auto industry passed from the United States to China," Jack Perkowski, a Western transplant and former chairman of a Beijing auto parts company, wrote in his blog "Managing the Dragon." Some of China's bigger manufacturers, such as Chery Automobile, have trumpeted their intent to export Chinese-made vehicles to the United States in the next few years. To get there, they'll need to revamp their products to meet stringent U.S. emissions and safety standards. That's no simple problem. Previous plans to ship Chinese cars to U.S. soil have crumbled. A company called Brilliance missed its goal of launching U.S. sales in 2009. BYD said it would introduce its cars to Americans in 2010, but has pushed their arrival to 2011. Other potential contenders have gone out of business or are struggling to stay afloat. In 1994, Beijing released a plan to triple auto production by 2000 and reduce imports. The government lured foreign producers to bring their technology overseas and invest in Chinese auto parts firms. It aimed to modernize domestic manufacturing by creating joint ventures with foreign automakers such as GM. As a result, China's auto sales took off in 2000. In 2002, they crossed the 1 million mark. More recently, the numbers have taken a hit in the economic crisis, forcing companies to curb exports to countries such as Russia and Vietnam. But after the industry pressed Beijing for a bailout late last year, the central government responded with subsidies and slashed the sales tax on small, fuel-efficient cars, spurring demand. And analysts say the expansion of the country's web of roads and highways -- part of an economic stimulus package -- coupled with a growing middle class could fuel more sales for years to come. In April, China's vehicle sales jumped 25 percent, compared with a year earlier, to a record monthly high of 1.15 million units. It was the third consecutive month that China has surpassed the United States in sales. GM, which has two joint ventures in the country, also hit a monthly record in April with its sales jumping 50 percent from a year earlier. The automaker plans to import cars from China starting in 2011, according to a GM plan circulating in Congress. But in the United States, auto sales fell 34 percent last month. And GM, which has received $15.4 billion in U.S. government loans, says it is likely to file for bankruptcy protection. http://www.washingtonpost.com/wp- dyn/content/article/2009/05/17/AR2009051702269_pf.html

83 18.05.2009 Weber opposes EU stress tests

Bundesbank president Axel Weber opposes a US-style stress test for banks, due to the “heterogeneity of banks’ portfolios”, according to an interview with FT Deutschland. He said such comparisons between European banks were potentially misleading. (We suspect that Weber is afraid that such a public comparison would make it transparent that Germany’s banking system is effectively insolvent). The article also said that Weber defended Germany’s proposed bad bank solutions, which allows banks to stretch its losses for twenty years. He also said it would be dangerous to pronounce a pre-mature end to the crisis. No green shoots yet FT Deutschland leads its political section with a survey of 16 bank economists, of which all but two expect the recovery to be postponed until the second half. In particular, they estimate a continued fall in GDP growth during the current quarter. The article also said that even if the German economy were to stop shrinking from Q2 onwards, the rate of growth for 2009 would be -5.8%. France claims lead in recovery programme France is four months ahead of other European countries in its economic recovery plan, according to the minister in charge of the €26bn fiscal stimulus announced by President Nicolas Sarkozy in December. In an interview with the Financial Times, Patrick Devedjian, minister for economic recovery and a close adviser to Mr Sarkozy, said France had managed to speed ahead because its centralised system allowed the government to mobilise resources more quickly. Three quarter of the €26bn stimulus package would be spent in 2009 with €10bn of the funding has already been disbursed to projects. Munchau says German banking resolution is next to useless The German bank resolution scheme is not going to work, according to Wolfgang Munchau. In his FT column he writes that the scheme is an accountancy trick, and tries to solve a problem by shifting money around, but without commitment any real funds. The schemes comes at zero cost to the taxpayer, but the bad bank it creates is merely an institutional way of non-resolution. It is likely deep-freezing your toxic assets, hoping that you can sell them after the crisis. The fundamental

84 problem is that this scheme makes recapitalisation even more unlikely. If this is Germany’s final answer to the banking crisis, the outcome will be even worse than Japan’s lost decade. Irish government weakened The government in Ireland is getting under pressure from inside the coalition after the Greens, junior governing party, called for a renegotiation of the three years budget plan and openly critisised government performance. The Irish Independent writes that the Greens want to strengthen their profile ahead of next month's local and European elections. Both parties, the Greens and Fianna Gail, are likely to face a backlash from angry voters at the polls.

Growing support for the Lisbon Treaty in Ireland A new opinion poll for the Irish Times shows that support for the Lisbon Treaty continues to grow, in particular among middle class voters and women. 52% of those polled would vote yes in a new referendum on the Lisbon Treaty, 29% are ready to vote no and 19% did not know yet. “The major issue that the Yes side now needs to work out is how its campaign should be structured if the Government suffers the kind of setback in the European and local elections that the poll is pointing to.” Sweden to prioritise De Larosiere reforms FT Deutschland has a lengthy interview with Anders Borg, the Swedish finance minister. He said that Sweden, which assumes the EU presidency in July, will prioritise financial reforms, and in particular the De Larosiere report, against opposition from the UK and Germany. Borg said Germany has yet to specify the nature of its opposition. It is also not clear whether Germany’s position might change after the September elections. The UK is particularly opposed to the ECB’s leadership in the proposed macro-prudential authority. Are we going to seen another joint rally in euros and oil? FT Deutschland has an article citing some analysis about the correlation of the euro’s exchange rate and the oil price, which warns that we might see another rally in both. Recently the euro and oil prices both stabilised at higher values. The research cites three reasons for the correlations. The US economy is less dependent on oil; du to the price stability orientation of European monetary policy, the ECB is expected to raise rates faster than the Fed; and a rising oil price strengthens the economy of the Gulf states, which tend to trend more with the euro area. German companies apply for industry fund Der Spiegel reports that the governments €100bn fund for government loan guarantees is becoming a subject of intense interest among large companies. BMW and Porsche have both asked for large government loans. Porsche even inquired about a €1bn. The government seems sceptical since the package was designed for companies without access to the capital markets.

85

Housing bubbles compared Here is a nice chart of housing bubbles, as measured by the price-rent ratio. The source is News N Economics (hat tip Kevin O’Rourke, plus further hat tips there)

Blinder warns of another 1936 As he did in 2003, when he panicked about deflation, Alan Blinder (hat tip Calculated Risk) now worries that the Fed and the US treasury might take back their accomodating stance too early. In an article in , he recalls the scenario of 1936, when Fed and Treasury were worried about inflation, and caused the recession of 1937. “...the consequences were as predictable as they were tragic. The United States economy, which had been rapidly climbing out of the cellar from 1933 to 1936, was kicked rudely down the stairs again.” We suspect that Blinder’s view will prevail, as no part of the government, including the Fed, will not want to be accused of repeating the mistakes of the 1930s. Hamilton on green shoots So much for the green shoots. After a decline of 1.7% in March, US industrial production continued to fall in April, by 0.5%. James Hamilton noted that some commentators took comfort from the slowdown, but makes the point that we need increases in growth, not a decline in negative growth rates. About the decline in eurozone GDP, Hamilton says it is a staggering number, beyond belief. http://www.eurointelligence.com/article.581+M5142fe4721e.0.html

86 COLUMNISTS Germany needs more than an accounting trick By Wolfgang Münchau Published: May 17 2009 19:31 | Last updated: May 17 2009 19:31 After the US, the country with the biggest banking problem is probably Germany. Last week the German cabinet adopted a bank rescue plan worth looking at in detail. If you want to know how long the European crisis will last, this might give you the answer. The Geithner/Summers plan in the US has two fundamental planks – a strategy to ring- fence structured finance products for which there is no market, and a strategy to recapitalise the banking system. Both seem to be based on unrealistically optimistic assumptions about the economic recovery. And both have been criticised sharply, mainly for that reason. The German scheme is constructed very differently. It is a ring-fencing plan only and it is voluntary. Under the draft legislation put forward by the German government last week, a bank can apply to set up its own bad bank. A bad bank is not really a bank at all. It is a special purpose vehicle, similar to those off-balance sheet vehicles that triggered this crisis in the first place. The proposed SPV will have a shelf life of up to 20 years. It buys the structured securities from the bank at 90 per cent of book value – the price at which the securities are currently valued on the balance sheet. In return, the SPV issues new debt securities to the bank, guaranteed by the government. So if a bank shifts structured securities with a notional value of €10bn ($13.5bn, £8.9bn) to the SPV, it gets €9bn in good securities back. The state is the guarantor. The idea is to give the banks an incentive to lend again. Will it work? The answer is: not in the way that has been proposed. First of all, the plan is a giant accounting trick. Under fair-value accounting, it could not possibly work because the bank would have to make a provision for future losses of the SPV. This would, of course, defeat the very purpose of the plan. It is constructed in the same spirit as some of the more eccentric debt securities. The fundamental problem is that the strategy might actually deter recapitalisation, which surely should be a priority. Under the plan the bank, not the government, is fully responsible for the SPV’s losses. So if the SPV sells the securities at a loss, the bank will have to pay for the loss out of earnings. So the bank will have to divert an uncertain proportion of its future earnings to pay off the SPV’s losses, and all this for up to 20 years. Which private investor in their right mind would provide new equity capital to a bank under such conditions? A spokesman for the federation of Germany’s private banks made a good analogy when he compared the scheme to a deep freezer. The banks are trying to buy time. When the crisis is over, they hope that the structured securities can be sold at reasonable prices. Until that happens nothing is resolved.

87 Why did the government opt for such an obviously daft plan? The answer is because it costs next to nothing. There is only a cost to the government if the SPV goes bankrupt, which is not going to happen soon, if at all. The SPV even pays a fee to the government to cover the expense of issuing the guarantee. So the scheme tries to be the equivalent of a free lunch. But it is only cost-free in a narrow accounting sense. The economic costs are huge. Last week the German government was told that the tax shortfall would be €300bn over three years – two-thirds of that due to the crisis. If you split the loss evenly over the three years, the pure tax effect of the crisis makes up some 3 per cent of gross domestic product for three years running. Not bailing out the banks will almost certainly end up being more costly than bailing out the banks. But a bail-out would be unpopular, and the government does not want to touch this issue until the federal elections in September. Until then, we have an insufficient ring-fencing plan only. What about after the elections? Will there be a better plan then? I am not sure. Peer Steinbrück, Germany’s finance minister, last week gave a characteristically belligerent comment about the US stress tests – effectively accusing the US authorities of fixing the results. His position is that recapitalisation is primarily a problem for the banks, not the government. If the state were to recapitalise the banks, his scheme might just work, but without it, it cannot. No sane private investors are going to pour money into a structure whose obvious purpose is to deceive them. The German political classes have yet to comprehend that recapitalisation is necessary, and that it will end up costing the taxpayer a lot of money. The plan as it stands now offers no resolution, only procrastination. While US banks have already written off a fair proportion of the bad debts, the Europeans are adopting schemes that allow the banks to postpone resolution. The more I think about it, the more I am reminded of Japan. But this might be unfair to the Japanese. They solved the problem eventually. If we freeze our toxic securities for 20 years, a Japanese-style lost decade will soon come to be regarded as the optimistic scenario. Wolfgang Münchau, “Germany needs more than an accounting trick”, FT, 17/Mayo/2009 http://www.ft.com/cms/s/0/606510ba-4310-11de-b793-00144feabdc0.html

88 News N Economics Daily analysis of global economic and financial conditions with a focus on the U.S.

Housing bubbles around the world: SATURDAY, MAY 16, 2009

The chart illustrates price-rent ratios for some of the most notorious housing bubbles - Ireland, Spain, the UK, and the US - indexed to 1997. The price-rent ratio can be compared to a price- earnings, or even better a price-dividend, ratio in finance. It measures the relative value of the asset: the price of the asset (purchase price of a home) divided by its flow of fundamental value (rental income earned or the value of having a roof over your head). As the price-rent ratio grows, the market value moves away from its fundamental value. The bubbles have been extreme, and there is probably still some downward price momentum left in the pipeline for many of these markets. Ireland's housing market, while having experienced the biggest relative bubble, has seen its price-rent ratio rise since Q3 2008. Crashing economic fundamentals have driven down rents (the denominator), and likewise the relative value of owning a home. I included the German price-rent ratio to show that housing bubbles are not uniformly the root cause of economic decline. The German housing market saw a bump early during the reunification years; but currently, it's falling exports brought on by anemic global demand (US demand to be sure) that caused the German economy to contract by 3.8% in Q1 2009. And for those of you who think in annualized terms (the European Commission releases the quarter on quarter growth rates), that's a 14.3% decline. Ouch! Rebecca Wilder Rebecca Wilder, Housing bubbles around the world News N Economics 16/ Mayo /2009 http://www.newsneconomics.com/2009/05/housing-bubbles-around-world- looks.html

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Politics

May 17, 2009 From a Theory to a Consensus on Emissions By JOHN M. BRODER WASHINGTON — As Congress weighs imposing a mandatory limit on climate- altering gases — an outcome still far from certain — it is likely to turn to a system that sets a government ceiling on total emissions and allows polluting industries to buy and sell permits to meet it. That approach, known as cap and trade, has been embraced by President Obama, Democratic leaders in Congress, mainstream environmental groups and a growing number of business interests, including energy-consuming industries like autos, steel and aluminum. But not long ago, many of today’s supporters dismissed the idea of tradable emissions permits as an industry-inspired Republican scheme to avoid the real costs of cutting air pollution. The right answer, they said, was strict government regulation, state-of-the- art technology and a federal tax on every ton of harmful emissions. How did cap and trade, hatched as an academic theory in obscure economic journals half a century ago, become the policy of choice in the debate over how to slow the heating of the planet? And how did it come to eclipse the idea of simply slapping a tax on energy consumption that befouls the public square or leaves the nation hostage to foreign oil producers? The answer is not to be found in the study of economics or environmental science, but in the realm where most policy debates are ultimately settled: politics. Many members of Congress remember the painful political lesson of 1993, when President Bill Clinton proposed a tax on all forms of energy, a plan that went down to defeat and helped take the Democratic majority in Congress down with it a year later. Cap and trade, by contrast, is almost perfectly designed for the buying and selling of political support through the granting of valuable emissions permits to favor specific industries and even specific Congressional districts. That is precisely what is taking place now in the House Energy and Commerce Committee, which has used such concessions to patch together a Democratic majority to pass a far-reaching bill to regulate carbon emissions through a cap-and-trade plan. The bill is poised to win committee approval this week, although with virtually no support from Republicans. If there was a single moment when cap and trade crossed the threshold from relatively untested economic concept to prevailing government policy, it came in May 1989 in the West Wing office of C. Boyden Gray, counsel to President George H. W. Bush. Mr. Gray had gathered a number of Mr. Bush’s economic and environmental advisers to try to come up with a politically palatable plan to break a decade-long deadlock on the problem of acid rain, caused by sulfur dioxide emissions from coal-burning power plants in the Midwest.

90 Mr. Gray and the other Bush advisers knew that the power companies — and their allies in Congress — would vigorously oppose a tax on sulfur emissions or stringent new regulations to control them. But the environmental costs of the problem were too big to ignore. One of Mr. Bush’s outside advisers, Daniel J. Dudek, an economist with the Environmental Defense Fund, recalled that after years of unsuccessfully trying to sell the idea of setting a national limit on such emissions and letting companies trade permits or allowances to pollute, he finally came up with an analogy that broke the ice. “I told Boyden: ‘Imagine you just fired up the government printing presses and dumped an endless stream of money into the system. You’d have no way of controlling the money supply,’ ” Mr. Dudek said. “He understood totally and intuitively the importance of maintaining the cap, the key ingredient in our acid rain policy.” A month later, the Bush White House sent Congress a cap-and-trade plan for sulfur dioxide emissions that 18 months later became the linchpin of the 1990 amendments to the Clean Air Act, considered by many to be the most successful domestic environmental legislation ever enacted. But the proposal came under ferocious political assault during those months. The final bill reflected a series of compromises needed to keep the coalition supporting it together. But the sulfur dioxide cap, a roughly 50 percent reduction in emissions over the next decade, held. The Environmental Protection Agency estimates that compliance with the program is close to 100 percent. “Our proposal was at first ridiculed by environmentalists as little more than a license to pollute,” said Representative Jim Cooper, a moderate Democrat from Tennessee and an early supporter of tradable permits. “But today, few dispute it is one of the government’s most successful regulatory programs ever.” Representative Henry A. Waxman, a California Democrat and chairman of the energy committee, and his allies are marshaling many of the same arguments for the cap-and- trade approach as they used two decades ago for acid rain. A cap-and-trade program brings support from industries that prefer it to a top-down federal regulatory scheme, they say. Many regard it as the lowest-cost solution to a global pollution problem and a means of producing clean-energy breakthroughs. And it is a much easier political sell than a tax on fossil fuels. A measure of the political appeal of the final compromise on the 1990 cap-and-trade plan can be seen in the final votes: 401 to 25 in the House and 89 to 10 in the Senate. But despite its success in the relatively contained problem of acid rain in the United States, cap and trade has proved less useful in other environmental problems and has gotten off to a troubled start in Europe. Even some early devotees of a system of tradable emissions permits believe that it will not work for carbon dioxide, by definition a planetary problem. A straightforward tax on each ton of carbon dioxide emitted by any source, they say, would provide more a more predictable price and a simpler system to police. “If a philosopher king could design a system, he or should might pick a taxation system,” said Robert Hahn, a White House economist under Mr. Bush who backed the

91 acid rain program but is skeptical that it will work for the much more pervasive problem of carbon dioxide. Former Vice President Al Gore has long supported a carbon tax. “Tax what you burn, not what you earn,” he says, as a way of both attacking global warming and remedying some of the inequities in the income tax. But Mr. Gore also says a domestic cap-and-trade system would be easier to coordinate with other countries’ carbon control programs. Cap and trade evolved from an academic debate that began in the early 1960s when Ronald H. Coase, then a professor at the University of Chicago Law School, wrote an influential paper, "The Problem of Social Cost,” that examined when government should intervene in cases where a private entity causes public harm. In 1971, W. David Montgomery, a Harvard graduate student in economics, fleshed out the idea of emissions trading in his doctoral thesis and has spent much of the last three decades trying to figure out how the marketplace can deal with environmental problems that are caused by relatively few actors but have consequences felt globally. He supported the acid rain trading program, but said it was based on “unique historical and economic circumstances” that did not apply to the much more difficult problem of carbon dioxide emissions. Mr. Montgomery, now a vice president at Charles River Associates International, a consulting firm, said Mr. Waxman’s proposal would ultimately act like a tax on carbon-producing industries, disguised by a complex cap-and-trade system. “It is a steel fist of regulation covered by a velvet glove of emission trading,” Mr. Montgomery said. “Why not just impose a carbon tax?”

92 WSJ Blogs Real Time Economics

Economic insight and analysis from The Wall Street Journal. BIS Report: Central Banks May Be on Cusp of Change

By Joellen Perry, May 17, 2009, 3:02 PM ET

The current crisis may prove as pivotal to central-bank evolution as chronic inflation in the 1970s and 1980s was. That’s a main conclusion of a hefty Sunday report on central-bank governance from the Bank for International Settlements, the central bankers’ central bank in Basel, Switzerland. Central banks have changed a lot since the first one (the forerunner of Sweden’s central bank) debuted in 1668. The inflation scare of the late 20th century pushed many central banks to make keeping prices steady a formal goal, for instance. The BIS speculates the current crisis could have equally weighty impacts for how central banks handle financial stability. “Once the now-urgent questions of deciding how to manage and resolve the current crisis have been fully addressed, the question will arise about what role the central bank should play in reducing the risk of future crises,” the report notes. While less than a fifth of 146 central-bank laws around the world give central banks an explicit financial-stability objective, 90% of central banks believe they have full or shared responsibility for preserving the stability of the financial system. To some degree, financial stability is already central banks’ bread and butter. Keeping prices and growth steady are often, themselves, seen as key for financial stability, as are central banks’ traditional lender-of-last resort role and their responsibility for payment- system oversight. Many central banks are also involved, directly or indirectly, in banking supervision. But giving central banks a formal mandate to monitor systemic risks in the financial system opens up a slew of questions “This issue, which was unsettled before the crisis, is an even livelier one now,” the BIS report notes. “Do central banks need new tools for such a purpose? If so, what tools? Should central banks on occasion use their monetary policy tools — over and above what current objectives would imply — to counteract threats to financial stability? Is there a risk that at times the two mandates … would come into conflict?” For example: Are interest rates, meant primarily as a tool for managing inflation and growth, also appropriate for maintaining financial stability? Some say central banks should pay more attention to asset-price buildups before they become

93 bubbles, by keeping interest rates higher than traditional measures of inflation might argue. (A recent speech by European Central Bank vice-president Lucas Papademos suggests some at the euro-zone’s central bank may be leaning this way: “One of the lessons from the current crisis … is that monetary policy tools should be among the instruments employed to prevent asset-market excesses and the systemic and deflation risks they entail.”) The question could come up before the current crisis ends. Slashing interest rates and launching asset-purchase programs has helped central banks worldwide counter both economic and financial-stability threats amid the turmoil, the BIS report notes. But it warns that happy coincidence may not continue: “The potential for such conflict may reappear when the time comes to exit from aggressively stimulative policy settings. Early removal of stimulus could delay the resumption of normal market functioning; late removal could risk the take-off of inflation.” The concept of financial stability itself is unwieldy, the BIS warns: “The definition of financial stability has been a matter of debate … nor is there any generally agreed way of measuring financial stability, which makes it especially difficult to identify how much financial stability is intended and whether the appropriate amount has been achieved.” Central banks pursuing a formal financial-stability goal also run the risk of blurring their role and that of the government - an overlap, the BIS report notes, that could threaten central banks’ independence. And there are tradeoffs: “Banking systems in the mid-20th century were generally regarded as robust, in large part because entry was tightly controlled … In many countries a relatively cozy cartel ensued, featuring low risk-taking and little innovation, but reasonable profits. Robustness came in part at the expense of efficiency and dynamism.” http://blogs.wsj.com/economics/2009/05/17/bis-report-crisis-to-have-impact-on-central-banks-focus/

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ENTREVISTA: PABLO GONZÁLEZ-CARRERÓ Juez en el concurso de acreedores de Martinsa "El concurso de Martinsa es trágico para muchos pequeños acreedores" JULIÁN RODRÍGUEZ - A Coruña - 17/05/2009 Desde el ventanal del despacho de Pablo González-Carreró (Santiago, 1962) se ve la sede de Martinsa-Fadesa, sin apenas actividad y con la rotulación devorada por el óxido. El titular del Juzgado de lo Mercantil número uno de A Coruña, que tramita el mayor concurso de acreedores de la historia de España, habla de plazos y del papel de la banca. En su opinión, la supervivencia de la compañía y el cobro de los 7.000 millones de deuda que arrastra "pasa porque el mercado inmobiliario mejore o que, por lo menos, no se deteriore más". El juez no entra a valorar los 3,5 millones de euros que cobró Fernando Martín el año pasado como presidente de la compañía ni el hecho de que algunos consejeros no firmasen las cuentas. Pregunta. El 90% de las compañías en concurso acaban en liquidación. Eso no invita al optimismo... Respuesta. Es cierto, pero no tiene tanto que ver con la regulación concursal o con el funcionamiento de los juzgados como con las circunstancias en las que las empresas acuden al concurso. Parece un estigma. La mayor parte acude en situación prácticamente irreversible. En España, muchos concursos se presentaban para enterrar empresas. P. Los administradores ya se han pronunciado sobre el plan de viabilidad presentado por la empresa, ¿cuál es su posición? R. Se acaba de presentar el escrito [de los administradores], pero no estoy en condiciones todavía de valorarlo. Sí puedo decir que ha sido favorable a los planteamientos del plan de viabilidad. P. La propuesta de convenio pasa por ampliar el plazo del pago de la deuda a ocho años y no hacer ninguna quita sobre el dinero que se debe. ¿No es fiarlo todo a que la crisis escampe? R. Todo convenio tiene que partir de unas previsiones. En este caso, con el pago de la deuda en ocho años, se hace con unas previsiones de mejora de la situación inmobiliaria. Partiendo de esa premisa se propone pagar íntegramente la deuda. Y ese es el contrapeso: por una parte se amplía el plazo legal de cinco años y por otro se propone un pago íntegro, incluso con intereses. P. Un convenio sin quitas y con esos plazos parece hecho a la medida de la banca. ¿Qué será de los pequeños acreedores y proveedores? R. El concurso siempre es un conflicto de intereses, en este caso colectivo, de acreedores. Es posible que un convenio de esta naturaleza sea el preferido por las entidades financieras y a lo mejor no es el más conveniente para los proveedores, que en muchos casos prefieren cobrar menos pero antes. La banca [tiene el 90% de la deuda] está en condiciones de imponer un convenio, no digo abusivo ni mucho menos, su punto de vista va a prevalecer.

95 P. Las recientes reformas en la Ley Concursal parecen responder a lo ocurrido con Martinsa. R. Creo que hay una gran preocupación por la situación que atraviesan las grandes inmobiliarias. El objetivo fundamental de la última reforma fue preservar cierta seguridad de actuaciones anteriores a la declaración del concurso, que lógicamente van a favorecer a unos acreedores y perjudicar a otros, pero que es la única posibilidad para que una empresa pueda seguir adelante. P. ¿Cree que hubo abuso de los bancos en el acuerdo de refinanciación previo al concurso? Dictó medidas cautelares... R. Puesto que se ha pedido la rescisión de determinadas operaciones realizadas en el período anterior al concurso, es lógico que se haya solicitado también, simultáneamente, la adopción de medidas cautelares. De otra manera se podrían ejecutar las garantías y quedaría sin contenido el proceso principal. Las medidas cautelares, si es que se ratifican, no prejuzgan el fondo. P. La fase común del procedimiento se ha prolongado. ¿Cree que afectará a los plazos? R. Sí. En esto la ley peca quizá de un exceso de optimismo porque siempre hay que conjugar los plazos que se marcan con las posibilidades de la propia administración de Justicia y las peculiaridades de cada concurso. En este tenemos del orden de diez mil acreedores y cerca de novecientos incidentes. La tramitación va razonablemente bien. Ahora estamos a la espera de saber cuándo vamos a acabar esta fase de impugnaciones [de la propuesta de convenio]. Creo que no se han producido dilaciones significativas. P. ¿Cómo va a pagar sus deudas Martinsa si su gran activo, el suelo, apenas tiene salida ahora? R. Todo pasa porque el mercado inmobiliario mejore. O que, por lo menos, que no se deteriore más. La propuesta de convenio establece los dos primeros años de carencia, pero todo dependerá del marco económico general. Es una propuesta. En esto el juzgado tiene que ser totalmente neutral. P. ¿Quién defiende a los pequeños acreedores y a los trabajadores en un concurso así? R. Está claro que hay mucha gente sacrificada. Que ha perdido y que sigue perdiendo. Hay montones de acreedores para los que el concurso es una auténtica tragedia porque son empresas pequeñas que precisaban del cobro inmediato de sus créditos para atender obligaciones y cumplir con trabajadores y proveedores. P. ¿Cómo está respondiendo la Ley Concursal ante la suspensión de pago de grandes empresas? R. Se suele comentar en determinados foros que la crisis ha puesto de manifiesto las insuficiencias de una ley que no está prevista para atender a los problemas específicos de los macroconcursos. En realidad, ninguna ley concursal lo estaría. Pensemos en Fórum y Afinsa, que tienen alguno de ellos creo que 400.000 acreedores. El problema no es tanto de regulación, sino de medios, de estructura judicial. Al final siempre habrá un embudo, que no es otro que lo que deberá dictar un juez. P. ¿Qué problemas encuentra usted en la aplicación de la ley? R. Es cierto que el respeto a las garantías procesales ha impuesto algunos procedimientos que son excesivamente lentos, como el de la impugnación a la lista de acreedores, y probablemente demasiado amplios, con unas posibilidades ilimitadas,

96 prácticamente. En esto la ley no es demasiado flexible. Habría que conjugar la seguridad jurídica con la celeridad, que es el gran dilema de las leyes procesales. P. De promotora a operadora de suelo. ¿Cree que es esa la salida de Martinsa? R. Es una decisión que la compañía debe tomar con sus acreedores. Dicen que una empresa endeudada es propiedad de sus acreedores, y no de sus accionistas. Y en términos económicos eso es cierto. P. ¿Baraja alguna fecha para la finalización del concurso? R. Tal y como vamos podrían estar los listados definitivos de acreedores y del inventario a finales de año, por lo que ya podríamos entrar en la discusión de un convenio. Es un cálculo que algunos me dicen que es demasiado optimista. Yo creo que se va a poder hacer. Y espero poder hacerlo, desde luego, porque también me quiero liberar de Martinsa. Mi cálculo, con impugnaciones incluidas, es que la fase procesal acabe a principios del próximo año. En cualquier caso, el concurso no termina hasta que se cumpla el convenio. Con la propuesta que hay, finalizará en ocho años.

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TRIBUNA: MICHELE BOLDRIN Otro modelo, pero en serio MICHELE BOLDRIN 17/05/2009 El presidente del Gobierno ha proclamado en su discurso sobre el estado de la nación que hace falta cambiar el modelo español de crecimiento. Sin duda ésta es una buena idea, dado que estamos en una recesión profunda y el modelo anterior (que nos permitió crecer de forma continuada durante 14 años y situar nuestra tasa de paro por debajo de la media europea) no tiene ninguna posibilidad de volver. Mejor tarde que nunca, pero realmente ha sido tarde. Si el Gobierno anterior, con el mismo presidente, hubiera escuchado a los que desde hace años reclamaban reformas estructurales, probablemente nos hubiéramos ahorrado unos cuantos disgustos. El presidente del Gobierno comenzó su discurso articulando debilidades y fortalezas, y nuestra primera debilidad es el retraso en ponernos a trabajar en la dirección correcta. Hay también fortalezas en las propuestas avanzadas por Rodríguez Zapatero. Ya que tengo a mi disposición sólo una parte de las palabras que pronunció el presidente, daré por aceptadas las fortalezas sin mencionarlas y me centraré en las debilidades de su discurso, que son -en mi opinión- dos. Primera, la convicción, equivocada, de que el nuevo modelo de crecimiento pueda ser el resultado de un dirigismo político que, en palabras de Zapatero, quiere "identificar y potenciar sectores con suficiente capacidad de generación de riqueza y de empleo, sectores que se hayan mantenido fuertes incluso durante la crisis". En segundo lugar, la renuncia a enfrentarse a los grandes obstáculos estructurales que, en los últimos diez años, han impedido una transición suave desde un modelo de crecimiento basado en sectores intensivos en mano de obra y bajo valor añadido a otro modelo basado en el cambio tecnológico y las ganancias de productividad. El discurso de Zapatero parece no entender que el crecimiento solamente puede venir desde la iniciativa privada y que el papel del Gobierno es crear las condiciones estructurales para que esa iniciativa se desarrolle, sin intentar adivinar qué actividades o sectores serán los ganadores y cuáles los perdedores. Esta falta de entendimiento lleva a contradicciones preocupantes. Consideremos la propuesta de eliminación de la deducción fiscal por compra de vivienda habitual. En este punto el presidente parece tener claro que distorsionar los precios relativos con la política fiscal puede llevar a resultados indeseados. No obstante, convertir esta medida en el eje fundamental de las reformas que impulsarán el nuevo modelo de crecimiento resulta contradictorio, dado que en el mismo discurso se propone distorsionar los precios de mercado ofreciendo incentivos fiscales a las "nuevas" y, supuestamente, milagrosas fuentes de energía. Y como si esto no fuera suficientemente contradictorio, se proponen ayudas fiscales directas a las compras de ese bien tan estratégico en el nuevo modelo denominado... ¡automóvil! O bien los incentivos fiscales sectoriales son distorsionantes o no lo son, pero no puede ser ambas cosas a la vez. Cambiar de modelo es abandonar la idea de que los ministros y sus expertos son capaces de decidir lo que los españoles deben comprar y producir, y que es una buena política utilizar la fiscalidad para que estas previsiones se cumplan. Es demasiado pronto para olvidarnos de que, durante los años del viejo modelo, los gobernantes empujaron a los españoles a comprar -y producir- viviendas. El nuevo

98 modelo de crecimiento no necesita estos incentivos fiscales; por el contrario, el camino es la eliminación de los obstáculos estructurales y la creación de un entorno económico que favorezca la creación y la llegada a España de trabajo con alto capital humano. Aquí encontramos la segunda debilidad fundamental: el presidente se ha quedado mudo sobre los problemas complicados, los de siempre, que no se solucionan ni con el silencio ni con la inercia. Que sean los de siempre no los hace menos graves, sino más urgentes. Primero, la reforma laboral. Hace semanas, cien académicos han puesto sobre la mesa una propuesta de reforma laboral clara, sencilla y factible. Lo que hace falta ahora es que los partidos, los interlocutores sociales y el Gobierno aborden esta cuestión sin excusas. La economía del conocimiento demanda un nuevo mercado de trabajo. En segundo lugar, una reforma de las pensiones que lleve a una sustancial reducción de las cotizaciones sociales y a un incremento de la edad de jubilación es el único camino posible. No hacen falta más medidas, pero éstas son tan necesarias para el cambio como el aire limpio. Sobre este tema el silencio del Gobierno, oposición e interlocutores sociales es atronador. En tercer lugar, una reforma orgánica de la imposición fiscal. Correctamente, el presidente del Gobierno ha subrayado que, con una presión fiscal del 33% del PIB, la imposición fiscal en España es menor que en muchos países de la UE. Así es, pero, al mismo tiempo, mantenemos una distribución de cargas entre los diferentes impuestos que es especialmente gravosa con el trabajo, especialmente el trabajo más cualificado, que es justo lo que necesitamos incentivar. En cuarto lugar: la inmigración. Los inmigrantes no constituyen solamente la mayoría de los parados, sino que siguen llegando inmigrantes escasamente cualificados. Un cambio radical en la política de inmigración es una pieza crucial para un nuevo modelo de desarrollo. Quinto, el sistema financiero. La reforma de las cajas de ahorro, para que den cuentas a alguien, preferiblemente al mercado, debe hacerse antes de que sea demasiado tarde. Finalmente, la educación y en especial las universidades. El discurso del presidente contenía varias y útiles medidas para el sector de la educación, pero se ha quedado corto con lo principal: reformar el sistema universitario para que las universidades españolas puedan competir libremente entre ellas, y que ganen las mejores. Es decir, hay que premiar a las universidades que producen más investigación de calidad y jóvenes trabajadores mejor preparados. Es aquí, únicamente desde estas bases, y no desde incentivos fiscales y dirigismo político, desde donde puede surgir el nuevo modelo de crecimiento que España necesita.

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TRIBUNA: Primer plano JOSÉ GARCÍA MONTALVO Desgravar se va a acabar JOSÉ GARCÍA MONTALVO 17/05/2009 El anuncio de la eliminación de la desgravación a la vivienda, aunque sea parcial y con efectos retardados, es un paso en la dirección correcta. No hay duda de que la intensidad de los tradicionales incentivos fiscales a la compra de vivienda en España ha colaborado decisivamente a la creación de la mal llamada "cultura de la propiedad", distorsionando la decisión entre compra y alquiler. La anunciada equiparación entre las dos formas de tenencia puede contribuir a vencer la negativa percepción social del alquiler. Además, el necesario adelgazamiento del sector de la construcción liberará recursos para otros sectores más productivos, y el fomento del alquiler permitirá mejorar la movilidad de los trabajadores y reducir distorsiones que dificultan el ajuste en el mercado laboral. En todo caso, si el objetivo es realmente favorecer el alquiler, el presidente del Gobierno debería haber anunciado a renglón seguido que todas las viviendas de protección oficial que se construyan en el futuro serán de alquiler (dado que sigue insistiendo en construir VPO pese al enorme inventario de viviendas sin vender). Con el peso que en los próximos años tendrá la VPO, este mecanismo sería un procedimiento muy directo de fomentar el alquiler. El objetivo evidente de retrasar el fin de la desgravación hasta 2011 es intentar animar la demanda de vivienda hasta entonces para reducir el enorme inventario acumulado. El truco no es original. Con el mismo objetivo, la Administración de Obama ha incluido una desgravación fiscal del 10%, hasta un máximo de 8.000 dólares, para compradores de primera vivienda en este año. No es la primera vez que el Gobierno español mira al otro lado del Atlántico para sus actuaciones económicas. La deducción de los famosos 400 euros fue aprobada después de que la Administración de Bush mandara cheques de 600 dólares a las familias. Por desgracia, no se esperó a ver la nula efectividad de esta medida. ¿Será efectivo ese aplazamiento para aumentar la demanda de vivienda? Pues dependerá de la dinámica de los precios en este periodo. El comprador cuya renta supere el umbral de la desgravación deberá comparar la posible bajada de los precios más allá de 2010, con el ahorro que obtendría al poder beneficiarse de la desgravación. Si los precios bajan al ritmo que dice el Ministerio de la Vivienda, aún queda mucho recorrido (y tiempo de ajuste) y quizá será más conveniente esperar aunque pierdan la desgravación en el futuro. En un escenario de bajadas de precios lentas pero sostenidas, al estilo japonés, el incentivo de la desgravación "ahora o nunca" sería mínimo. Aunque la competencia entre inmobiliarias y bancos por colocar el stock de viviendas que acumulan podría acelerar la caída de los precios. A su vez, la dinámica de los precios se verá afectada por la efectividad de la medida pues un impacto colateral que podría tener posponer la eliminación de la desgravación, si fuera mínimamente efectiva, sería mantener un ritmo de caída de los precios de la vivienda menor del que se observaría si se eliminara de forma inmediata (dado que los precios descontarán la desgravación hasta 2010 sin límites de renta). Otros motivos que cuestionan la efectividad de ese retraso son las dificultades de financiación y los problemas de inconsistencia temporal. Aunque los tipos están

100 cayendo rápidamente para préstamos hipotecarios en vigor, para nuevos préstamos no se observa este efecto. La disminución de la cuota mensual neta de la desgravación no puede compensar la vuelta a los estándares tradicionales para la concesión de créditos. También existe un problema de credibilidad. Nada impide que llegados a finales de 2010 el Gobierno decida extender la desgravación otros dos años o incluso indefinidamente. Por último, puede existir un efecto psicológico que incite a la compra ("que me quedo sin desgravación") aunque, racionalmente, no fuera lo más conveniente. La incertidumbre sobre las ventajas de esperar a que los precios bajen más en el futuro puede jugar también a favor de una compra impulsiva. En resumen, el sector de la vivienda presenta claras anomalías, como una ínfima proporción de alquiler, un gran número de viviendas desocupadas o una excesiva producción. Si finalmente se elimina la desgravación a la compra de vivienda se habrá dado un paso importante en su normalización.

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TRIBUNA: Laboratorio de ideas Joseph E. Stiglitz La primavera de los zombis Joseph E. Stiglitz 17/05/2009 Ahora que la primavera llega a Estados Unidos, los optimistas ven los brotes verdes de la recuperación de la crisis financiera y la recesión. El mundo es muy distinto de como era la pasada primavera, cuando el Gobierno de Bush afirmaba una vez más que veía la "luz al final del túnel". Las metáforas y los Gobiernos han cambiado, pero, por lo visto, no el optimismo. La buena noticia es que podríamos encontrarnos al final de la caída libre. La tasa de descenso económico se ha ralentizado. El fondo podría estar cerca, quizá a finales de año. Pero eso no significa que la economía mundial se disponga a iniciar pronto una recuperación sólida. Tocar fondo no es razón para abandonar las fuertes medidas adoptadas para revitalizar la economía mundial. Esta recesión es compleja: una crisis económica combinada con una crisis financiera. Antes de que se iniciara, los endeudados consumidores estadounidenses eran el motor del crecimiento mundial. Ese modelo se ha roto, y tardará en ser sustituido, porque aunque se pudiera sanear los bancos estadounidenses, la riqueza de las familias está por los suelos y los estadounidenses se endeudaban y consumían dando por hecho que el precio de sus casas subiría eternamente. La caída del crédito empeoró las cosas, y las empresas, enfrentadas a unos altos costes de endeudamiento y a unos mercados en descenso, respondieron con rapidez recortando inventarios. Los pedidos cayeron bruscamente -de manera muy desproporcionada respecto al descenso del PIB-, y los países que dependían de los bienes de inversión y duraderos (gastos que podían posponerse) se vieron especialmente golpeados. Es probable que en algunas de estas áreas observemos una recuperación respecto al mínimo alcanzado a finales de 2008 y comienzos de este año. Pero examinemos los fundamentos económicos: en Estados Unidos, los precios inmobiliarios siguen cayendo; millones de hogares pagan hipotecas sobrevaloradas que superan el precio de mercado; el desempleo aumenta, y cientos de miles de personas se acercan al final de sus 39 semanas de seguro de desempleo. Las administraciones estatales se ven obligadas a despedir a trabajadores a medida que los ingresos fiscales se desploman. El sistema bancario ha sido sometido a una prueba para ver si está adecuadamente capitalizado -una prueba de "resistencia" a la que no se ha aplicado estrés-, y algunos bancos no han podido superarla. Pero en lugar de aprovechar la oportunidad para recapitalizarse, quizá con ayuda estatal, los bancos por lo visto prefieren responder a la japonesa: capear el temporal. Los bancos zombis -muertos, pero que todavía caminan entre los vivos- están, usando las inmortales palabras de Ed Kane, "apostando por la resurrección". Repitiendo el desastre de las cajas de ahorro en la década de 1980, los bancos están usando una contabilidad peligrosa (se les permitía, por ejemplo, mantener los activos desvalorizados en sus libros sin amortizarlos, con la falsa pretensión de que podían retenerlos hasta su vencimiento y que de algún modo se volverían sólidos). Peor aún, se les está

102 permitiendo endeudarse a bajo precio con la Reserva Federal de Estados Unidos, respaldados por avales defectuosos, y al mismo tiempo asumir posiciones arriesgadas. Algunos de los bancos registraron ganancias en el primer trimestre del año, basadas principalmente en trucos contables y beneficios de explotación (léase "especulación"). Pero esto no va a hacer que la economía eche a andar rápidamente. Y si las apuestas no salen bien, el coste para los contribuyentes estadounidenses será aún mayor. También el Gobierno estadounidense está apostando por capear el temporal: las medidas tomadas por la Reserva Federal y los avales del Gobierno permiten a los bancos acceder a financiación de bajo coste, y los tipos de interés de los préstamos siguen estando altos. Si no sucede nada serio -pérdidas en hipotecas, inmuebles comerciales, préstamos empresariales y tarjetas de crédito-, los bancos podrían salir del paso sin otra crisis. Dentro de unos años estarán recapitalizados y la economía volverá a la normalidad. Ésta es la hipótesis optimista. Pero las experiencias en todo el mundo dan a entender que es una perspectiva arriesgada. Incluso si los bancos estuviesen saneados, el proceso de desapalancamiento y la pérdida de riqueza asociada significan que, con toda probabilidad, la economía se mantendrá débil. Y una economía débil significa, también con toda probabilidad, más pérdidas bancarias. Los problemas no se circunscriben a Estados Unidos. Otros países (como España) padecen una crisis inmobiliaria. Europa del Este está pasando apuros, que probablemente repercutirán en los bancos fuertemente endeudados de Europa occidental. En un mundo globalizado, los problemas en una parte del sistema reverberan rápidamente en las demás. En crisis anteriores, como la del este de Asia hace una década, la recuperación fue rápida porque los países afectados podían volver a la prosperidad mediante las exportaciones. Pero ésta es una recesión mundial sincrónica. América y Europa no pueden salir del bache agarrándose a las exportaciones. Arreglar el sistema financiero es necesario para la recuperación, pero no basta con eso. La estrategia estadounidense para arreglar su sistema financiero es cara e injusta, porque recompensa a los mismos que causaron el caos económico. Pero hay una alternativa que básicamente significa seguir las normas de una economía de mercado normal: una permuta financiera de deudas por capital social. Con dicha permuta podría restaurarse la confianza en el sistema bancario y podría reanudarse el préstamo sin o con muy pocos costes para el contribuyente. No es especialmente complicado y tampoco novedoso. Obviamente no gusta a los titulares de bonos, que preferirían un regalo del Gobierno. Pero hay usos mucho mejores para el dinero público, como otra ronda de estímulos. Toda recesión llega a su fin. La cuestión es cuánto durará y qué profundidad tendrá ésta. A pesar de algunos brotes primaverales, deberíamos prepararnos para otro oscuro invierno: es hora de aplicar el plan B a la reestructuración bancaria y de administrar otra dosis de medicina keynesiana. http://www.elpais.com/articulo/semana/primavera/zombis/elpepueconeg/20090517e lpneglse_6/Tes

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TRIBUNA: Laboratorio de ideas ANTÓN COSTAS ¿Cambiar o mejorar el modelo económico? ANTÓN COSTAS 17/05/2009 Hagan la prueba. Pregunten a un economista, un empresario, un experto o un político qué hay que hacer para que la economía española vuelva a funcionar. Probablemente acabarán diciendo una de estas dos cosas, o ambas: que hay que "cambiar de modelo productivo" o que hay que hacer "reformas estructurales". Lo de cambiar de modelo va camino de convertirse en un estribillo. Lo que quiere decir que no está claro. Algo así como que hay que abandonar la construcción, el turismo y la manufactura como motores de crecimiento y reemplazarlos por otros nuevos basados en la alta tecnología. Esta idea, formulada de forma simplista, es peligrosa. Por dos razones. Primera, porque a fuerza de desear lo que no tenemos podemos minusvalorar lo que sí tenemos. Segunda, porque supone que el nuevo modelo productivo puede surgir por generación espontánea, ex novo, sin necesidad de apoyarse en las viejas actividades. Permítanme comentar estos dos riesgos. En los últimos quince años España ha experimentado una espectacular transformación. Un país acomplejado, socialmente atrasado, exportador de emigrantes, acostumbrado a vivir fuertes desequilibrios económicos e incapaz de competir en el exterior se ha transformado en un país con economía estable, empresariado dinámico y socialmente confiado en su capacidad para competir, no sólo en la economía, sino en el deporte, la arquitectura o las artes. ¿Cuál fue la espoleta de esa explosión de dinamismo y creatividad? Sin duda, influyó la entrada en el euro y el dinero barato y abundante. Pero hubo más. Un factor psicológico poco valorado: una nueva generación de españoles confiada en sí misma, sin el complejo de inferioridad que limitó a las generaciones nacidas bajo el franquismo. El protagonismo que tuvo la construcción generó cierto desasosiego con los "pies de barro" del modelo. La crisis ha acentuado el desencanto. Pero deberíamos evitar que ese desencanto debilite la autoconfianza, que es el motor más potente que tenemos para salir de la crisis. 'The party is over', tituló la influyente revista The Economist un monográfico sobre España. ¿Será cierto que todo ha sido una fiesta? No lo creo. La familia española en su conjunto no ha sido manirrota, en contra de lo que se dice. Las nuevas infraestructuras no son un espejismo. Tampoco lo es ese ejército de empresas españolas, muchas de ellas del sector de la construcción y del turismo, que han ganado en tamaño, ambición y presencia internacional. Esto no significa complacencia ni desconocimiento de la necesidad de redimensionar muchos sectores y fomentar el cambio de especialización productiva. Pero tengo la impresión de que para algunos cambiar de modelo económico es lo mismo que cambiar de modelo de coche, que basta con ir un día al concesionario, elegir, pagar y llevarse uno nuevo. Como ocurre en la naturaleza, en la vida económica lo nuevo surge de lo viejo mediante pequeños cambios graduales, evolutivos, darwinianos, que al acumularse en el tiempo

104 dan lugar a algo distinto de lo inicial. La finlandesa Nokia, ejemplo exitoso de empresa de nueva tecnología, surgió de una vieja empresa manufacturera. Más que hablar de cambiar el modelo, que no se sabe qué quiere decir, tenemos que ponernos a mejorar las prestaciones del que tenemos. Veamos un ejemplo. La construcción es un sector maduro, pero no podrido. En su estado actual es minifundista, segmentado, con costes elevados, falto de innovación y con mala calidad del servicio. Pero eso no es algo inevitable. Es la consecuencia de cómo funciona en España. Tiene que hacer lo que hizo el sector automovilístico: transformarse en industria. Ahora cada uno va a su aire: el urbanista legisla, el empresario promueve, el arquitecto diseña, el constructor generalista coordina el proyecto, el ingeniero o el constructor ejecutan una parte del proyecto y el fabricante suministra productos y materiales. El resultado es unos costes elevados, una baja productividad y una mala calidad del producto y del servicio. La solución no es despreciar la construcción, sino innovar y fomentar la colaboración entre todos los actores implicados. Lo dicho vale también para el turismo. Sorprende que el país más turístico del mundo cuide tan poco los recursos en que se apoya y no invierta en mejorar la capacidad de innovación del sector. ¿Cómo lograr mejorar la innovación y la productividad del modelo que tenemos? El problema no son los salarios. Una economía donde más del 40% de los empleados ganan menos de mil euros no tiene un problema salarial. Tampoco está en las ayudas públicas. Gastamos mucho en bonificaciones a la contratación y demasiado poco en formación de los trabajadores. El camino no es tampoco que los poderes públicos decidan cuál ha de ser el nuevo modelo de crecimiento. No corresponde a nuestro nivel de desarrollo. El camino está en mejorar los resultados del modelo que tenemos, mediante un compromiso entre empresas, trabajadores y Gobiernos que fortalezca la colaboración y la confianza mutua sobre la base de unos objetivos y medidas compartidas. El nuevo modelo surgirá del viejo mediante la innovación y el cambio gradual y continuo. Eso es lo que nos dice la experiencia de otros países que han transitado con éxito ese camino. No deberíamos desaprovechar la oportunidad de esta crisis. Contrariamente a la máxima de san Ignacio, los tiempos revueltos pueden ser favorables para hacer mudanzas. Pero a condición de lograr esa confianza y compromiso por el cambio Antón Costas, “¿Cambiar o mejorar el modelo económico?”, El País, Negocios, 17/05/2009 http://www.elpais.com/articulo/semana/Cambiar/mejorar/modelo/economico/elpepueconeg/20090517elpn eglse_7/Tes?print=1

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REPORTAJE: Empresas & sectores El Dorado no estaba en el Este Los inversores inmobiliarios quedan atrapados tras el desplome de los precios LLUÍS PELLICER 17/05/2009 Era la tierra prometida. The sky is the limit (el cielo es el límite) era el eslogan que las promotoras popularizaron en el este de Europa. Y empezaron a levantar pisos. Bloques de viviendas, oficinas, hoteles y centros comerciales. Los españoles, entonces los reyes del ladrillo en Europa, desembarcaron en masa. Pequeñas, medianas y grandes inmobiliarias aterrizaron en Polonia y desde allí saltaron a Hungría y Rumania con grandes desarrollos de viviendas, en muchos casos de lujo, y con el mantra de que en estos países había "muchas necesidades de vivienda". La construcción, la inversión y los precios se dispararon. Pero la recesión ha roto las costuras del sector inmobiliario en estos países, especialmente en Rumania, donde las ventas y los precios se han desplomado. Rafael García es el director de una firma que reúne a un grupo de inversores y constructores españoles con activos en Rumania. "Estamos a la expectativa de ver qué pasa. Teníamos a punto de salir al mercado un producto residencial para clase media- alta y hemos decidido no empezar. Esperaremos a que el mercado dé signos claros", explica. Los precios de la vivienda en Bucarest, según las estimaciones de las inmobiliarias rumanas, escalaron un 160% entre 2005 y 2007 y se situaron entre los 1.200 y 4.000 euros el metro cuadrado, dependiendo de la zona. Una horquilla muy amplia entre la que se mueven muchas ciudades españolas. El encarecimiento afecta a todas las rentas. Un piso modesto de unos 50 metros cuadrados en 2002 se vendía por sólo 10.000 euros, mientras que en 2008 llegó a 110.000 euros. El sueldo medio creció, pero no a la misma velocidad. En 2002 era de unos 150 euros, y el año pasado se situó en unos 370. "A raíz del boom español y del exceso de liquidez llegaron muchos inversores. Compraron apartamentos para dar el pase [revender]. Eso hacía subir los precios. El mercado se calentó demasiado, hasta que llegó el parón y los precios empezaron a descender", explica García. No hay una estadística clara sobre las bajadas de precios. La consultora CB Richard Ellis (CBRE)apunta que en 2008 los valores cayeron alrededor del 30%, mientras que Atisreal, filial de BNP Paribas, cifra el desplome en hasta un 40%. Y para este año pintan bastos. El director de inversión internacional de Atisreal, Fausto Vizoso, explica que el cuento empieza cuando los ciudadanos pasan a ser propietarios de la vivienda que habitan y a acceder al crédito. A la vez, muchos abandonan el campo para ir a la ciudad. Empieza a estallar entonces la mecha. Los precios se disparan y empiezan a acudir promotoras españolas. Desde las grandes -Martinsa Fadesa, Hercesa, Prasa y la entonces Ferrovial Inmobiliaria- hasta las pequeñas. "En España, el mercado se iba agotando, y muchas empresas decidieron renunciar a los márgenes tan amplios que tenían aquí y compensarlo ampliando los que obtenían en Rumania", explica Vizoso. A medida que la burbuja se iba hinchando, el suelo se encarecía hasta llegar a quintuplicar su valor en pocos años. Eso encareció los costes, los precios, y fue apartando del acceso a la vivienda a buena parte de la población.

106 Bucarest se quedó pronto pequeño y las inmobiliarias buscaron otras ciudades de cierto tamaño, como Timisoara, Iasi, Galati, Brasov, Craiova, Constanza o Cluj. En todos esos sitios había "necesidades de vivienda". Y las sigue habiendo. Sin embargo, la demanda que alimentaba a las promotoras era sobre todo especulativa. Un informe de la consultora internacional Colliers de este año calcula que los inversores compraron más del 75% de los pisos que se vendieron entre 2005 y 2007. Una proporción desmesurada en comparación con el otro gran boom europeo, el español, donde los inversores acapararon entre el 30% y el 40% de las viviendas. Hoy este inversor se ha retirado. En 2008 sólo adquirió un 10% de los pisos entregados, según CBRE, y este año prácticamente ha desaparecido. Pero no sólo se ha ido el inversor. También ha fallado el comprador final. El grifo del crédito también se ha cerrado, y tras los descensos de precio de 2008, los compradores posponen cualquier decisión. El informe de CBRE apunta que muchas reservas y precontratos se han cancelado porque los compradores no pueden obtener financiación. "En Rumania y otros países del Este tenemos clientes que están desinvirtiendo, algunos de forma total y otros parcialmente", asegura Mikel Marco- Gardoqui, director de la consultora Cross Border. Algunos de los promotores que fueron o estudiaron la posibilidad de instalarse en Rumania hoy están en concurso de acreedores. Por ejemplo, Tremón, Lábaro, Construccions Riera o Martinsa Fadesa. La promotora de Fernando Martín desarrolla en el área metropolitana de Bucarest un auténtico barrio de 7.600 viviendas que promocionaba prometiendo rentabilidades de entre "el 15% y el 20% a corto plazo". Eso cuando los precios iban al alza. Pero la lista de promotores es muy vasta. Grupo Menchero, Realia, Grupo Mangle, Prasa... "El sector se mueve de forma muy gregaria. ¿Adónde van? Allí donde están los otros, sin análisis de riesgo ni macroeconómico, sin valorar que la moneda no es el euro. Se drenó la tesorería de España a esos países, y en época de crisis eso es muy incierto", explica el consejero delegado de Irea, Mikel Echavarren. Una vez allí, muchos optaron por aliarse con un socio local. "El compañero de viaje en varias ocasiones quebró, por lo que muchos españoles han quedado atrapados y sin tener tiempo para obtener resultados", añade. Esta misma semana, el promotor catalán Felip Massot, que lleva más de 40 años en el negocio al frente de Vèrtix, se jactaba en un foro inmobiliario de la suerte de quienes fueron al este de Europa. "Hay que volver a empezar. ¿Qué hacíamos en Polonia? ¿Y en Bulgaria? Estamos todos locos yendo a países con leyes que ni entendemos. ¿Y ahora qué ha pasado con todo esto? Todos marcha atrás. Ha sido una exageración", lamentó. No piensa lo mismo el presidente de Hercesa, Juan José Cercadillo. Afirma estar tranquilo porque adquirió los suelos para desarrollar entre 2000 y 2001, mucho antes de que todos se subieran a la cresta de la ola. "La situación ha empeorado, pero no tanto como en España. Hemos adaptado algunos proyectos a usos que se demandan más. Uno de los principales errores de muchos fue el de comprar suelo esperando revalorizaciones del 200%, porque Rumania es un país para trabajar a largo plazo", afirma. Una estrategia, la del largo recorrido, que no valoraron quienes hoy están atrapados con cientos de metros cuadrados de suelo sin salida.

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TRIBUNA: Laboratorio de ideas AURELIO MARTÍNEZ ESTÉVEZ El papel del ICO en la crisis AURELIO MARTÍNEZ ESTÉVEZ 17/05/2009 En las últimas semanas asistimos, un día sí y otro también, a una constante crítica centrada en una supuesta incapacidad del ICO para afrontar los retos de la presente crisis. Dado que me parecen muy injustas muchas de esas manifestaciones, intentaré desentrañar algunas de las críticas más habituales, que no dejan de ser lo que son, juicios de valor, opiniones basadas en el desconocimiento de lo que se habla o tergiversaciones de compleja intencionalidad. Primera insinuación: el "insignificante" papel del ICO en la actual situación. Hasta el presente, el ICO tiene encargadas líneas de actuación por un monto total de unos 37.000 millones de euros, que unido a su actividad en préstamos directos y descontadas las amortizaciones de los préstamos previamente otorgados, determinan un crecimiento neto de los recursos puestos a disposición de la sociedad de unos 35.000 millones. La forma más sencilla de ver esta aportación consiste en comprobar la evolución del balance del ICO. Pues bien, dicho balance ha crecido en lo que llevamos de año unos 15.000 millones de euros. Si pensamos que las necesidades de financiación neta de la economía española serán este año de unos 60.000 millones (el déficit por cuenta corriente), el hecho de que el ICO aporte el 60% de todas las necesidades de financiación netas de la economía española no me parece irrelevante. Por si alguien puntualiza que, en el fondo, todo lo que financia el ICO no son aportaciones netas "en sentido estricto", dado que no todas sus emisiones se colocan en el exterior, le aclararía que, tradicionalmente, las emisiones del ICO se colocan en los mercados exteriores, no se utilizan los recursos presupuestarios, ni tampoco son subvenciones. Es ahorro externo captado en mercados exteriores que hay que devolver si se quiere mantener la actividad futura y una cuenta de resultados positiva. En consecuencia, e hilando muy fino, el ICO aportará este año, si se cumplen las expectativas y se mantienen las tendencias, el 45% de las necesidades de financiación neta de la economía española, más que ninguna otra institución financiera. Segunda insinuación: una cosa es hablar y otra cumplir; las líneas no llegan a sus destinatarios. Un segundo bloque de acusaciones se refiere a la baja utilización de algunas de las líneas. El ICO no tiene red, ni cuentas corrientes, ni descuento de papel, ni la mayor parte de los servicios que puede ofrecer una entidad financiera, porque así lo acordaron los gobiernos que regularon su funcionamiento, pensando que había que evitar a toda costa crear una banca pública que compitiera con la privada. El ICO, al configurarse como banca de segundo piso (salvo las excepciones de las operaciones grandes y singulares), debe utilizar la red de la banca para distribuir sus productos (ICO-PYME, ICO-liquidez, y así hasta 24 líneas, por ahora). Al no contar con red propia, el problema del ICO no radica en cómo distribuir los potenciales préstamos (eso es fácil, la banca electrónica está inventada hace mucho),

108 sino en cómo valorar los riesgos de las personas solicitantes. Distribuir las líneas a ciegas no es prestar, es asumir riesgos muy elevados de quebrantos futuros. De los 37.000 millones previstos para este año, las entidades financieras han prestado unos 5.000 en tres meses y medio efectivos de funcionamiento de las líneas. Si se mantiene la tendencia (que previsiblemente se acelerará), el ICO terminará el año aportando al sistema unos 18.000 millones. Esto es, en un contexto de caída y contracción del crédito, el ICO aportará el 1,7% del PIB de financiación al sistema. Adicionalmente, algunas líneas son compartidas. Esto es, en la línea ICO-liquidez de 10.000 millones de euros, el ICO pone 5.000 millones y las entidades otros 5.000 millones. Por lo tanto, si el ICO ha dado, hasta esta semana, en esta línea 1.500 millones de euros, las entidades habrán dado otros 1.500 millones que, en el actual contexto, no es un mal dato. Tercera insinuación: el problema del ICO es la burocracia. Tal vez de la acusación más injusta sea la generalización insidiosa de que el ICO no funciona, no porque las entidades no pidan las líneas, sino porque la enorme burocracia del ICO ahoga su funcionamiento. El ICO es la entidad que menos burocracia tiene, menor que la propia banca, en los tramos de las líneas de mediación, que es de lo que hablamos. La banca, al solicitar los fondos cada quince días, cumplimenta una serie de datos en la solicitud electrónica (lo que en nuestra terminología llamamos anexo 0) de cada operación que concede y ya está todo. Los datos pedidos son elementales (nombre de la entidad, CIF, volumen, domicilio, email, cantidad, etcétera), esto es, los datos imprescindibles y básicos de la operación. El control se efectúa ex post. Se contratan empresas especializadas que informan al ICO de si las líneas han cumplido o no sus objetivos. No se pide nada más; ¿dónde está la burocracia?; ¿no será más bien que el ICO es utilizado como coartada fácil para enmascarar una denegación del préstamo solicitado? Cuarta insinuación: las líneas están mal diseñadas. Las entidades financieras siempre desearían que las líneas del ICO tuvieran plazos más cortos, tipos de interés más elevados, mayores garantías, mejores comisiones, etcétera. La otra parte, los autónomos y las empresas, desean exactamente lo contrario de esas posiciones. Al final, ambas partes sólo se ponen de acuerdo en solicitar que el ICO preste sus fondos por debajo del coste al que lo obtiene y, además, asuma cuanto más riesgo y morosidad mejor. Las líneas que ofrece el ICO se aprueban en condiciones algo más favorables que las estrictas exigencias del mercado. El ICO se financia como mínimo unos 100/120 puntos básicos más barato que la mejor entidad financiera y unos 250 puntos básicos mejor que la media del sistema y traslada ese menor coste a las líneas. Esto es, el ICO utiliza el rating del Reino de España y lo transforma en financiación sensiblemente mejor que la que pueda captar cualquier entidad financiera. Por otra parte, si hay algún problema con el diseño técnico de una línea, el ICO no tiene problema en modificarla. Y de hecho así lo hace. Por lo tanto, en este tipo de críticas al diseño de las líneas subyace más bien el deseo de lograr, vía subvenciones públicas, posiciones aún más ventajosas. Quinta insinuación: el ICO tiene que asumir más riesgo.

109 Una forma sutil de denunciar que el ICO no opera bien es indicar que tiene que asumir más riesgo, confundiendo lo que es riesgo y morosidad. Siendo conscientes de que el mercado financiero estaba basculando desde los problemas de liquidez hacia los de valoración del riesgo, el ICO, en noviembre, diseñó unas líneas en las que, por primera vez, asumía y compartía riesgo con las entidades de crédito. De esta forma, si una empresa recibe 1.000 euros de la línea ICO-liquidez, 500 los aporta la entidad y 500 el ICO. Ambas partes asumen el riesgo potencial del fallido íntegramente. Si esa empresa deja de pagar a la entidad financiera, ésta pierde los 500 euros y el ICO los otros 500. Ahora bien, una cosa es asumir el 50% del riesgo y otra la morosidad. Si la morosidad media de la economía española es el 4,1%, quiere decir que en los 5.000 millones aportados por el ICO a esta línea el ICO podría llegar a perder, con los datos actuales, hasta 205 millones. Como la morosidad podía subir, ya en noviembre se asumió que el ICO aceptaría hasta un 5% de morosidad (250 millones de euros). ¿Por qué se puso ese tope del 5%?: Muy sencillo, para evitar que se trasladara al ICO la cartera de morosos de las entidades. ¿Se puede ampliar a otras líneas? En eso estamos trabajando y planificando el futuro para el año próximo; 2009 es el primero en el que el ICO asume riesgos y cubre fallidos en sus líneas, y la prudencia aconseja observar cómo funciona, analizar detenidamente ciertas prácticas que nos han sido denunciadas, o desviaciones no deseadas en su aplicación, para, en segunda fase, proceder a ampliarlo a otras líneas. En resumen, si los préstamos no aumentan de acuerdo con las expectativas de los agentes económicos: - No es porque el ICO ponga pegas o complique la gestión de las entidades. O porque carezca de capacidad de gestión (afirmación totalmente injusta para con los trabajadores del ICO que han visto multiplicado por casi cuatro veces su trabajo y responsabilidades). - Tampoco porque las líneas del ICO estén mal diseñadas (que se diga qué hay que corregir y lo haremos, si pensamos que debe hacerse). - Ni porque el ICO asuma poco riesgo (tal vez el desiderátum de algunos sea que te den el dinero, que el otro asuma el 100% del riesgo y que el beneficio sea para ellos). - Ni por la burocracia (inexistente). ¿Por qué no pensamos que, en una crisis tan acusada como la presente, el crédito tiene, por desgracia, que reducirse y las entidades, que también tienen que vigilar nuestros depósitos, van a ser más restrictivas a la hora de asumir riesgos? ¿Cómo es posible que muchas personas no se hayan dado cuenta del cambio radical de escenario que se ha dado en los últimos meses y sigan pensando aún con pautas no lejanas, cuando las entidades iban a ofrecerles dinero, casi sin garantías y a coste mínimo? Este escenario hoy ya no existe, ni posiblemente se repetirá en muchos años.

110 2 Economía La máquina del dinero divide al BCE Las medidas extraordinarias para inyectar liquidez siembran la discordia entre quienes quieren ir más allá y quienes lo consideran demasiado arriesgado CLAUDI PÉREZ - Madrid - 16/05/2009 Antes de la crisis, los banqueros centrales tenían fama de serios, de predecibles, incluso de ser algo aburridos. Eso se acabó. La profundidad de la recesión en Europa y la entrada del banco central en territorio comanche -tipos de interés cada vez más próximos a cero y medidas no convencionales como la máquina de imprimir dinero- han resquebrajado la unidad en el consejo del Banco Central Europeo (BCE). Antes de la crisis, los banqueros centrales tenían fama de serios, de predecibles, incluso de ser algo aburridos. Eso se acabó. La profundidad de la recesión en Europa y la entrada del banco central en territorio comanche -tipos de interés cada vez más próximos a cero y medidas no convencionales como la máquina de imprimir dinero- han resquebrajado la unidad en el consejo del Banco Central Europeo (BCE), donde se sientan 22 miembros de todas las nacionalidades y de formación muy diversa. En el BCE hay un debate soterrado sobre los llamados brotes verdes: algunos de sus consejeros ven esos signos de luz, mientras otros advierten de que la crisis puede ir a más. Pero lo que de veras ha sembrado la discordia es la impresora de billetes. El presidente del BCE, Jean-Claude Trichet, explicó hace unos días que el banco central adquirirá 60.000 millones de euros en cédulas hipotecarias. Y se dedicó a ganar tiempo: aseguró que los detalles de esa operación -que en la práctica supone inundar de liquidez ese mercado para tratar de reactivarlo, y rebajar así los tipos de interés reales en la economía- se conocerán en la reunión de julio. Eso ha abierto la caja de los truenos: de nuevo aparece la guerra entre halcones -los más ortodoxos en cuestiones de política monetaria, arracimados alrededor de Alemania y la sombra del Bundesbank- y palomas, los consejeros más proclives a seguir la senda tomada por Estados Unidos para ampliar el arsenal del banco central y atacar la recesión y la crisis del crédito con medidas tan atrevidas como, según sus detractores, arriesgadas. "No veo necesidad de más compras ni de ampliar las adquisiciones a otros activos", aseguró Axel Weber, presidente del Bundesbank. "Esos 60.000 millones son suficientes por el momento", aseguraron tanto el austriaco Ewald Nowotny como el holandés Nout Wellink. Pero el BCE destila cualquier cosa menos consenso. El consejero esloveno Marko Kranjec explicó que el BCE probablemente gaste más que esos 60.000 millones propuestos inicialmente. Se abrió la veda en toda Europa: el eslovaco Iván Sramko afirmó a que no puede excluirse nada. Ni siquiera la compra de papel comercial -como hace EE UU- o de otro tipo de activos. El español José Manuel González Páramo se apresuró a aclarar que el BCE "no considera" ampliar el programa de compra a otros activos "por el momento". "El consejo del BCE parece un campo de batalla", resumió gráficamente a Bloomberg Laurent Bilke, economista de Nombra Internacional en Londres. En medio del huracán financiero y de la peor recesión desde la Segunda Guerra Mundial, la disparidad de las

111 opiniones sugiere que el consejo del BCE dista mucho de tener una posición común acerca de cómo afrontar los problemas en el sector bancario. Los economistas han criticado con dureza tanto el retraso como el trasfondo de las medidas del BCE a lo largo de la crisis. Ahora, el eurobanco se enfrenta a un test de credibilidad aún mayor. Al elegir las cédulas, beneficia básicamente a Alemania, Francia y España, los países que más han usado ese instrumento respaldado por hipotecas. Trichet no consigue poner orden en el gallinero porque en los detalles que anunciará en junio están las claves de la medida: hay que decidir qué tipo de activos entran y cuáles no, y cómo se llevará a cabo la adquisición, lo que puede beneficiar a unos países en detrimento de otros. El nerviosismo es evidente: una muestra más de que la crisis está muy viva. "El BCE está tremendamente influido por Alemania, junto con Francia y, en menor medida, España", asegura Santiago Carbó, consultor de la Reserva Federal estadounidense. "El caso es que Alemania tiene problemas bancarios pero no tiene burbuja inmobiliaria ni los problemas de otros. Como sus bancos, al igual que los españoles, cuentan con numerosos activos hipotecarios titulizados, ha dado vía libre para las medidas no convencionales, pero instrumentadas en la compra de estas cédulas hipotecarias y hasta el límite anunciado. Ése ha sido probablemente el requisito que ha puesto Alemania para la política monetaria laxa que ahora exhibe el BCE, incluso para la bajada de tipos y posibles rebajas futuras", asegura. La fórmula definitiva que adopte la máquina de imprimir dinero en Europa afectará de forma muy diferente a los 16 países de la zona euro, que tienen problemas muy distintos. Para Carbó, hay dos ganadores claros: "En este caso la medida ha beneficiado a Alemania y a España y será difícil que haya medidas muy distintas de éstas en las próximas semanas". Pero las espadas están en todo lo alto. Entretanto, la banca española empieza a moderar la demanda de financiación al BCE. En abril requirió 67.434 millones de euros, un 7,2% menos que en marzo. http://www.elpais.com/articulo/economia/maquina/dinero/divide/BCE/elpepueco/20090516elpepieco_4/T es

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TRIBUNA: CÉSAR MOLINAS El necesario debate sobre las pensiones El sistema español de reparto no es sostenible con hipótesis económicas y demográficas razonables. Hay que reformarlo. El debate debe ser sosegado y despolitizado. Lo ideal sería crear una comisión independiente CÉSAR MOLINAS 16/05/2009 La política del avestruz acostumbra a llevar a resultados desastrosos. De aquellos que la practican dijo Gorgeous George Carman, el célebre abogado londinense, que "entierran su cabeza en la arena dejando expuestas sus partes pensantes". España no debe adoptar esta actitud irresponsable con su sistema de pensiones: es necesario reformarlo y, para hacerlo bien, primero hay que debatir para llegar a un consenso. Hay que debatir porque en tema de pensiones hay en España opiniones muy diversas, intereses muy encontrados y recetas muy divergentes. Hay que llegar a un consenso porque las reformas necesarias deben ser comprendidas y apoyadas por el conjunto de la sociedad. En este artículo me propongo contestar a las cuatro preguntas siguientes: ¿Por qué hay que debatir sobre las pensiones? ¿Qué debe debatirse? ¿Cómo debe organizarse el debate? ¿Cuándo debe comenzar? Comencemos por la primera de ellas. ¿Están equivocados la inmensa mayoría de los estudiosos cuando pronostican que, si no se reforma a tiempo, el sistema de pensiones público español tendrá problemas de financiación en menos de dos décadas? ¿Yerran todos los organismos económicos internacionales -OCDE, FMI, Comisión Europea- que urgen al Estado español a reformar las pensiones? ¿Aciertan, en cambio, los que aseguran que nuestro sistema es sólido y sostenible, y que ponerlo en duda crea una alarma innecesaria entre la población? Sería muy útil que el CIS hiciese una encuesta para conocer de manera actualizada lo que piensa la población sobre el futuro de las pensiones pero, con alarma o sin alarma, guste o no guste, el debate está ya servido y no se puede detener. Debatir sobre si hay que debatir, como parecen intentar algunos, resulta en discusiones estériles y en confusión. Hay que delimitar los temas, establecer una metodología y un calendario. Sólo así podrán tomarse las medidas oportunas, si acabaran demostrándose necesarias. ¿Cuáles son las cuestiones que deben debatirse? En primer lugar, la evolución previsible del sistema de pensiones públicas bajo hipótesis demográficas y económicas razonables. A este respecto hay muchísimos estudios de economistas, demógrafos, académicos e instituciones diversas que muestran que el sistema, sin reformas, no es sostenible a largo plazo. El denominador común de estos estudios es el siguiente. Para que un sistema de reparto como el español, en el que las cotizaciones de los trabajadores activos financian las pensiones de los jubilados, sea viable desde una óptica financiero-actuarial es preciso que los compromisos de pago de pensiones que adquiere el Estado crezcan a una tasa menor o igual que la masa salarial. En caso contrario, inevitablemente, se acaba generando un déficit insostenible. Pues bien, con la actual normativa legal, los compromisos crecen a una tasa que resulta ser más del doble que la del crecimiento salarial, incluso en los escenarios más optimistas. Esto hace que el sistema sea

113 actuarialmente insolvente. Por otra parte, no conozco ningún estudio que avale las tesis de que el sistema español de reparto, tal y como está, sea sostenible. En segundo lugar debe discutirse la situación del sistema complementario de pensiones privadas. Tras más de 20 años de funcionamiento, el sistema languidece sin haber conseguido progresos relevantes en la consecución de sus objetivos. Se ha generado muy poco ahorro-previsión: el patrimonio de los planes y fondos de pensiones en España no supera 8% del PIB, cifra que compara mal con el 130% de Holanda, el 77% del Reino Unido o el 14% de Portugal. Por otra parte, la industria financiera no ha sido capaz de generar un mercado de pensiones vitalicias privadas a precios razonables, objetivo éste primordial del sistema complementario. A mi juicio, el sistema complementario español debe replantearse sin descartar, a priori, ninguna alternativa. Hoy en día es un sistema voluntario, pero inspirándose en los dos países europeos que han reformado recientemente sus pensiones -Suecia y Reino Unido- podría hacerse total o parcialmente obligatorio. Hoy en día es un sistema de gestión privada, pero esto no tiene por qué ser necesariamente así: el sistema complementario sueco, por ejemplo, es de gestión pública. Y, en tercer lugar, debería discutirse la arquitectura básica de nuestro sistema de pensiones, es decir, la interacción entre el reparto y la capitalización, a la luz de la experiencia de reforma internacional de la que, insisto, Suecia y el Reino Unido son ejemplos muy relevantes. Un sistema de pensiones tiene que atender a dos objetivos diferentes. En primer lugar, como dijo Beveridge, tiene que "garantizar unos mínimos vitales por debajo de los cuales no debe permitirse que nadie caiga". En segundo lugar, tiene que minimizar la pérdida de poder adquisitivo de los trabajadores cuando se jubilan. En España se han hecho progresos en el primer objetivo, pero se ha retrocedido en el segundo. Por una parte, las contribuciones del Estado para complementos de mínimos, financiadas con impuestos generales, han permitido fortalecer la dimensión asistencial del sistema de pensiones sin merma del principio de contributividad (a más cotización mayor pensión). Pero, por otra parte, el Estado está reduciendo las pensiones futuras mediante la no actualización plena de las bases máximas de cotización con el IPC. Esto hace derivar al sistema público hacia un sistema de mínimos y, dado el carácter subrepticio de la medida y el mal funcionamiento del sistema complementario, puede acabar creando un grave problema a muchos futuros pensionistas. Es, pues, necesario discutir cómo debe modificarse la arquitectura del sistema para que pueda atender mejor, simultáneamente, a los dos objetivos arriba mencionados. Paso ahora a responder a mi tercera pregunta: ¿cómo debe organizarse el debate? Vaya por delante que hay que evitar a toda costa seguir el método tradicional, inmortalizado por Goya en su célebre Duelo a garrotazos. La experiencia de los países que han tenido éxito reformando sus pensiones debería servir de guía. Como se apunta en el informe Instrumentos Financieros para la Jubilación de la Fundación de Estudios Financieros "tanto en Suecia como en el Reino Unido el proceso de reforma comenzó con el nombramiento de una comisión independiente, compuesta por personas de elevada autoridad moral, con el mandato de elevar un informe al Gobierno o al Parlamento con propuestas de reforma. Tras periodos de consulta a expertos y agentes sociales, que consiguieron generar amplios debates en las respectivas sociedades, las recomendaciones de las comisiones fueron tomadas como base de las reformas". Aunque en España hay poca tradición de este tipo de debates, hay algunas experiencias

114 muy positivas como el Grupo Especial de Trabajo que armonizó las recomendaciones de los grupos Olivencia y Aldama sobre gobernanza de sociedades cotizadas. ¿Y el Pacto de Toledo? Dicho Pacto, constituido en la actualidad como una Comisión Parlamentaria no Permanente, no es el instrumento adecuado para generar y liderar con independencia el gran debate que, en mi opinión se necesita. Además, su mandato está circunscrito a las pensiones públicas. Sin embargo, el Pacto podría muy bien ser el marco en el que se decidiese la constitución de la comisión independiente a la que me estoy refiriendo. Por último, ¿cuándo debería comenzar el debate? Pues hoy mismo, dado que no comenzó ayer. Los sistemas de pensiones tienen muchísima inercia: dentro de dos décadas es el inmediato futuro. Una reforma modesta adoptada hoy puede tener efectos muy sustanciales dentro de 20 años, pero para que tenga esos mismos efectos en 10 años, la medida tendrá que ser mucho más agresiva. Cuanto más se tarde en comenzar el debate y el proceso de reformas, más radicales y traumáticas deberán ser éstas. Aún estamos a tiempo para adoptar de manera gradual y respetuosa de todos los derechos adquiridos un conjunto de reformas menores que, en su conjunto, garanticen la viabilidad de las pensiones públicas basadas en el sistema de reparto. Pero no hay tiempo que perder. Por lo que respecta al sistema complementario, las reformas tendrán que ser de mucho más calado, pero, dado su tamaño, es un sistema con mucha menos inercia que el sistema público. En cualquier caso es fundamental discutir y abordar las reformas de ambos sistemas simultáneamente. http://www.elpais.com/articulo/opinion/necesario/debate/pensiones/elpepiopi/20090516 elpepiopi_11/Tes/

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May 16, 2009 TALKING BUSINESS Hedge Fund Manager’s Farewell By JOE NOCERA Two weeks from now, a seven-year-old hedge fund called Alson Capital Partners will return around $800 million to its investors, and shut its doors for good. The fund was founded and managed by , 51, a former Wall Street Journal reporter-turned-Morgan Stanley analyst, who started his first hedge fund in 1998, just as the “hedge fund decade” was gaining steam. He was an old-fashioned stock picker who ran Alson Capital as a classic “long-short” stock fund, meaning that he bought companies he thought had good long-term prospects, while shorting companies he thought were likely to fall off the cliff. At its peak, Alson Capital had $3.5 billion under management, charged a 1.5 percent management fee, took 20 percent of the profits, and, when you include Mr. Barsky’s predecessor fund, produced compounded annualized returns of 12.11 percent a year. It’s fair to say he’s made a pretty penny. Mr. Barsky is also a source of mine. In the decade or so that I’ve known him, I was able to quote him by name only once. As he explained to me recently, hedge fund managers who become too visible can make their investors wonder, “Why are you spending all your time on TV when you should be managing my money?” But he was one of the people I turned to when I wanted to learn what was really going on in the market. He is blunt, sardonic, funny and passionate, an insider who never lost his outsider’s perspective. So when I read that he was quitting, I went to see him. I was hoping he would be willing to reflect on his life and times as a hedge fund manager, on the record this time. Happily, he was. • A bit of context first. For all the talk these last few years about the risks to investors of “secretive, unregulated” hedge funds, they certainly haven’t turned out to be the big problem, have they? Like most hedge funds, Alson Capital had a rough year in 2008, down more than 20 percent. Indeed, thousands of hedge funds lost, in the aggregate, hundreds of billions of dollars last year, and hundreds have shut down. But nobody in government is calling for a hedge fund bailout because hedge funds losses, however painful to investors, don’t create systemic risks to the nation’s financial apparatus. As it turns out, it was the big regulated entities, the banks and investment banks, that were the problem, not the unregulated hedge funds. Why did all the fear about hedge funds turn out to be unjustified? One reason is that most hedge funds didn’t have the kind of 30-1 leverage ratios that the big banks had. Mr. Barsky’s fund, for instance, didn’t need much leverage to carry out his long-short strategy. But even if he had wanted to “lever up,” as they say, his prime broker — that is, the investment bank that did his back-office work — probably wouldn’t have let him.

116 In a wonderful irony, the banks and investment banks that were themselves drowning in debt were fearful of allowing their hedge fund clients to carry too much debt. They still remembered Long Term Capital Management, a hedge fund that a decade earlier had, indeed, brought the financial system to the brink because of its extreme leverage. The second reason is that, while hedge fund managers could make extraordinary sums, they had far fewer incentives than Wall Street traders to take truly insane risks. “Ninety percent of my net worth was in the fund,” said Mr. Barsky, and that is true of most hedge fund managers. Wall Street traders got rich by making deals that brought short-term profits, even if they “blew up” later. Hedge fund managers who blew up hurt not only their investors but themselves. “As long as the hedge fund manager has his own capital in the fund, the risk equation is different,” Mr. Barsky said. Although his fund lost money in 2008, it did not blow up; as he put it, the 20 percent loss was “not a disaster but not good.” Although he was forced to make redemptions to investors who bailed out, enough remained that he could have stayed in business. What really caused him to exit the hedge fund business is that he felt ground down by the relentlessness of the job. “When you manage a hedge fund,” Mr. Barsky said, “the cost is the incredible stress you endure. You can never escape it. You are never free. The thing that is different about running a hedge fund is that your investors own you.” The goal of a hedge fund manager is not to beat an index, as it is for a mutual fund manager, but to generate positive returns no matter what the market is doing. Failure to do so would invariably mean redemptions, and could often mean the end of the business. “Hedge funds are fragile,” Mr. Barsky said. Over the years, I could always tell when Mr. Barsky was feeling especially stressed; he did not hide it well. He was also tired of the ways the business had changed. “When I first started in 1998, we used to send out quarterly numbers. Now investors want weekly numbers. Professor Louis Lowenstein” — the iconoclastic and recently deceased Columbia University business law professor — “has a great line in one of his books: ‘You manage what you measure.’ ” Mr. Barsky shrugged, as if to say: don’t feel sorry for me. “That’s life,” he said. “None of us should ever lose sight of the fact that we were in one of the most profitable industries ever. I’m just saying it became a little less fun. And last year was no fun at all.” • Finally, though, Mr. Barsky felt that staying in business would mean having to operate in an investing environment that he no longer quite understood. Making macro bets about the economy was suddenly more important than individual stock picking. And that wasn’t his strength. Besides, at 51, he felt he had another act left in him, and he wanted to find out where life might take him if he were no longer in the business of running money, particularly in the arena of public policy, which fascinates him. “So,” he concluded, “giving people their money back was the best course for everyone.” Although Mr. Barsky has clearly gotten rich, he was surprisingly clear-eyed about the societal imbalances of hedge fund mania. The industry, he told me, “was part of this huge trend towards the celebration of wealth. Hedge fund managers overearned. It just became too easy. There has been a massive misallocation of human resources. I have so many smart guys here who were making seven figures. And I think it is a fair

117 question to ask: what would they have been doing in 1948 — going into the foreign service? If Obama does anything, the best thing he could do is change a generation’s values.” He continued: “I have a friend whose son is a senior at Princeton. She said all his friends want to work for Goldman Sachs.” He added, “We have an overground railroad to finance. It is not the best way for a society to be run.” One of the things that struck him when he first started working on Wall Street, he said, was “how compensation-oriented Wall Street is. When I was a journalist, I could get rewarded in 100 ways, including being on Page 1. Wall Street is the other extreme. There is a singular focus on compensation that is simple, it is clean, but ultimately it is unhealthy.” He thought the outcry over the Merrill bonuses was helping the rest of the country see Wall Street’s skewed priorities more clearly. Earlier in his career, while still at Morgan Stanley, Mr. Barsky helped edit “Buffett: The Making of an American Capitalist,” written by his good friend, the writer Roger Lowenstein (who is also Louis Lowenstein’s son). As he talked about that experience, I asked him if he had modeled his own investing style on Warren Buffett. He let out a small chuckle. Then he stood up and walked over to his desk, where he showed me two framed letters, one he had sent to Mr. Buffett, and the Oracle of Omaha’s reply. They were written in the fall of 2000, shortly after Viacom had spun off its Blockbuster unit. Mr. Barsky had bought the stock — and then had written to Mr. Buffett suggesting that he buy the company. Mr. Buffett sent back a one-sentence reply: “I’ve thought about the business a lot but have never been able to come up with a conviction as to where the industry will be in 10 years.” “Ten years!” Mr. Barsky said. “I think of myself as a long-term investor and I have a two- or three-year horizon.” He shook his head. “In addition to an outsize intellect, Buffett has something that very few investors have. He has a temperament that makes him suitable to being a great long-term investor.” “I don’t feel a sense of defeat,” Mr. Barsky said, as I was preparing to leave. “We have done well by investors and by our employees. We comported ourselves ethically. Three months ago,” he added, “I started to read books on Buddhism. What I learned is how much of what we do is ego-driven. Why do I feel I have to be the best hedge fund manager? I started to have perspective. You probably want your hedge fund manager to eat raw meat. But as we unwind, I’m pretty comfortable with my mind-set.” Sounds like he’s getting out just in time. Joe Nocera Hedge Fund Manager’s Farewell May 16, 2009, en: http://www.nytimes.com/2009/05/16/business/16nocera.html?_r=1&8dpc

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The Machinery Behind Health-Care Reform How an Industry Lobby Scored a Swift, Unexpected Victory by Channeling Billions to Electronic Records By Robert O'Harrow Jr. Washington Post Staff Writer Saturday, May 16, 2009 When President Obama won approval for his $787 billion stimulus package in February, large sections of the 407-page bill focused on a push for new technology that would not stimulate the economy for years. The inclusion of as much as $36.5 billion in spending to create a nationwide network of electronic health records fulfilled one of Obama's key campaign promises -- to launch the reform of America's costly health-care system. But it was more than a political victory for the new administration. It also represented a triumph for an influential trade group whose members now stand to gain billions in taxpayer dollars. A Washington Post review found that the trade group, the Healthcare Information and Management Systems Society, had worked closely with technology vendors, researchers and other allies in a sophisticated, decade-long campaign to shape public opinion and win over Washington's political machinery. With financial backing from the industry, they started advocacy groups, generated research to show the potential for massive savings and met routinely with lawmakers and other government officials. Their proposals made little headway in Congress, in part because of the complexity of the issues and questions about whether the technology and federal subsidies would work as billed. As the downturn worsened last year, advocates helped persuade Obama's advisers to dust off electronic records legislation that had stalled in Congress -- legislation that the advocates had a hand in writing, the Post review found. Their sudden success shows how the economic crisis created a remarkable opening for a political and financial windfall: the enactment of a sweeping new policy with no bureaucratic delays and virtually no public debate about an initiative aimed at transforming a sector that accounts for more than a sixth of the American economy. "It was perhaps a once-in-a-generation opportunity to make something happen," said H. Stephen Lieber, the trade group's president. Obama "identified the vehicle that he could use to move his policy agenda forward without the crippling policy debate." Obama and some of his advisers had been thinking about health-care reform for years before they made it a top campaign issue. Some advocates have talked about improving use of health information technology for decades. Government and private studies have found that much of the $2.5 trillion spent on health care each year is wasted on the duplication of tests and unneeded procedures. Many technology advocates, including health policy specialists, say that networked electronic patient records that can be transmitted instantly would make health care more

119 efficient and provide valuable insights about costs and care. Only a small minority of doctors use such technology to track the care they give people. Some health policy analysts have recommended the use of government subsidies and incentives to spur the adoption -- as the stimulus spending is intended to do. Some advocates also say the savings could amount to tens of billions of dollars each year from reduced paperwork, faster communication and the prevention of harmful drug interactions. An equally important benefit, they say, could be to enable researchers to determine the most effective procedures for an ailment. Such an approach would rely on unprecedented data-mining into medical records and the practices of doctors, a kind of surveillance that also would enable insurers to cut costs by controlling more precisely the care that patients receive. "Finally, we're going to have access to millions and millions of patient records online," said Blackford Middleton, a physician, Harvard professor and chairman of the Center for Information Technology Leadership, whose studies have concluded the health-care system could save $77.8 billion each year through the universal use of information technology networks. "This is the biggest step for health-care information technology in this country's history." But others said the case was far from being so clear. Some observers said the projected savings are overly optimistic and that launching such vast computer networks under tight deadlines is risky, a lesson learned by the Bush administration when it botched a variety of homeland security systems rushed into place after the Sept. 11 terrorist attacks. Some proponents said they worry that an over-reliance on technology as a solution could distract the health-care system from difficult questions about quality of care. They said efforts to find a quick technological fix will likely run up against complex cultural challenges. "I would like to believe that the effective use of technology to augment health care will lead to substantial savings and improvements in the quality of care," said Mark Frisse, a physician and professor of biomedical informatics at Vanderbilt University, who leads an electronic health record program in Nashville. "But the evidence does not consistently bear this out." Many groups have been involved in the push for health information technology, including physician groups. At the center of those efforts is the Healthcare Information and Management Systems Society. Started a half-century ago, it represents 350 companies and about 20,000 members. Corporate members include government contractors such as Lockheed Martin and Northrop Grumman, health-care technology giants such as McKesson, Ingenix and GE Healthcare, and drug industry leaders, including the Pharmaceutical Research and Manufacturers of America. The group, known as HIMSS, runs a trade show for technology vendors, publishes a health technology newspaper and operates a research unit to help members find new markets. The group also maintains a government affairs office in Washington and chapters in state capitals across the country. "HIMSS has a very effective grass roots advocacy program that reaches all levels of government," Dave Roberts, a senior executive, said in the group's literature. For a decade, the group has pressed Congress and other government officials to mandate and subsidize the adoption of health records technology. Over the years, those meetings

120 have included Obama and the man now leading the Office of Management and Budget, Peter Orszag. In 2004, the group persuaded White House speechwriters to include a favorable line in President Bush's State of the Union address. "By computerizing health records, we can avoid dangerous medical mistakes, reduce costs and improve care," Bush said. That was the group's single greatest success until the stimulus passed, Lieber, its president, said. "We worked very hard to get that one line in there," he said. 'The Nature of My Dream' In their quest to generate a favorable policy buzz, advocates created and funded nonprofit organizations to press for electronic health records. HIMSS has a "strategic alliance" with the Center for Information Technology Leadership, a nonprofit that produces research reports -- which HIMSS prints and distributes to Congress and elsewhere. The center was chartered in 2002 by Partners HealthCare System, the largest health-care provider in Massachusetts. Among those sponsoring the center or its reports are Kaiser Permanente, , Google, Siemens Medical Solutions Health Services and other technology companies. The role of the center's chairman, Blackford Middleton, shows the web of connections behind the drive for electronic health records. Middleton is a physician at Partners HealthCare and during the dot-com boom in the 1990s was a senior executive at a start-up that raised hundreds of millions of dollars to develop electronic health records technology. Middleton left the company in 2001, joined Partners and became an assistant professor of medicine and health policy at Harvard. The next year, he became a fellow at the Healthcare Information and Management Systems Society. Middleton eventually came to lead the boards of directors for both that group and the Center for Information Technology Leadership, meaning he was immersed in advocacy of the issue as well as the research to persuade the public of its merit. He was also involved with other nonprofits started in part to promote the use of technology. One of the center's most important reports was issued with HIMSS one month after Bush's 2004 State of the Union address. It concluded that a complete embrace of health information technology could save $77.8 billion annually. In an interview, Middleton said support from the group and from technology companies came with no strings attached. "HIMSS and our corporate sponsors had no influence over the content or the conduct of the research," he said. Middleton said research showed that the projected savings could be achieved only if the government stepped in with incentive payments for doctors, who have resisted investing in the computers because there was no evidence they could profit from them. Middleton said he is motivated by a desire to improve the health-care system, not by financial rewards. "This is the nature of my dream," Middleton said. 'Everything We Know' After volunteering on John Kerry's presidential campaign in 2004, Middleton said he was recruited as an Obama volunteer last year and provided information about electronic

121 records to the candidate's health-care policy group. Middleton said he worked with several campaign officials, including David Blumenthal, a colleague at Partners HealthCare and a Harvard professor, who was Obama's health-care adviser and is now the administration's national coordinator for health technology. "We didn't have to go very far to get our information," said one senior Obama adviser, who was not authorized to speak publicly and discussed the campaign on the condition of anonymity. Blumenthal "taught all the rest of us everything we know." Middleton said he provided many of those details. "I sent them a LOT of stuff, many papers and most of the reports. I probably spoke or communicated with David Blumenthal, David Cutler (the health economist on the team), or Dora Hughes about every other week during the heat of the campaign," Middleton said in an e-mail. In an e-mail, Blumenthal wrote: "It would be flatout wrong to say Blackford Middleton was a key campaign adviser or had an official role on the campaign. He was one of many people the campaign reached out to, and I personally had minimal contact with him." The Obama campaign used the center's $77.8 billion cost-savings figure. After the election, as the economy threatened to collapse, Obama pitched emergency spending on health-care technology as one of many solutions to include in a stimulus package. In a Dec. 6 radio address, the president-elect said that "We will make sure that every doctor's office and hospital in this country is using cutting-edge technology and electronic medical records so that we can cut red tape, prevent medical mistakes and help save billions of dollars each year." Five days later, Obama and his top advisers listened as Thomas A. Daschle, then the nominee to lead the Department of Health and Human Services, made a PowerPoint presentation in a Chicago conference room spelling out the virtues of using the stimulus package for electronic health records. Daschle, a proponent of health information technology, had cited the center's cost-saving estimate in a 2008 book promoting health- care reform. Orszag, the OMB director, was among those at the meeting. While the spending on health records will not stimulate the economy immediately, he said, Obama views it as a long-term "investment" against one of the most persistent drags on the U.S. economy. "It is a key first step toward a high-performing health-care system," Orszag said in an interview. On Dec. 17, Lieber, the Healthcare Information group's leader, said in a letter to the president-elect that a "minimum of $25 billion" in subsidies was needed to spur doctors to buy the technology. In an interview, Lieber said his group was interested not in profit for its members but in improving the health-care system. "It's 'What will this do for health care,' not 'What will this do for GE or Siemens or Phillips.' " 'Overly Optimistic' The stimulus bill suggests that the government will recoup about a third of the spending allocated for electronic health records over the next decade, an assumption that some

122 health-care observers question, in part because of a critical analysis by the Congressional Budget Office last year. The CBO, then led by Orszag, examined the industry-funded study behind the $77.8 billion assertion, among other things, and concluded that it relied on "overly optimistic" assumptions and said much is unknown about the potential impact of health information technology. A CBO analysis of the stimulus bill this year projected that spending on electronic health records could yield perhaps $17 billion in savings over a decade. Under the stimulus package, Medicaid and Medicare providers will receive incentive payments to offset the cost of electronic health record systems they buy. No one knows for sure how widely the technology will be adopted, and no one knows for sure whether those systems will yield the expected savings, specialists said. Another open question relates to the development of technical standards that define what equipment qualifies for stimulus payments. Some critics contend those standards could choke off innovation and funnel profit to certain vendors, without necessarily improving care. To qualify for federal funding, the technology must enable "meaningful use" by doctors and others, according to the legislation -- a standard that policymakers, researchers, vendors and others are struggling to define now. Joseph Antos, a health-care policy specialist who has examined the legislation, said the risks of the technology plan are high because of the haste with which it is being implemented and the special interests seeking to profit from it. "This is the real way things get done," said Antos, of the American Enterprise Institute, a Washington think tank. "The stimulus bill looked like a bonanza to an awful lot of people." http://www.washingtonpost.com/wp- dyn/content/article/2009/05/15/AR2009051503667_pf.html

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Opinion

May 15, 2009 OP-ED COLUMNIST Empire of Carbon By PAUL KRUGMAN TAIPEI, Taiwan I have seen the future, and it won’t work. These should be hopeful times for environmentalists. Junk science no longer rules in Washington. President Obama has spoken forcefully about the need to take action on climate change; the people I talk to are increasingly optimistic that Congress will soon establish a cap-and-trade system that limits emissions of greenhouse gases, with the limits growing steadily tighter over time. And once America acts, we can expect much of the world to follow our lead. But that still leaves the problem of China, where I have been for most of the last week. Like every visitor to China, I was awed by the scale of the country’s development. Even the annoying aspects — much of my time was spent viewing the Great Wall of Traffic — are byproducts of the nation’s economic success. But China cannot continue along its current path because the planet can’t handle the strain. The scientific consensus on prospects for global warming has become much more pessimistic over the last few years. Indeed, the latest projections from reputable climate scientists border on the apocalyptic. Why? Because the rate at which greenhouse gas emissions are rising is matching or exceeding the worst-case scenarios. And the growth of emissions from China — already the world’s largest producer of carbon dioxide — is one main reason for this new pessimism. China’s emissions, which come largely from its coal-burning electricity plants, doubled between 1996 and 2006. That was a much faster pace of growth than in the previous decade. And the trend seems set to continue: In January, China announced that it plans to continue its reliance on coal as its main energy source and that to feed its economic growth it will increase coal production 30 percent by 2015. That’s a decision that, all by itself, will swamp any emission reductions elsewhere. So what is to be done about the China problem? Nothing, say the Chinese. Each time I raised the issue during my visit, I was met with outraged declarations that it was unfair to expect China to limit its use of fossil fuels. After all, they declared, the West faced no similar constraints during its development; while China may be the world’s largest source of carbon-dioxide emissions, its per-capita emissions are still far below American levels; and anyway, the great bulk of the global warming that has already happened is due not to China but to the past carbon emissions of today’s wealthy nations.

124 And they’re right. It is unfair to expect China to live within constraints that we didn’t have to face when our own economy was on its way up. But that unfairness doesn’t change the fact that letting China match the West’s past profligacy would doom the Earth as we know it. Historical injustice aside, the Chinese also insisted that they should not be held responsible for the greenhouse gases they emit when producing goods for foreign consumers. But they refused to accept the logical implication of this view — that the burden should fall on those foreign consumers instead, that shoppers who buy Chinese products should pay a “carbon tariff” that reflects the emissions associated with those goods’ production. That, said the Chinese, would violate the principles of free trade. Sorry, but the climate-change consequences of Chinese production have to be taken into account somewhere. And anyway, the problem with China is not so much what it produces as how it produces it. Remember, China now emits more carbon dioxide than the United States, even though its G.D.P. is only about half as large (and the United States, in turn, is an emissions hog compared with Europe or Japan). The good news is that the very inefficiency of China’s energy use offers huge scope for improvement. Given the right policies, China could continue to grow rapidly without increasing its carbon emissions. But first it has to realize that policy changes are necessary. There are hints, in statements emanating from China, that the country’s policy makers are starting to realize that their current position is unsustainable. But I suspect that they don’t realize how quickly the whole game is about to change. As the United States and other advanced countries finally move to confront climate change, they will also be morally empowered to confront those nations that refuse to act. Sooner than most people think, countries that refuse to limit their greenhouse gas emissions will face sanctions, probably in the form of taxes on their exports. They will complain bitterly that this is protectionism, but so what? Globalization doesn’t do much good if the globe itself becomes unlivable. It’s time to save the planet. And like it or not, China will have to do its part. http://www.nytimes.com/2009/05/15/opinion/15krugman.html

TRIBUNA: Economía global PAUL KRUGMAN El Imperio del Carbono PAUL KRUGMAN 17/05/2009 He visto el futuro, y no va a funcionar. Éstos deberían ser tiempos de esperanza para los defensores del medio ambiente. La ciencia basura ya no impera en Washington. El presidente Obama ha hablado de forma enérgica sobre la necesidad de tomar medidas contra el cambio climático; la gente con la que hablo tiene cada vez más confianza en que el Congreso apruebe pronto un sistema de incentivos económicos que limite las emisiones de gases de efecto invernadero, y que los límites vayan siendo más estrictos con el paso del tiempo. Y una vez que Estados Unidos actúe, podemos esperar que gran parte del mundo siga sus pasos. Pero esto deja sin resolver el problema de China, donde he pasado casi toda la semana pasada. Como todas las personas que visitan China, me he quedado pasmado con la escala de desarrollo del país. Incluso los aspectos molestos (gran parte de mi tiempo lo he pasado contemplando la Gran Muralla del Tráfico)

125 son subproductos del éxito económico del país. Pero China no puede seguir por el mismo camino, porque el planeta no es capaz de soportar esa presión. El consenso científico sobre las perspectivas del calentamiento global se ha vuelto mucho más pesimista durante los últimos años. De hecho, las últimas previsiones de reputados expertos en clima rayan en lo apocalíptico. ¿Por qué? Porque la velocidad a la que están aumentando las emisiones de gases de efecto invernadero iguala o supera las peores previsiones. Y el aumento de las emisiones procedentes de China (que ya es el mayor productor mundial de dióxido de carbono) es uno de los principales motivos de este pesimismo. Las emisiones de China, que proceden en su mayoría de las centrales eléctricas en las que se quema carbón, se han duplicado entre 1996 y 2006. Este ritmo de crecimiento ha sido mucho más rápido que en la década anterior. Y la tendencia parece que va a mantenerse: en enero, China anunciaba que planeaba seguir dependiendo del carbón como su principal fuente de energía y que, para sostener su crecimiento económico, aumentaría la producción de carbón en un 30% de aquí al año 2015. Ésta es una decisión que por sí sola contrarrestará cualquier reducción en las emisiones que se lleve a cabo en cualquier otro sitio. Así que, ¿qué se debe hacer respecto al problema de China? Los chinos dicen que nada. Cada vez que he sacado el tema a relucir durante mi visita, me he topado con indignadas declaraciones sobre lo injusto que era esperar que China limitase el uso de los carburantes fósiles. Afirmaban que, después de todo, Occidente no ha tenido que padecer restricciones similares durante su época de desarrollo; aunque China sea la mayor fuente mundial de emisiones de dióxido de carbono, sus emisiones per cápita siguen estando muy por debajo de los niveles estadounidenses; y, en cualquier caso, la mayor parte del calentamiento global que ya se ha producido no es culpa de China, sino de los gases que en el pasado emitieron los que ahora son países ricos. Y tienen razón. Es injusto esperar que China viva sometida a restricciones que nosotros no tuvimos que afrontar cuando nuestra economía iba hacia arriba. Pero esa injusticia no cambia el hecho de que permitir que China iguale el anterior libertinaje occidental supondrá una condena para la Tierra tal como la conocemos. Dejando a un lado la injusticia histórica, los chinos también han insistido en que no se les debería hacer responsables de los gases de efecto invernadero que emiten al producir bienes para los consumidores extranjeros. Pero se niegan a aceptar la implicación lógica de ese punto de vista: que la carga recaiga entonces sobre esos consumidores extranjeros; que los compradores que adquieran productos chinos paguen una tarifa de carbono que sea un reflejo de las emisiones asociadas a la producción de esos bienes. Según los chinos, eso sería una violación de los principios del libre comercio. Lo sentimos, pero las consecuencias que la producción china tiene para el cambio climático tienen que reflejarse en algún sitio. Y en cualquier caso, el problema de China no es lo mucho que produce, sino la forma en que lo produce. Recuerden que ahora China emite más dióxido de carbono que Estados nidos, a pesar de que su PIB es sólo la mitad de grande (y Estados Unidos, a su vez, es un monstruo de las emisiones en comparación con Europa o Japón). La buena noticia es que la propia ineficacia de China en su uso de la energía brinda enormes oportunidades de mejora. Con las políticas adecuadas, China podría seguir creciendo rápidamente sin incrementar sus emisiones de carbono. Pero primero tiene que darse cuenta de que es necesario cambiar de política. En algunas declaraciones procedentes de China hay indicios de que los responsables políticos del país están empezando a darse cuenta de que su postura actual es insostenible. Pero sospecho que no se dan cuenta de lo deprisa que todo el juego está a punto de cambiar. A medida que Estados Unidos y otros países desarrollados empiecen por fin a actuar frente al cambio climático, también sentirán que tienen más poder moral para enfrentarse a aquellos países que se nieguen a tomar medidas. Antes de lo que la mayoría de la gente piensa, los países que se niegan a limitar sus emisiones de gases de efecto invernadero se enfrentarán a sanciones, probablemente en forma de impuestos sobre sus exportaciones. Se quejarán amargamente de que eso es proteccionismo, pero ¿y qué? La globalización no tiene mucho de bueno si el propio globo se convierte en un lugar inhabitable. Ha llegado la hora de salvar el planeta. Y, le guste o no, China tendrá que contribuir a ello.

126 Energy & Environment

May 28, 2009 China Is Said to Plan Strict Gas Mileage Rules By KEITH BRADSHER HONG KONG — Worried about heavy reliance on imported oil, Chinese officials have drafted automotive fuel economy standards that are even more stringent than those outlined by President Obama last week, Chinese experts with a detailed knowledge of the plans said on Wednesday. The new plan would require automakers in China to improve fuel economy by an additional 18 percent by 2015, said An Feng, a leading architect of China’s existing fuel economy regulations who is now the president of the Innovation Center for Energy and Transportation, a nonprofit group in Beijing. The plan is going through the interagency approval process, with comments sought from automakers, and is scheduled for release early next year, he said. The Chinese government tends to make few changes in automotive regulations once the interagency review process has started. The average fuel economy of family vehicles in China is already higher than in the United States, mainly because cars in China tend to be considerably smaller than those in the United States — and are getting even smaller because of recent tax changes. Cars with small fuel-sipping engines are now subject to a 1 percent sales tax, while sports cars and sport utility vehicles with the largest engines are subject to a 40 percent sales tax. Stricter fuel economy standards have won support from four interest groups within the Chinese government, said a Chinese government official who spoke on the condition of anonymity because he was not authorized to discuss the issue. Many in the government see a strategic and geopolitical need to reduce China’s reliance on oil imports, the official said. China was self-sufficient in oil until 1995, but soaring demand means that China now imports nearly three-fifths of its oil, much of it from potentially unstable countries along sea lanes controlled by the United States Navy. Others in the government are concerned about limiting toxic air pollution and see reductions in the total combustion of gasoline as one way to achieve this. Still other officials are worried about the potential for international efforts to limit China’s emissions of global warming gases, or view greater fuel economy as a way to increase the competitiveness of Chinese car exports. “Different stakeholders have different views,” the official said. China uses a different system from the United States to regulate fuel economy. China sets minimum standards for each of 16 weight categories and tests only urban fuel economy, not highway driving. Adjusting for these differences is difficult and controversial. Mr. An estimated that the average new car, minivan or sport utility vehicle in China already gets the equivalent of 35.8 miles a gallon this year based on the American measurement system of corporate averages and will be required to get 42.2 miles a gallon in 2015. By comparison, President Obama announced last week that each automaker will be required to reach a corporate average of 35.5 miles per gallon by 2016. The details of China’s new fuel economy standards may favor domestic automakers at the expense of multinationals, several auto industry officials said. That is because the new rules call for the steepest increases in fuel economy — as much as 26 percent — for midsize and compact cars, market segments where multinationals are strong. Subcompacts, a market where domestic automakers are stronger, will be required to increase their gas mileage by as little as 9 percent compared with the existing standards, which took effect on Jan. 1.

127 Large cars, minivans and sport utility vehicles will face percentage increases between those extremes. The Chinese government had already cracked down on these vehicles by setting very high gas mileage benchmarks for them as part of the existing rules. When told late Wednesday of China’s gas mileage plans, Michael Dunne, the managing director for China at J. D. Power & Associates, the consulting firm, said that Japanese, Korean and German automakers had models of very small cars that they might start building in China if they have trouble meeting the new standards for larger models. “The short-term impact is it would favor the Chinese, no doubt about it,” he said. “Global automakers care so deeply about this market that they’ll do whatever it takes, and adjust.” Automakers were cautious in their responses to the Chinese initiative. “Ford China is pleased to be part of the industry consultation process on fuel efficiency,” said Whitney Small, a Ford spokeswoman. “Given our role in the process, it would not be appropriate for us to comment prematurely on an ongoing discussion.” Several auto industry officials said that while a substantial increase in fuel economy standards is inevitable, two other issues have not yet been resolved. One issue is how China treats imports. The current fuel-economy standards ban the production of any vehicle in China that does not meet the minimum requirement for its vehicle weight range. But imports are exempt, so practically all of the sport cars and large sport utility vehicles sold in China are imported. One possibility is to tax imported or domestically produced vehicles that fall short of the standard instead of banning them. The United States does this. But new taxes are bureaucratically complex to impose in China. Imports made up only 1.9 percent of China’s car market in the first four months of this year because of heavy import taxes. The other unresolved issue is whether China will impose corporate average fuel economy standards in addition to minimum standards for each vehicle weight range, auto industry officials said. This would make it harder for companies to specialize in larger vehicles that may consume more fuel but may also be more profitable.

128 May 15, 2009, 7:48 pm China and the liquidity trap I liked this David Leonhardt article about the China-US economic relationship. But I do have a problem with this passage: The most obviously worrisome part of the situation today is that the Chinese could decide that they no longer want to buy Treasury bonds. The U.S. government’s recent spending for bank bailouts and stimulus may be necessary to get the economy moving again, but it also raises the specter of eventual inflation, which would damage the value of Treasuries. If the Chinese are unnerved by this, they could instead use their cash to buy the bonds of other countries, which would cause interest rates here to jump, prolonging the recession. Um, no. Right now we’re in a liquidity trap, which, as I explained in an earlier post, means that we have an incipient excess supply of savings even at a zero interest rate. (By the way, I’ve had a chance to see the transcript of the PEN/ NY Review event, and I don’t think I was misrepresenting Niall Ferguson’s position.) In this situation, America has too large a supply of desired savings. If the Chinese spend more and save less, that’s a good thing from our point of view. To put it another way, we’re facing a global paradox of thrift, and everyone wishes everyone else would save less. Or to put it a third way, the argument that a reduction in China’s dollar purchases would be contractionary for America because it would drive up interest rates is equivalent to the argument that fiscal expansion is contractionary for the same reason — and equivalently wrong. But what if China doesn’t spend more, but just reallocates its reserves from dollars to, say, euros? The answer is, that’s also good for us: a weaker dollar will help our exports, at Europe’s expense. One of the things I tried to tell the Chinese was precisely that the old co-dependence no longer exists. For now, at least, their dollar purchases are an unalloyed bad thing from America’s point of view.

May 15, 2009, 8:03 pm Forgotten snark Brad DeLong catches a footnote in a decade-old paper by Olivier Blanchard:

Paul Krugman recently wondered how many macroeconomists still believe in the IS-LM model. The answer is probably that most do, but many of them probably do not know it well enough to tell.

I actually have no memory of saying that. But I was worrying about the state of macro a decade ago. Here’s a short piece (THERE'S SOMETHING ABOUT MACRO) I wrote back then. Even then, it was obvious that the Great Forgetting was underway; only

129 economists of a certain age knew how to think about what remain the essential insights of macro. So in a way it should be no surprise to find, 10 years later, that we have entered a Dark Age of macroeconomics. THERE'S SOMETHING ABOUT MACRO (notes about teaching graduate macroeconomics) 1998 It's holiday season, and my thoughts have turned to ... course preparation. Classes don't begin until February, but books must be ordered, reading packets must receive copyright clearance and go to Graphic Arts, and background notes must be prepared. This spring I have a new assignment: to teach Macroeconomics I for graduate students. Ordinarily this course is taught by someone who specializes in macroeconomics; and whatever topics my popular writings may cover, my professional specialties are international trade and finance, not general macroeconomic theory. However, MIT has a temporary staffing problem, which is itself revealing of the current state of macro, and I have been called in to fill the gap. Here's the problem: Macro I (that's 14.451 in MIT lingo) is a quarter course, which is supposed to cover the "workhorse" models of the field - the standard approaches that everyone is supposed to know, the models that underlie discussion at, say, the Fed, Treasury, and the IMF. In particular, it is supposed to provide an overview of such items as the IS-LM model of monetary and fiscal policy, the AS-AD approach to short-run versus long-run analysis, and so on. By the standards of modern macro theory, this is crude and simplistic stuff, so you might think that any trained macroeconomist could teach it. But it turns out that that isn't true. You see, younger macroeconomists - say, those under 40 or so - by and large don't know this stuff. Their teachers regarded such constructs as the IS-LM model as too ad hoc, too simplistic, even to be worth teaching - after all, they could not serve as the basis for a dissertation. Now our younger macro people are certainly very smart, and could learn the material in order to teach it - but they would find it strange, even repugnant. So in order to teach this course MIT has relied, for as long as I can remember, on economists who learned old-fashioned macro before it came to be regarded with contempt. For a variety of reasons, however, we can't turn to the usual suspects this year: Stan Fischer has left to run the world, Rudi Dornbusch is otherwise occupied, Olivier Blanchard is department head, Ricardo Caballero - who is a bit young for the role, but can swallow his distaste if necessary - is on leave. All of which leaves me. Now you might say, if this stuff is so out of fashion, shouldn't it be dropped from the curriculum? But the funny thing is that while old-fashioned macro has increasingly been pushed out of graduate programs - it takes up only a few pages in either the Blanchard-Fischer or Romer textbooks that I am assigning, and none at all in many other tracts - out there in the real world it continues to be the main basis for serious discussion. After 25 years of rational expectations, equilibrium business cycles, growth and new growth, and so on, when the talk turns to Greenspan's next move, or the prospects for EMU, or the risks to the Brazilian rescue plan, it is always informed - explicitly or implicitly - by something not too different from the old-fashioned macro that I am supposed to teach in February. Why does the old-fashioned stuff persist in this way? I don't think the answer is intellectual conservatism. Economists, in fact, are in general neophiles, always looking for something radical and different. Anyway, I have seen over and over again how young economists, trained to regard IS-LM and all that with contempt if they even know what it is, find themselves turning to it after a few years in Washington or New York. There's something about primeval macro that pulls us back to it; if Hicks hadn't invented IS- LM in 1937, we would end up inventing it all over again. But what is it that makes old-fashioned macro so compelling? To answer that question, I find it helpful to think about where it came from in the first place. Afficionados know that much of what we now think of as Keynesian economics actually comes from John Hicks, whose 1937 article "Mr. Keynes and the classics" introduced the IS-LM model, a concise statement of an argument that may or may not have been what Keynes meant to say, but has certainly ended up defining what the world thinks he said. But how did Hicks come up with that concise statement? To answer that question we need only look at the book he himself was writing at the time, Value and Capital, which has in a low-key way been as influential as Keynes' General Theory.

130 Value and Capital may be thought of as an extended answer to the question, "How do we think coherently about the interrelationships among markets - about the impact of the price of hogs on that of corn and vice versa? How does the whole system fit together?" Economists had long understood how to think about a single market in isolation - that's what supply-and-demand is all about. And in some areas - notably international trade - they had thought through how things fitted together in an economy producing two goods. But what about economies with three or more goods, where some pairs of goods might be substitutes, others complements, and so on? This is not the place to go at length into the way that Hicks (and others working at the same time) put the story of "general equilibrium" together. But to understand where IS-LM came from - and why it continues to reappear - it helps to think about the simplest case in which something more than supply and demand curves becomes necessary: a three good economy. Let us simply call the goods X, Y, and Z - and let Z be the "numeraire", the good in terms of which prices are measured. Now equilibrium in a three-good model can be represented by drawing curves that indicate combinations of prices for which each of the three markets is in equilibrium. Thus in Figure 1 the prices of X and Y, both in terms of Z, are shown on the axes. The line labeled X shows price combinations for which demand and supply of X are equal; similarly with Y and Z. Although there are three curves, Walras' Law (if all markets but one are in equilibrium, that market is in equilibrium too) tells us that they have a common intersection, which defines equilibrium prices for the economy as a whole. The slopes of the curves are drawn on the assumption that "own-price" effects are negative, cross- price effects positive - thus an increase in the price of X increases demand for Y, driving the price of Y up, and vice versa; it is also, of course, possible to introduce complementarity into such a framework, which was one of its main points. This diagram is simply standard, uncontroversial microeconomics. What does it have to do with macro? Well, suppose you wanted a first-pass framework for thinking coherently about macro-type issues, such as the interest rate and the price level. At minimum such a framework would require consideration of the supply and demand for goods, so that it could be used to discuss the price level; the supply and demand for bonds, so that it could be used to discuss the interest rate; and, of course, the supply and demand for money. What, then, could be more natural than to think of goods in general, bonds, and money as if they were the three goods of Figure 1? Put the price of goods - aka the general price level - on one axis, and the price of bonds (1 divided by 1+i, if they are one-period bonds) on the other; and you have something like Figure 2 - or, more conventionally putting the interest rate instead of the price of bonds on the vertical axis, something like Figure 3 . And already we have a picture that is essentially Patinkin's flexible-price version of IS-LM. If you try to read pre-Keynesian monetary theory, or for that matter talk about such matters either with modern laymen or with modern graduate students who haven't seen this sort of thing, you quickly realize that this seemingly trivial formulation is actually a powerful tool for clarifying thought, precisely because it is a general-equilibrium framework that takes the interactions of markets into account. Here are some of the things it suddenly makes clear: 1. What determines interest rates? Before Keynes-Hicks - and even to some extent after - there has seemed to be a conflict between the idea that the interest rate adjusts to make savings and investment equal, and that it is determined by the choice between bonds and money. Which is it? The answer, of course - but it is only "of course" once you've approached the issue the right way - is both: we're talking general equilibrium here, and the interest rate and price level are jointly determined in both markets. 2. How can an investment boom cause inflation (and an investment slump cause deflation)? Before Keynes this was a subject of vast confusion, with all sorts of murky stuff about "lengthening periods of production", "forced saving", and so on. But once you are thinking three-good general equilibrium, it becomes a simple matter. When investment (or consumer) demand is high - when people are eager to borrow to buy real goods - they are in effect trying to shift from bonds to goods. So as shown in Figure 4 , both the bond-market and goods-market equilibrium schedules, but not the money-market schedule, shift; and the result is both inflation and a rise in the interest rate. 3. How can we distinguish between monetary and fiscal policy? Well, in a fiscal expansion the government sells bonds and buys goods - producing the same shifts in schedules shown in Figure 4. In a monetary expansion it buys bonds and "sells" newly printed money, shifting the bonds and money (but not goods) schedules as shown in Figure 5 .

131 Of course, this is all still a theory of "money, interest, and prices" (Patinkin's title), not "employment, interest, and money" (Keynes'). To make the transition we must introduce some kind of price-stickiness, so that incipient deflation is at least partly translated into output decline; and then we must consider the multiplier impacts of that output decline, and so on. But the basic form of the analysis still comes from the idea of a three-good general-equilibrium model in which the three goods are "goods in general", bonds, and money. Sixty years on, the intellectual problems with doing macro this way are well known. First of all, the idea of treating money as an ordinary good begs many questions: surely money plays a special sort of role in the economy. Second, almost all the decisions that presumably underlie the schedules here involve choices over time: this is true of investment, consumption, even money demand. So there is something not quite right about pretending that prices and interest rates are determined by a static equilibrium problem. (Of course, Hicks knew about that, and was quite self-conscious about the limitations of his "temporary equilibrium" method). Finally, sticky prices play a crucial role in converting this into a theory of real economic fluctuations; while I regard the evidence for such stickiness as overwhelming, the assumption of at least temporarily rigid nominal prices is one of those things that works beautifully in practice but very badly in theory. But step back from the controversies, and put yourself in the position of someone who must reach a judgement about the likely impact of a change in monetary policy, or an investment slump, or a fiscal expansion. It would be cumbersome to try, every time, to write out an intertemporal-maximization framework, with microfoundations for money and price behavior, and try to map that into the limited data available. Surely you will find yourself trying to keep track of as few things as possible, to devise a working model - a scratchpad for your thoughts - that respects the essential adding-up constraints, that represents the motives and behavior of individuals in a sensible way, yet has no superfluous moving parts. And that is what the quasi-static, goods-bonds-money model is - and that is why old-fashioned macro, which is basically about that model, remains so useful a tool for practical policy analysis.

http://web.mit.edu/krugman/www/islm.html

132 Grasping Reality with Both Hands

The Semi-Daily Journal of Economist Brad DeLong: A Fair, Balanced, Reality- Based, and More than Two-Handed Look at the World May 11, 2009 Progress in Macroeconomics? A decade ago, Olivier Blanchard, now IMF chief economist, wrote that there had been a lot of progress in macroeconomics since 1920: What Do We Know that Fisher and Wicksell Did Not?: The answer to the question... is: A lot.... Pre 1940. A period of exploration.... From 1949 to 1980. A period of consolidation... an integrated framework was developed--starting with the IS-LM, all the way to dynamic general equilibrium models--and used to clarify the role of shocks and propagation mechanisms.... since 1980. A new period of exploration, focused on the role of imperfections... nominal price setting... incompleteness of markets... asymmetric information... search and bargaining in decentralized markets.... [...] The right [picture] is one of a steady accumulation of knowledge.... [R]evolutionaries make the news... [their ideas are] discarded... bastardized, then integrated. The insights become part of the core.... [...] Relative to Wicksell and Fisher, macroeconomics today is solidly grounded in a general equilibrium structure. Modrn models characterize the economy as being in temporary equilibrium, given the implications of the past, and the anticipations of th efuture. They provide an interpretation of shocks working their way through propagation mechanisms... [...] One way to end is to ask: Of how much use was macroeconomic research in understanding... the Asian crisis?... Macroeconomists did not predict either the time, place, or scope of the crisis.... [W]hen the crisis started, macroeconomic mistakes... were made. But fairly quickly the nature of the crisis was better understood, and the mistakes correcxted. And most of the tools needed were there.... since then, a large amount of further research has taken place, leading to a better understanding of the role of financial intermediaries in exchange-rate crisis... Even then Paul Krugman snarked: Paul Krugman recently wondered how many macroeconomists still believe in the IS-LM model. The answer is probably that most do, but many of them probably do not know it well enough to tell.. Today things look considerably different on the progress-in-macroeconomics front. John Quiggin: Refuted/obsolete economic doctrines #7: New Keynesian macroeconomics at John Quiggin: [Here is] a new entry for my list of refuted economic doctrines... the target... has... [been] rendered obsolete by events... New Keynesianism an approach to macroeconomics, to which Akerlof and Shiller have made some of the biggest contributions, but which they have now... repudiated.... [T]he

133 research task was seen as one of identifying minimal deviations from the standard [rational foresight, self-interest, and competiative markets] microeconomic assumptions which yield Keynesian macroeconomic conclusions.... Akerlof’s ‘menu costs’ arguments... are an ideal example of this kind of work. New Keynesian macroeconomics has been tested by the current global financial and macroeconomic crisis and has, broadly speaking, been found wanting. The analysis of those Keynesians who warned of impending crisis combined an ‘old Keynesian’ analysis of mounting economic imbalances with a Minskyan focus on financial instability.... [T]he policy response... has been informed mainly by old-fashioned ‘hydraulic’ Keynesianism... massive economic stimulus... large-scale intervention in the financial system. The opponents of Keynesianism have retreated even further into the past, reviving the anti-Keynesian arguments of the 1930s and arguing at length over policy responses to the Great Depression. There is of course, still a need to explain why wages do not adjust rapidly to clear labour markets in the face of an external financial shock. But in an environment where the workings of sophisticated financial markets display collective irrationality on a massive scale, there is much less reason to be concerned about the fact that such an explanation must involve deviations from rationality, and seeking to minimise those deviations.... New Keynesianism... was a defensive adjustment to the dominance of free market ideas.... New Keynesians sought a theoretical framework that would justify medium-term macroeconomic management based on manipulation of interest rates by central banks, and a fiscal policy that allowed automatic stabilisers to work, against advocates of fixed monetary rules and annual balanced budgets. But now that both... the efficient markets hypothesis and the policy framework that brought us the Great Moderation have collapsed, there is no need for such a defensive stance... George Akerlof and Robert Shiller agree with Quiggin rather than Blanchard: Akerlof and Shiller, Animal Spirits: The economics of the textbooks seeks to minimise as much as possible departures from pure economic motivation and from rationality.... [E]ach of us has spent a good portion of his life writing in this tradition. The [self-interest and rational foresight-based] economics of Adam Smith is well understood. Explanations in terms of small deviations from Smith’s ideal system are thus clear because they are posed within a framework that is already very well understood. But that does not mean that these small deviations from Smith’s system describe how the economy actually works.... In our view, economic theory should be derived not from the minimal deviations from the system of Adam Smith but rather from the deviations [from competitive markets, self-interested motivation, and rational foresight] that actually do occur... So does Greg Clark: his rant from his seat as chair of the U.C. Davis Economics Department: Dismal scientists: how the crash is reshaping economics - The Atlantic Business Channel: In the long post WWII boom, as free market ideology triumphed, economists have won for themselves a privileged place inside academia.... [C]ash.... Not much by the pornographic standards of finance, but a fat paycheck compared to your average English or Physics professor. It is not just the stars. Journeyman assistant professors in economics routinely come in at $100,000 or more... fresh from their PhDs, without a publication to their name and without years of low pay as post-docs. The high salaries have been accompanied by dramatic declines in the teaching burden.... Why did academic economics generate so much prestige?... [W]hat drove demand was the unquenchable thirst for economists by banks, government agencies, and

134 business schools - the Feds, the Treasury, the IMF, the World Bank, the ECB. Economics had powerful insights to offer the world, insights worth a lot of treasure. Economics was powerful voodoo.... The current recession has revealed... as useless the mathematical contortions of academic economics. There is no totemic power.... (1) Almost no-one predicted the world wide downtown. Academic economists were confident that episodes like the Great Depression had been confined to the dust bins of history. There was indeed much recent debate about the sources of "The Great Moderation" in modern economies, the declining significance of business cycles.... [M]acroeconomists had turned their considerable talents to a bizarre variety of rococo academic elaborations. With nothing of importance to explain, why not turn to the mysteries of online dating, for example.... (2) The debate about the bank bailout, and the stimulus package, has all revolved around issues that are entirely at the level of Econ 1. What is the multiplier from government spending? Does government spending crowd out private spending? How quickly can you increase government spending? If you got a A in college in Econ 1 you are an expert in this debate: fully an equal of Summers and Geithner. The bailout debate has also been conducted in terms that would be quite familiar to economists in the 1920s and 1930s. There has essentially been no advance in our knowledge in 80 years.... Bizarrely, suddenly everyone is interested in economics, but most academic economists are ill-equipped to address these issues. Recently a group of economists affiliated with the Cato Institute ran an ad in the New York Times opposing the Obama's stimulus plan. As chair of my department I tried to arrange a public debate between one of the signatories and a proponent of fiscal stimulus -- thinking that would be a timely and lively session. But the signatory, a fully accredited university macroeconomist, declined the opportunity for public defense of his position on the grounds that "all I know on this issue I got from Greg Mankiw's blog -- I really am not equipped to debate this with anyone." Academic economics will no doubt survive this shock to its prestige.... [But] the days of the $500,000 economics professor may have passed.... [W]ill the focus of academic economics change?... I would rate the chances of Chrysler producing once again a competitive US automobile at least as high as the chances of academic economics learning any lesson from this downturn... Watching the scrum over the past six months, I have to call this one for Krugman, Clark, Akerlof, Shiller, and Quiggin and against Blanchard's vision of growing knowledge and analytical convergence. Economists have been worrying about the industrial business cycle and the proper role of the government in trying to tame it since 1825. Yet there are an extraordinary number of people out there calling themselves macroeconomists who do not have the slightest clue as to what the issues have been over the past two hundred years. Comments Back in 1979, I sighed very loudly in Dornbush's advanced Macro course. He heard me and, unlike every other professor at MIT, actually knew my name (having memorized the student yearbook, I think). "Mr. Cecere, whatever has caused you to be so troubled?" "These models are so flawed...they all rest on rational behavior assumptions that could be destroyed by the simplest thought experiment. No wonder they don't predict, and barely fit historical data. And don't tell me it washes out in the average, it doesn't -- if anything, irrationality is worse if it catches on." "Well, I'm glad to see you've learned much of what I wanted to teach you." Posted by: Tom C | May 11, 2009 http://delong.typepad.com/sdj/2009/05/progress-in-macroeconomics.html

135

TRIBUNA: JOSÉ LUIS FEITO, 15/05/2009 Visiones 'krugmaniáticas' contra el euro Hace unos días, Paul Krugman manifestó que la pertenencia de España al euro había acentuado la crisis y dificultaba nuestra salida de la misma. El núcleo argumental de estas y otras críticas se puede resumir como sigue. El euro impuso a España una política monetaria excesivamente expansiva. En consecuencia, la inflación en nuestro país ha superado año tras año la media de la eurozona haciéndonos perder competitividad y configurando tipos de interés reales negativos que han alentado el endeudamiento y alimentado la burbuja inmobiliaria. Además, la economía no puede contar con el estímulo de la devaluación para recuperar la competitividad perdida y propulsar la salida de la crisis. Así pues, la mejora de la competitividad ha de realizarse reduciendo el avance de los costes laborales unitarios por debajo del de los otros países, ajuste que entraña fuertes reducciones de los niveles de renta y empleo. Los costes que se imputan al euro sólo serían tales en la medida que fueran mayores que los existentes bajo el patrón alternativo que se postula: la persistencia de la peseta como moneda independiente. Los críticos del euro olvidan que un tipo de cambio variable puede tanto depreciarse como apreciarse. Además, dan por sentado que una economía relativamente pequeña y muy abierta, como la española, puede llevar a cabo una política monetaria independiente de la que estén instrumentando sus principales socios comerciales. Esto es, presuponen que si España no hubiera entrado en el euro podría haber subido sus tipos de interés al tiempo que los principales países europeos los bajaban y hubiera evitado así el diferencial de inflación e impedido la acumulación de pérdidas de competitividad y volúmenes de endeudamiento como los registrados en los últimos 10 años. También consideran que una devaluación del tipo de cambio nominal ejerce siempre efectos positivos sobre los niveles de producción y empleo. Tenemos lo más parecido a un experimento controlado para evaluar los límites y consecuencias de aplicar una política monetaria independiente en España: lo sucedido entre 1985 y 1992. En aquel periodo, el Banco de España elevó intensamente los tipos de interés, hasta situarlos casi dos veces por encima de los vigentes en los países centrales de Europa, a pesar de lo cual nuestra inflación media anual casi dobló la media europea. La pérdida de competitividad fue superior a la ocasionada por los amplios diferenciales de inflación debido a la apreciación registrada por el tipo de cambio nominal de la peseta. Así, en un periodo que duró la mitad de lo que lleva de vida el euro, la pérdida de competitividad fue más del doble de la sufrida dentro de la moneda única, siendo más de una tercera parte de dicha pérdida atribuible a la apreciación deltipo de cambio nominal de la peseta. Por otra parte, las sucesivas devaluaciones de la peseta no impidieron que el ajuste de la economía se realizara mediante pérdidas voluminosas de producción y empleo, alcanzando la tasa de paro niveles cercanos al 25% en la primera mitad de 1994. No hace falta mucha imaginación analítica para visualizar lo que habría ocurrido si con los mercados de capitales y la globalización más potentes aún en lo que llevamos de siglo que en aquellos años nuestro país hubiera seguido con la peseta. Cualquier diferencial de tipos de interés no sólo habría inducido una apreciación del tipo de cambio nominal o diferenciales de inflación aún más intensos que entonces, sino que habría llevado a nuestros bancos a endeudarse fuertemente en divisas con bajos tipos de

136 interés para satisfacer la demanda de financiación barata por parte de familias y empresas. Es difícil saber si en estas circunstancias la burbuja inmobiliaria hubiera sido mucho menor. Ciertamente no lo ha sido en países que tenían una política monetaria independiente, como el Reino Unido, Islandia, Hungría o Rumania. Lo que se puede afirmar con certeza es que en todo caso habría habido un exceso de endeudamiento y que la eventual devaluación de la peseta habría sido muy dañina para las familias y empresas endeudadas y, especialmente, para nuestro sistema financiero. Es verdad que, llegada la crisis, podríamos contar con la devaluación del tipo de cambio nominal, pero cuando el sector privado o público de un país está fuertemente endeudado en divisas dicha devaluación tiene efectos contractivos. Por eso, el Banco de España, como están haciendo los bancos centrales de muchos países del este de Europa, se habría visto obligado a mantener tipos de interés muy elevados a fin de evitar el desplome del tipo de cambio y del sector financiero. Las consideraciones anteriores sirven para refutar un mito firmemente arraigado en el subconsciente colectivo de nuestro país: la idea de que las devaluaciones de la peseta han sido el resorte fundamental para recuperar la competitividad perdida y suavizar las crisis económicas del pasado. El verdadero mecanismo de ajuste de la competitividad en el pasado, como en el presente, han sido las brutales pérdidas de empleo necesarias para reducir los costes laborales unitarios en presencia de la extraordinaria viscosidad nominal y real de nuestra estructura salarial. Ciertamente, las devaluaciones del tipo de cambio nominal en el pasado tuvieron efectos positivos, pero rápidamente evanescentes y además contrarrestados por la necesidad de mantener tipos de interés relativamente elevados como consecuencia de las expectativas de elevada inflación a largo plazo que anidan en un país propenso a devaluar de tiempo en tiempo su moneda. Las devaluaciones de la peseta de los noventa tuvieron efectos más duraderos que otras precisamente porque la entrada en el euro ancló las expectativas de inflación muy por debajo de las que existían antes y de las que hubieran existido si nuestro país se hubiera quedado fuera de la moneda única. En resumen, dentro o fuera de un área monetaria, cuando un país tiene un mercado de trabajo tan inauditamente distorsionado como el nuestro está condenado a realizar cualquier ganancia duradera de competitividad a costa de ajustes de producción y empleo. Estos ajustes son menores dentro que fuera del euro por dos razones. En primer lugar, porque en el euro las pérdidas de competitividad son de menor entidad ya que el tipo de cambio nominal frente al grueso de nuestros socios comerciales no se puede apreciar durante la fase expansiva y el diferencial de precios acumulado es inferior por el anclaje de las expectativas de inflación a largo plazo. En segundo lugar, porque los tipos de interés son significativamente menores cuando se elimina la propensión a las devaluaciones recurrentes. Comparado con estos beneficios, los costes de perder la posibilidad de una devaluación, que en el mejor de los casos tendría efectos efímeros y rápidamente contraproducentes, son irrisorios. Krugman terminaba sus admoniciones sobre España comparando la situación de nuestro país con la de California y Florida, señalando la ineluctable necesidad en unas y otras economías de sufrir dolorosos ajustes de producción y empleo. Es curioso, sin embargo, que no postulara para esos dos Estados norteamericanos lo que predicaba para España: que hubieran estado mejor si en lugar de adoptar el dólar hubieran tenido una moneda propia susceptible de devaluarse frente a la del resto de Estados del país. http://www.elpais.com/articulo/opinion/Visiones/krugmaniaticas/euro/elpepiopi/20090515elpepiopi_4/Tes

137 Markets Exchanges sense bonanza in OTC overhaul By Aline van Duyn and Anuj Gangahar Published: May 14 2009 20:30 | Last updated: May 14 2009 20:30 Some of the big derivatives dealers breathed a sigh of relief when they saw the details of this week’s sweeping plan from the Obama administration to regulate over-the-counter derivatives.

With parts of the $680,000bn market blamed for exacerbating the financial crisis, large swathes of which are opaque even to regulators, there had been draft proposals flying around Washington that would have had an even more far-reaching effect than the current plans. In particular, the proposals unveiled by Tim Geithner, US Treasury secretary, on Wednesday, include plans for “the encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives”. “Exchange trading of all derivatives has not been made mandatory, which is a big relief for the industry,” said an executive at one large derivatives dealer. Nevertheless, the proposals have plenty of other details which will significantly overhaul the industry, which has grown to one of the most profitable parts of Wall Street and the City of London, and which has managed to fight off calls for stringent regulation for the last two decades. The big banks, which have long dominated the over-the-counter (OTC) derivatives market, have already moved to adopt some of the proposed changes, which include changes in US laws to require the clearing of all standardised OTC derivatives through regulated central counterparties.

138 Bankers said the collapse of Lehman Brothers last September was a key turning point as it showed how vulnerable the financial system was to meltdown if one dealer went under, because most other dealers were exposed to such a default through trillions of dollars of derivatives contracts. Since then, large amounts of interest-rate swaps – the largest OTC market – have been shifted to centralised clearing, as have commodities, particularly in the energy sector. Efforts are also underway to clear credit default swaps. These are regarded as the riskiest part of the derivatives market and are particularly under scrutiny as they led to the collapse of AIG. Even without mandatory exchange trading, which is being encouraged, exchanges are expected to be among the main beneficiaries of the derivatives industry shifts. So are other electronic trading systems, such as , which is used in the swaps market. “Expanding the scope of the mandatory clearing through central clearing counterparty [beyond credit derivatives] is a material step up in the shift from OTC to on-exchange,” said Dirk Hoffmann-Becking, analyst at Sanford Bernstein. For years, exchanges have been trying to break into the vast OTC market without upsetting their largest customers – the banks. Now, they can press harder and argue they are acting the way regulators want them to. However, other electronic trading systems may also benefit and there could be tussle between the exchanges and smaller electronic rivals. Shares of the CME Group and the Intercontinental Exchange, the exchanges best positioned to take advantage of moves to introduce a central clearer for a range of derivative products, gained strongly on Thursday, adding to gains on Wednesday. CME shares are up over 16 per cent for the week. The losers are likely to be the big dealers. “In the banking sector, these developments are significantly negative,” said Mr Hoffman-Becking. “Bid-offer spreads on an exchange trading platform are always much narrower than they are OTC due to higher transparency.” The full impact of the new rules is still not clear, however. First of all, the response from European regulators will be key (see below). The derivatives markets are global and any weaknesses in regulation in one part of the world could shift activity to another. “The whole regulatory approach needs to be global, otherwise activity will just shift elsewhere,” said Larry Tabb, of the Tabb Group. “At the moment it is jawboning, and the words need to be followed through with actions in the US, Europe and elsewhere.” Second, the proposed regulatory changes apply to “derivatives dealers and all other firms who create large exposures to counterparties”. Whether that includes companies using derivatives for hedging is not clear. Also, there are many smaller investors active in the market that do not have sophisticated technology or risk-management systems set up. Third, there are concerns that a plethora of clearing houses could increase risks. Recent research by Darrell Duffie, professor in finance at the Stanford Graduate School of Business, found that risks could be increased if clearing was only applied to one category of OTC derivatives. His study focused on the credit default swaps market, where centralised clearing has already started.

139 “Our results make it clear that regulators and dealers should carefully consider the trade- offs involved in carving out a particular class of derivatives, such as credit default swaps, for clearing,” the research says. The reason is that the big dealers in OTC derivatives offset many of their risk positions. But if one large slice of risk is suddenly removed from that pie, the remaining risks could potentially be larger. Hence key questions include: what exactly ends up being classified as “standardised” and how quickly are different types of OTC derivatives forced to move to centralised clearing? Though the industry is appearing supportive, it is clear there is a degree of caution. “Our members continue to support efforts to reduce systemic risk, strengthen the infrastructure for derivatives transactions, and improve regulatory transparency,” said Tim Ryan, president of the Securities Industry and Financial Markets Association (SIFMA). “It is important that new regulatory measures preserve the usefulness of derivatives as risk management tools for American businesses.” Copyright The Financial Times Limited 2009 http://www.ft.com/cms/s/0/38fe6322-40b9-11de-8f18-00144feabdc0.html The eurozone’s terrible recession

Published: May 15 2009 09:17 | Last updated: May 15 2009 15:58

This has to be the worst of it. If it is not, then the eurozone’s prospects are grim indeed. The German economy shrank by 4 per cent in the first quarter compared to the last three months of 2008. That is far from the astonishing 11 per cent shrinkage suffered by Slovakia over the same period, but it was still by far the lousiest performance of any major eurozone country. If the German economy continues to shrink at this rate it will be a fifth smaller by the year-end, entirely reversing the past decade and a half of growth since unification. This has worrying implications for government revenues, which will fall as the recession bites. Even the hairshirts in Berlin forecast a budget deficit of more than 4.2 per cent of gross domestic product for next year; at €90bn it will be Germany’s biggest since the second world war in absolute terms. Further tax rises and spending cuts required to return the budget deficit to within the 3 per cent limit stipulated by the eurozone’s stability pact rules will only slow growth further. All eurozone countries, but especially those with proportionately bigger deficits, such as Italy and Spain, face similar challenges. That being the case, the credit quality of European sovereigns can only worsen. Yet, paradoxically, spreads of other European government debt over German bunds have tightened dramatically over the past three months. That is partly thanks to the market rally, which has boosted not only equities but also the prices of European sovereigns that some had speculated might even default. Yields on 10-year Irish government bonds, for example, have fallen by 32 basis points, and on 10-year Spanish debt by 11 bp. A larger part of the tightening spreads, however, has been because bund yields have risen, by some 25bp over the same period. That is a uniquely bad performance by German bonds among the eurozone. If the recession should prove to be more entrenched than currently hoped, Germany increasingly looks like the short.

140 BACKGROUND NEWS Germany’s economy contracted by a record 3.8 per cent at the start of this year – even more than feared – dragging down overall eurozone growth and confirming it has been the worst hit among the big European countries by the global downturn. Germany’s recession has become the deepest in its postwar history. The latest quarterly contraction was the biggest since comparable records were first published in 1970, the country’s statistical office said. The final quarter had already seen a contraction of 2.2 per cent, revised from 2.1 per cent. Germany’s weak performance resulted in eurozone GDP falling by a larger-than-expected 2.5 per cent in the first quarter. That was significantly faster than in the US or UK, which have reported falls of 1.6 per cent and 1.9 per cent. The latest eurozone data also pointed to an acceleration in the pace of decline from the 1.6 per cent contraction reported in the final quarter of last year.

ECB favours using monetary policy as asset-price tool

Published: May 15 2009 03:00 | Last updated: May 15 2009 03:00 The European Central Bank has come out in favour of using monetary policy to control asset prices - with the aim of avoiding a repeat of the current financial crisis. A policy of "leaning against the wind" - raising interest rates earlier than would otherwise be the case when asset prices are booming - was given backing yesterday by Lucas Papademos, the ECB's vice-president. The bank also concluded in its latest monthly bulletin that the current crisis "calls into question the wisdom of ignoring asset price imbalances in the conduct of monetary policy". Such ideas have gained ground in the US , where Alan Greenspan, former chairman of the US Federal Reserve, had previously argued central banks could do little to prevent bubbles growing and then bursting. Mr Papademos argued in a speech in Vienna that "leaning against the wind" would curb inflation in the short term and help maintain price stability in the longer term "by helping to prevent the materialisation of deflation risks when the asset bubble bursts".

The Financial Times Limited 2009 ECB favours using monetary policy as asset-price tool May 15 2009 http://www.ft.com/cms/s/0/0ecd1cc8-40e7-11de-8f18-00144feabdc0.html

141 May 13, 2009 'Bad Bank' Proposal in Germany: Internal Memo Puts Toxic Assets At €800bn Overview: May 12 Paul Mortimer-Lee (BNP Paribas): Overview of German toxic asset plan: 1) voluntary participation; 2) the toxic assets of each bank will be assigned a market price or a “fair value” assessed by a third party. Discounting this for potential risksgives each asset a “fundamental value”; 3) each bank creates an SPV and transfers its toxic assets; 4) the SPV issues a bond guaranteed by the government to the bank against a guarantee fee to the SPV (up to 20 years maturity); 5) the fee offsets the losses in the SPV; 6) fee is to be paid either from dividends or from profits. o April 27 Eurointelligence/Harrison: A report by Sueddeutsche Zeitung, citing an internal paper by the banking regulator that puts the total of bad assets in the German banking system at €816bn, caused outrage among German officials (in particular as the report appears to be true). The number includes toxic securitized assets, and also bad loans, and unlike previous lists, this one names and shames the banks. In one case, half of all assets of a particular Landesbank are classified as toxic, Commerzbank is also on the list with a huge depot of toxic waste. o April 22 FT: Final plan will be unveiled within 2 weeks. Idea is to park toxic assets off-balance sheet without capital requirements and give banks time to write assets off as losses materialize. Senior officials put possible cost at EUR1T for taxpayers. o April 20 Eurointelligence: FT Deutschland has the details, according to which the government is currently favouring a model proposed by investment bank . According to one variant of this model, the government takes the toxic assets from the banks, in return for government debt obligtation, which carry ultra-low interest rates, and which the banks promise to keep on their books for a long time. The idea is that such a construction prevents spillovers into the general . Another construction is a bad bank, which holds the bad assets, and which issues government-guranteed debt obligations to the good bank. o March 30 TIME: German banks have an estimated $265 billion to $400 billion in bad debt on their books. Put another way: that's as much as 12% of German GDP. o Steinbrueck (via Reuters):"The respective banks and their shareholders will have to take on the highest possible degree of responsibility for their own toxic assets." o cont.: "If all the toxic assets were to be placed in a single bad bank it would put a burden of more than 200 billion euros ($265.6 billion) on taxpayers. I couldn't justify that to anyone." o cont.: "We've got to differentiate between the toxic paper on the one hand and those assets that are only temporary having liquidity problems -- that's where the solution could be found."

142 o Der Spiegel news magazine reported on April 9 the problem loans hived off would be backed by the state guarantees. Finance Ministry officials expect that at most three or four banks would take up such a government offer, the magazine said. o Janury, Mizuho: As well as presenting new challenges to the German banking system, the credit crunch has also exacerbated the pre-existing problems in the sector and in some cases (e.g. IKB and the other Landesbanken) the combination of weak profitability, poor franchises, toxic assets and a reliance on wholesale market funding has been a deadly one. http://www.rgemonitor.com/385/Germany?cluster_id=13702 Is Mexico's Credit Rating at Risk? May 13, 2009 o May 12th: Rating woes. Speaking at EMTA conference in NY, Claudio Loser, the ex-director of the Western Hemisphere at the IMF, said that Mexico's credit rating should be downgraded on the back of the economic slump, rising drug-related violence, and derivative losses by companies. Loser said that Mexico -currently rated three notches above junk by all three major rating agencies - should not lose its investment grade, but that an adjustment was necessary. (BNP) o May 12th: Standard & Poor’s lowered Mexico’s rating outlook to negative from stable, signaling it’s considering the first reduction since the aftermath of the 1994 peso devaluation. New York-based S&P rates Mexico BBB+, the second-highest grade among major Latin American countries after Chile. Fitch Ratings, which also assigned the government’s debt BBB+, or three levels above junk, gave the country a negative outlook in November (Bloomberg) o April 2009: Congressional mid-term elections on July 5th will likely limit the scope of passing structural reforms in the upcoming months, thus likely compromising Mexico’s credit standing. (RGE Monitor) o March 25th: Moody’s echoed Fitch’s concerns over Mexico’s fiscal challenges in 2010. However, the rating agency said that Mexico’s investment grade rating is not at risk and added that suggestions that Mexico is a “failed state” are “far-fetched”. (BNP) o March 24th: Mexico is not about to become a failed state as a result of escalating drugs-related violence and is in no immediate danger of losing investment grade status, Moody’s Investors Service said. The ratings agency said: “Despite heightened anxiety about the escalation of violence and organised crime activity, Mexico does not fit the general profile of countries identified as failed states.” However, Mauro Leos, vice-president at Moody’s sovereign risk group, added that the security issue could pose potential risks in the future. According to Mr. Leos, “escalating problems in the areas of public safety could potentially impact investor sentiment affecting the country’s medium-term outlook,”. The agency rates Mexico at Baa1, three notches above its lowest investment grade. (FT) o The recent slowdown in the global economy increases uncertainties surrounding external accounts and fiscal revenues for most of the EM countries, especially for those highly dependent on commodity exports. Rating agencies have revised many countries' external debt outlook and ratings as credit availability is limited and risk aversion put a dent on both FDI and portfolio flows. http://www.rgemonitor.com/423/Mexico?cluster_id=13664

143 Business

May 14, 2009 Obama Urges Rules on Investments Tied to Crisis By STEPHEN LABATON and JACKIE CALMES WASHINGTON — In its first detailed effort to overhaul financial regulations, the Obama administration on Wednesday sought new authority over the complex financial instruments, known as derivatives, that were a major cause of the financial crisis and have gone largely unregulated for decades. The administration asked Congress to move quickly on legislation that would allow federal oversight of many kinds of exotic instruments, including credit-default swaps, the insurance contracts that caused the near-collapse of the American International Group. The Treasury secretary, Timothy F. Geithner, said the measure should require swaps and other types of derivatives to be traded on exchanges or clearinghouses and backed by capital reserves, much like the capital cushions that banks must set aside in case a borrower defaults on a loan. Taken together, the rules would probably make it more expensive for issuers, dealers and buyers alike to participate in the derivatives markets. The proposal will probably force many types of derivatives into the open, reducing the role of the so-called shadow banking system that has arisen around them. “This financial crisis was caused in large part by significant gaps in the oversight of the markets,” Mr. Geithner said in a briefing. He said the proposal was intended to make the trading of derivatives more transparent and give regulators the ability to limit the amount of derivatives that any company can sell, or that any institution can hold. The initiative was well received by senior Democrats in Congress with over the issue. The proposal had been expected, but some lawmakers, impatient with the pace of the new administration’s efforts, had begun moving ahead themselves. Hinting at a lobbying campaign to come, Robert Pickel, the chief executive of the International Swaps and Derivatives Association, a trade group, said his organization “looked forward to working with policy makers to ensure these reforms help preserve the widespread availability of swaps and other important risk management tools.” But some in the financial industry say that regulation is inevitable. “Nobody is in a ‘just say no’ mode,” said Steven A. Elmendorf, a former aide to the House Democratic leadership who represents several major financial institutions and groups. “Everybody understands that we’ve been through a financial crisis and that change has to happen. And the only question is how the change happens.” The administration is seeking the repeal of major portions of the Commodity Futures Modernization Act, a law adopted in December 2000 that made sure that derivative instruments would remain largely unregulated.

144 The law came about after heavy lobbying from Wall Street and the financial industry, and was pushed hard by Democrats and Republicans alike. It was endorsed at the time by the Treasury secretary, Lawrence H. Summers, who is now President Obama’s top economic adviser. At the time, the derivatives market was relatively small. But it soon exploded, and the face value of all derivatives contracts across the world — a measure that counts the value of a derivative’s underlying assets — outstanding at the end of last year totaled more than $680 trillion, according to the Bank for International Settlements in Switzerland. The market for credit-default swaps — a form of insurance that protects debtholders against default — stood around $38 trillion, according to the international swaps group. That represents the total amount of insurance that has been written on various kinds of debt, but the amount that would have to be paid out if the debt went into default is considerably less. As the credit crisis has unfolded, trading in credit-default swaps has cooled, market participants said. The collapse of A.I.G. took a huge player out of the market and banks, hobbled by losses, have curbed their activities in the market. Still, derivatives trading desks have been profit centers at major banks recently. The biggest banks and brokerage firms, including JPMorgan Chase, Citigroup and Goldman Sachs, as well as major insurers, are all major players in derivatives. Derivatives are hard to value. They are virtually hidden from investors, analysts and regulators, even though they are one of Wall Street’s biggest profit engines. They do not trade openly on public exchanges, and firms disclose few details about them. The new rules are meant to change most, but not all, of that opacity. Used properly, they can reduce or transfer risk, limit the damage from market uncertainty and make global trade easier. Airlines, food companies, insurers, exporters and many other companies use derivatives to protect themselves from sudden and unpredictable changes in financial markets like interest rate or currency movements. Used poorly, derivatives can backfire and spread risk rather than contain it. The administration plan would not require that custom-made derivative instruments — those with unique characteristics negotiated between companies — be traded on exchanges or through clearinghouses, though standardized ones would. The plan would require the development of timely reports of trades, similar to the system for corporate bonds. The letter suggested that the Commodity Futures Trading Commission would play a leading role in the oversight of the market, although it would also leave important elements to the Securities and Exchange Commission. Over the years, the turf battle between those agencies contributed to the neglect of that market by government overseers. Some lawmakers in the House and Senate have already introduced measures to regulate derivatives. But a number of members have pressed the administration to put out its own plan. Representative Barney Frank of Massachusetts, the chairman of the House Financial Services Committee that oversees the S.E.C., and Representative Collin C. Peterson of Minnesota, chairman of the House Agriculture Committee with oversight of the commodities trading commission, released a joint statement saying, “we agree there

145 must be strong, comprehensive and consistent regulation” of derivatives. “We will work closely together to achieve that goal,” they added. While derivatives regulation will be a focus of some market players, of equal concern to many in the financial industry are what the Obama administration and Congress might do to regulate compensation for executives across the board, not just at institutions that have accepted federal bailout money. The Treasury is acting on two paths. First, it plans as soon as next week to announce revised compensation rules for companies getting assistance, to make those rules conform with a law Congress passed in February that was more stringent than the Treasury’s own guidelines. Separately, Treasury officials have just begun discussing with the Federal Reserve and the S.E.C. what the government can do industrywide — through incentives, restrictions or a mix of the two — to guard against eye-popping compensation that rewards excessive risk-taking of the sort that contributed to the current crisis. The fear among many in the industry — and some in the administration — is that whatever limits Mr. Obama proposes, Congress will seek to add even more, in response to public anger. In addition to the regulatory changes it is seeking, the administration is also continuing to expand its bailout programs for various industries. Mr. Geithner announced on Wednesday that the administration would provide a new round of capital assistance to smaller community banks, and would increase the amount that they can borrow from the program. Beyond derivatives, he also said that the administration would be presenting a comprehensive proposal to overhaul the regulation of the financial system. He said a central goal would be to eliminate the ability of companies to pick the least onerous regulator. “We need a much simpler financial oversight structure,” he said. “It’s not going to be comfortable for everybody but it’s important to do.” http://www.nytimes.com/2009/05/14/business/14regs.html?_r=1&th&emc=th

146

AIG Could Repay U.S. in 3 to 5 Years, Chief Tells Congress By Brady Dennis Washington Post Staff Writer Thursday, May 14, 2009 Edward M. Liddy, American International Group's chief executive, said yesterday that he believes that the beleaguered insurer could pay back the federal government's massive investment within several years. "It will take somewhere between three to five years," Liddy told the House Committee on Oversight and Government Reform. "There's great opportunity for the taxpayer to be repaid." Since September, the Treasury and the Federal Reserve have committed about $180 billion in cash and loans to saving the company. But Liddy's estimate came with a caveat, a variation of which he repeated again and again. "It is heavily dependent on what happens with the worldwide economic situation," Liddy said. "We are not an island." He said the company's bottom line rises and falls with the market for its wide-ranging assets, which span from mortgage securities to airplanes. Liddy last visited Capitol Hill two months ago, amid the nationwide uproar over $165 million in retention payments to employees at AIG's Financial Products division, the troubled unit whose complex derivative contracts nearly wrecked the global insurance giant. The ire he encountered during that appearance had mostly vanished by yesterday. Lawmakers who had earlier seethed seemed merely skeptical about AIG's prospects for survival and its openness. "Is AIG, in effect, a giant sinkhole?" asked Rep. William Lacy Clay (D-Mo.). "It appears investors are simply propping AIG up." "I think we have a good plan," Liddy responded. He outlined a future in which AIG would pay back taxpayers and "emerge as a much smaller, more nimble company." He pledged that "the Financial Products unit will not exist." He noted that "we have reduced, but not eliminated, the systemic risk that AIG presents to the global financial system." While Liddy experienced a warmer reception yesterday, he didn't escape unscathed. Lawmakers returned over and over to the issue of bonuses at AIG, seeking assurances that no similar controversy lies ahead. They also inquired about a bevy of lawsuits involving AIG, the company's ongoing quarterly losses, its billions of dollars in payments to various counterparties and its use of high-dollar public relations firms. Liddy was grilled about whether his former position on the board of Goldman Sachs and his continuing investment in the company pose a conflict of interest because of that firm's tangled financial relationship with AIG.

147 Lawmakers also probed Liddy about the particulars of Project Destiny, the company's detailed plan for the future, which has been shared with Fed officials but not yet with Congress. Liddy outlined the broad objectives of the plan but hesitated to provide specific operating details, saying that AIG's competitors could exploit that information. Also yesterday, the three trustees appointed by the government to represent taxpayers and exercise their 77.9 percent stake in AIG emerged for their first public appearance, saying they intend to seek an imminent shake-up of the company's board of directors. The trustees are Chester B. Feldberg, a former senior official at the New York Fed and a former chairman of Americas; Douglas L. Foshee, the chief executive of El Paso Corp., a natural gas producer and pipeline operator; and Jill M. Considine, a former member of the board of directors of the New York Fed and now chairman of the Butterfield Fulcrum Group in Bermuda, a firm that provides administrative support to hedge funds. The trustees yesterday told the House committee that they have selected five new candidates for AIG's board of directors and expect that they will be elected at the company's annual shareholder meeting next month. Those five new members, along with another candidate nominated by AIG and several others who joined the board less than a year ago, would represent wholesale change in the leadership for the troubled company. "If AIG is to succeed, it needs a fresh start -- a reset, if you will," Foshee said of the sweeping change. From 1990 to the third quarter of 2007, AIG reported total profit of more than $98 billion. Since then, the company has lost nearly $109 billion, according to data complied by Bloomberg. The trustees serve under an arrangement established by the New York Fed for the purpose of acquiring, holding and ultimately disposing of the government's massive stake in AIG. The three trustees were appointed in January by the New York Fed in consultation with the Treasury, and formally began their work in early March. Until yesterday, the trustees, each of whom are paid $100,000 annually, have operated largely out of public view. They have met weekly, they said, usually through conference calls but also in meetings at least once a month. Lawmakers pressed the group to provide minutes of those meetings, saying that a group charged with representing taxpayers should not be shrouded in secrecy. Like Liddy, the trustees did not entirely escape the vitriol that surrounds AIG. As the hearing drew to a close, Rep. Marcy Kaptur (D-Ohio) decried the bailouts as "an inside deal" favorable to many of the same Wall Street executives who contributed to the crisis. "What you've done to Middle America is a sacrilege," Kaptur said. Foshee chimed in. "For the record, I'm from Texas," he said. http://www.washingtonpost.com/wp- dyn/content/article/2009/05/13/AR2009051301548.html?wpisrc=newsletter

148

U.S. Pushes Ahead With Derivatives Regulation First in Broad Overhaul: Rules on 'Dark Markets' That Fueled Meltdown By David Cho and Zachary A. Goldfarb, Washington Post Staff Writers, May 14, 2009 The Obama administration yesterday unveiled a plan to regulate a vast market of exotic financial instruments known as derivatives, which fueled the global economic crisis and wounded some of the biggest names on Wall Street. As the administration's first step to overhaul financial regulations, the proposal calls on Congress to establish rules that would restrict the banks, hedge funds and other investors that trade derivatives on what have been called "dark markets" for their lack of oversight. The proposal would for the first time empower regulators to probe more deeply into the inner workings of these markets, and the firms that profit from them, and curb the risks traders can take. But the proposal doesn't go as far as some analysts and officials want. The administration would allow a set of highly specialized derivatives to trade largely outside government view. Some analysts warn this exception might lead traders to create increasingly complex derivatives to avoid regulation. In just a few years, trading in derivatives -- which are essentially contracts between two investors betting on whether a stock, bond or other security will go up or down in value -- has mushroomed into the world's largest market, estimated to be in the tens of trillions of dollars. It has allowed unregulated traders around the world to influence and bet on a vast array of sectors, from how much companies pay to borrow money to the value of currencies and critical goods such as oil and cotton. Losses on a type of derivative known as a credit-default swap helped topple American International Group, prompting a government bailout that has grown to $180 billion. And when Washington Mutual, the country's largest thrift, collapsed last fall, regulators struggled to understand how the losses on its derivatives investments would spread across the financial system. "The financial crisis was caused by significant gaps in oversight," Treasury Secretary Timothy F. Geithner said yesterday at a briefing with reporters. "One of the reasons crisis can spread so rapidly . . . is the uncertainty people have in judging risk." For Geithner, regulating derivatives represents a turnaround. He was part of a Clinton administration team that favored the innovation of new financial products and rejected regulation of derivatives as they emerged in the 1990s. As the president of the Federal Reserve Bank of New York, Geithner began to realize the threat that derivatives posed. He called for new ways to regulate the market with technology and other mechanisms that would make it easier to track the trades. Yet some of those efforts ended up stoking the derivatives market.

149 The administration's proposal faces a complicated political landscape on Capitol Hill. While the crisis has convinced most lawmakers that regulation is needed, there is intense debate about how far it should go -- and who should be in charge. The split is not just along party lines. Lawmakers representing agricultural and energy- producing states have a strong interest in ensuring that their committees and the Commodity Futures Trading Commission have authority over these new regulations. But the Securities and Exchange Commission, which has more experience in enforcement and is favored by lawmakers representing states with heavy financial industry presence, is also angling to regulate derivatives. Yesterday, SEC chairman Mary L. Schapiro and CFTC acting chairman Michael Dunn pledged to work together to regulate the market, even as Dunn at a briefing at the Treasury acknowledged that many details need to be ironed out. Geithner, sitting between the two, said details would be worked out later. The Obama administration's proposal has four goals. First, it proposes that most derivatives must trade through a regulated clearinghouse run by the industry that requires traders to report their activities and hold a minimum level of capital to cover losses. This would solve a big problem exposed by the crisis, when AIG didn't have enough money to cover the losses incurred by its derivative portfolio, which focused on credit- default swaps. A swap is a type of insurance contract in which one party agrees to cover the losses if an investment goes sour, in exchange for periodic fees. Under the government's plan, a clearinghouse would have required AIG to put cash in reserve for each credit-default swap it sold. Second, the proposal would require clearinghouses and firms dealing in derivatives to provide copious information to regulators about their trades, allowing the government to track activity in these markets. An exception was made for certain specialized derivatives often employed by industrial companies, but traders in those instruments would still have to post information about their activity to clearinghouses. Third, it would empower regulators to force traders to turn over detailed paperwork about their activities and to pursue cases of fraud and manipulation against wrongdoers. Finally, it would ensure that derivatives are not marketed to groups that may not understand their complexities. Michael Greenberger, a law professor at the University of Maryland and former director of trading and markets at the CFTC, said the proposal does not bring as much transparency to the derivatives market as there currently is for stocks and bonds. "There is a reluctance on the part of the administration to go that full distance," he said. "It therefore leaves hanging in the balance customized or individualized derivative products, which can also be toxic in their nature." Industry officials welcomed the proposals but expressed some caution about whether the measures would shrink the derivatives market. Robert Pickel, chief executive of the International Swaps and Derivatives Association, said it is important that policymakers "ensure these reforms help preserve the widespread availability of swaps and other important risk-management tools." http://www.washingtonpost.com/wp- dyn/content/article/2009/05/13/AR2009051302393.html?wpisrc=newsletter

150

14.05.2009 A bad proposal for banks

The German cabinet yesterday decided on the bad bank proposal, where banks can voluntary set up a bad bank, transfer their toxic assets to such a bad bank, which in turns issues “good”, i.e. government guaranteed, securities to the good bank. The banks are responsible for all the losses, but they can stretch those losses into the future. An article in FT Deutschland quotes banking experts as saying that this scheme will be counter-productive as it effectively prevents banks from raising new capital. Investors do not know how large the future losses will be, and the banks will not be able to pay dividends for long periods. The government has rejected proposals to make the bad bank scheme obligatory, as some parliamentarians have demanded. The German Banking Association criticised the scheme as too onerous, and even the heavily affected Commerzbank has not yet decided whether it wants to apply to set up a bad bank. Steinbruck says US stress tests are pointless This piece of wisdom comes from the man who said in September, after the fall of Lehman, that the crisis was first and foremost an American problem. Germany’s finance ministers Peer Steinbruck told the Bundestag yesterday that the US stress were pointless because the US Treasury and the central bank have fiddled with the figures before hand. The FT, which has the story, calls Mr Steinbruck “outspoken”. Verhofstadt’s crisis plan In an interview with Le Monde, Guy Verhofstadt said that Europe needs a common approach to combat the crisis. Toxic assets should be grouped in a single European structure; recapitalise banks that are worth recapitalising; and common stress tests for the whole sector. Verhofstadt called on Europe’s leaders not to hide the crisis but to use it as a springboard to deepen European integration. (We agree, but suspect that there may one or two politicians, especially in Berlin, who might not.)

151 Germany wants a job in the new commission, but has no candidates There is a very good article in FT Deutschland this morning, giving the latest on the state of play regarding jobs in the next Commission. Sarkozy and Barroso have apparently met for lunch, and agreed that Christine Lagarde would make an excellent competition commissioner. There is still also the possibility of Michel Barnier as the PermRep/Foreign Affairs Commissioner in the next Commission; but Germany does not have candidate; Merkel and Steinmeier insist that Barroso gives them a top portfolio, preferably internal market but the article this is difficult if Germany cannot nominate a Commissioner; Germany’s decision might depend on the outcome of the next election. But whatever happens, it seems that Barroso gets reappointed. Forget 2012 In an interview with Le Figaro prime minister Francois Fillon said that under current conditions the French government “accepts a deterioration of the budget deficit. No government in Europe is to reach a balanced budget by 2012.” He shies away from tax increases and promises instead expenditure cuts in the 2010 budget. Fillon thereby counts on efficiency raising reforms and the reduced public employment and new burden sharing with local authorities.

ECB plans more asset purchases ECB governing board member Marko Kranjec, president of the Slovenian central bank, said the ECB was considering asset purchases beyond covered bonds. Discussions had not been finalised though, he said. Among those categories the ECB is considering are top-rate corporate bonds and commercial paper. The article also says the decision to buy covered bond, or Pfandbriefe, would primarily benefit Germany, by far the largest covered bond market. The Wall Street Journal has a nice story about the cacophony among ECB members, which has led to a marked in unpredictability. The Chinese and the dollar Brad Setser has an excellent discussion about China and the dollar. One would have thought that after the complaints about the dollar trap by the Chinese central bank, the country would now diversify. This is apparently not true. They are still buying US Treasuries as if there is no tomorrow. The article also contains a brief discussion about US inflation. Setser says the real risk to China is not US inflation, but the scenario of a dollar devaluation that comes without inflation. He says the renminbi, as well as the euro, are both very likely to appreciate strongly against the dollar, which would expose Chinese taxpayers to future losses. Why the markets are wrong Dieter Wermuth, in the blog Herdentrieb, gives a frank description of his problem that while he remains a pessimist about the economic recovery, the market seem to ignore all that and race ahead. But he says it is extremely unlikely that we are already in a recovery phase, given that most of the house price declines are still ahead of us in Europe (and some are still ahead even in the US, where it started in 2007). He also said the corporate earnings expectations are far too rosy, and we might experience a set

152 back in the market at one point. (We agree.) The credit crunch of 1294 We had no idea. Adrian R. Bell, Chris Brooks, Tony Moore, writing in Vox, challenge the view that the current credit squeeze, leading to bank failures, is a modern phenomenon arising from the interplay of a historically unique set of circumstances that could not have been foreseen. In the article they look at a medieval credit crunch that bears remarkable parallels with the current crisis. The future of capitalism: more capitalism Leszek Balcerowicz writes in the Financial Times that the crisis holds lessons for regulation, and macroeconomic policy in terms of controlling asset price bubbles, but it has no consequences for the future of capitalism. But he says the opposition to the market economy is strong from within, which should be seen as a call for action. http://www.eurointelligence.com/article.581+M500e808c133.0.html#

153

Business

May 14, 2009 Slow Start to Federal Plan for Modifying Mortgages By TARA SIEGEL BERNARD The Obama administration’s plan to help millions of troubled homeowners avoid foreclosure by reducing the size of their mortgage payments is just getting off the ground. So far, two months after the program went into effect, about 55,000 homeowners have been extended loan modification offers, according to a senior administration official. At the same time, foreclosures continue apace. RealtyTrac reported Wednesday that foreclosure filings reached 342,000 last month, up 32 percent from April 2008. Moody’s has estimated that more than 2.1 million homeowners will lose their homes this year. Because of the size and complexity of the modification program, the administration has only recently assembled most of the pieces. In late April, officials fleshed out their plan to modify or forgive second mortgages — one of the big stumbling blocks in modifying primary mortgages — and provided more details on the Hope for Homeowners program, for borrowers who owe more than their homes are worth. Congress is close to acting on legislation to protect mortgage servicers from potential lawsuits from investors, while also expanding the Federal Housing Administration’s ability to modify loans. The banks, too, are just now beginning to get their mortgage modification machines up and running. While it is still too early to know how effective the program will ultimately be, many homeowners who have tried to gain entrance say they have been successful only through persistence — and sometimes, the help of a lawyer. What may be a larger issue, however, is the continuing deterioration of the economy, experts say. The longer it takes to set the program in motion, they say, the fewer people will qualify for modifications. The expected rise in unemployment in coming months may keep a growing number of homeowners out of the program. “We have a debt crisis, and mortgage is at the center of it,” said Alan M. White, an assistant professor at Valparaiso University School of Law in Indiana who specializes in foreclosures. “To get out of it, we need to reduce the debt, and that is not really happening.” The administration remains confident that the program will end up offering help to as many as three million to four million homeowners, with the pace of modifications beginning to pick up in coming months.

154 “If you think about the context and scale involved, it is an extraordinary, rapid effort,” said Jenni Engebretsen, a Treasury spokeswoman. She noted that 14 mortgage servicers had signed up for the program, covering 75 percent of the market. A vibrant mortgage modification program is a necessary bulwark against the wave of foreclosures. Without it, housing prices will continue their downward spiral longer, said Mark Zandi, chief economist at Moody’s Economy.com. “It prolongs the economic agony,” he said. “The pain will not go away until foreclosures subside.” Mr. Zandi was not as optimistic that the program would help as many as the administration expects. He estimated it would end up assisting only 1.5 million to 2 million homeowners over the next few years. Even so, he added, the program will, in the end, “make a meaningful difference.” The Obama plan aims to lower monthly payments to 31 percent of the borrower’s gross income by reducing interest rates to as low as 2 percent, extending the loan term or deferring principal. Mortgage servicers can reduce principal but are not required to. The mortgage modifications to date have come in various forms, but some have not reduced monthly payments and most have not reduced the balance owed — crucial for people who owe more than their homes are worth. Still, the number of loan modifications with lower payments has increased in recent months, an encouraging sign. In April, 59 percent of loan modifications reduced payments, 29 percent increased payments and 12 percent of modifications kept payments steady, according to Professor White at Valparaiso. Borrowers with loan modifications that have not cut their payments tend to default again within six to 12 months. To persuade mortgage servicers and investors to sign on to mortgage modifications, Democrats originally sought legislation that would have given bankruptcy judges the power to reduce primary mortgages. The threat of a principal reduction in bankruptcy would have served as a stick to have modifications done outside court, experts said. But the measure failed in the Senate last week after intense lobbying by the banking industry. Several experts said reducing the amount of principal would go a long way toward helping borrowers who owe more than a home is worth — those informally known as under water. “Even if they do drop your loan payment, you can still be in deep negative equity, which is not an immediate crisis,” said Adam J. Levitin, an associate professor at Georgetown University Law Center. “But let’s say you need to relocate because the auto manufacturer you work for is radically downsizing. You are faced with losing your house in foreclosure or a huge balloon payment. And neither of those is palatable.” “If you don’t want all of the spillover effects from foreclosure, you have to keep people in their houses,” he added. But the modifications may not be enough for the underwater homeowners. “In many ways, we are kicking the can down the road,” Mr. Zandi said. “Many of these homeowners are under tremendous amounts of financial pressure, and they have significant negative equity positions. Lowering their mortgage debt-to-income ratio

155 helps, but it doesn’t solve their problem in a significant way and many will redefault in the future.” About 15.4 million borrowers, 20 percent of single-family homeowners, are underwater, up from 13.6 million at the end of last year, according to Moody’s. Being underwater is one of the biggest indicators of default, experts said. The administration tries to address the problems of the underwater homeowners through its Hope for Homeowners refinancing program. In its previous incarnation, the program was deemed a failure after it produced only about 50 new loans. Under the new initiative, mortgage servicers are required to vet borrowers for Hope for Homeowners after they have qualified for a trial loan modification. If borrowers are qualified, they refinance into new loans through the Federal Housing Administration. Mortgage investors must accept a write-down on their investment and the government backs the new loan. Despite the federal backing, lenders must also be willing to make the new loans, said Rod Dubitsky, a mortgage analyst at Credit Suisse. Many homeowners, consumer advocates say, do not even know they are eligible for a modification. Others may think they are eligible, but have to navigate a maze of rules and bureaucracies. Amy and Robert Darr, of Coshocton, Ohio, for instance, fell behind on their payments in October after Robert’s hours were cut; he is a maintenance worker at a foundry. They tried to catch up on their payments when they received their tax refund, but by that time the couple had received a foreclosure notice. They contacted their lender to see if they would qualify for a loan modification, and provided the lender with the required paperwork. But CitiMortgage refused to suspend the foreclosure proceedings. Citigroup declined to comment. “Hopefully, we will qualify,” Mrs. Darr said, “because I don’t want to lose my home.” The couple contacted Southeastern Ohio Legal Services, which filed a motion with the local court to suspend the foreclosure and is currently waiting for a response. “The right hand doesn’t know what the left hand is doing,” said Melissa Benson, a staff lawyer with the legal services organization. “Most people who get foreclosure complaints don’t even know how to put up a fight at all. And they lose fairly quickly.” Ashley Southall contributed reporting. http://www.nytimes.com/2009/05/14/business/14mortgage.html?th&emc=th

156

Opinion

May 14, 2009 OP-ED CONTRIBUTOR China’s Heart of Gold By VICTOR ZHIKAI GAO Beijing IN China, many people refer to the dollar as mei jin, or “American gold.” Government officials, businessmen and people on the street all use the term. So if a Chinese person tells you that he owes you 100 American gold, don’t expect a big fortune, because he’s planning to pay you $100. Chinese impressions of the American dollar as the gold standard were so deeply entrenched that they survived President Richard Nixon’s 1971 delinking of gold and the greenback. Around 30 years ago, China’s foreign exchange reserves were as little as $167 million. At one important meeting in the late 1970s, Deng Xiaoping, the leader of China, prophesied to an audience of top government officials: “Comrades, just imagine! One day we may have a foreign reserve as big as $10 billion!” Silence fell on the audience, because that figure seemed so improbable. After a long pause, Deng went on to tell the unconvinced crowd: “Comrades, just imagine! With 10 billion American gold, how much China can do!” Deng’s view of the dollar reflected his admiration for many positive elements of American capitalism. In November 1986, I served as Deng’s interpreter when he met with John Phelan, the chairman of the New York Stock Exchange, who was visiting Beijing. During the meeting, Deng told him: “You are the rich capitalists with great wealth, and China is still very poor with little wealth. You know finance and capital markets very well. You need to teach China a lot about finance and capital markets. One day in the future, China will also have its own stock exchange.” That was the prelude to China’s rapid economic growth. China’s foreign reserves are now close to $2 trillion, and around $1.5 trillion of it is invested in dollar assets. With the global financial crisis, the attention of the world often focuses on this huge pile of American dollars in Chinese hands. What many don’t remember is that for years, there was either a shortage or a feared shortage of American dollars. In the 1980s, for example, the government required everyone to convert dollars into the Chinese currency, the renminbi, which literally means “people’s money.” As a result, American gold became a status symbol. Despite the mandatory conversion into renminbi, many people held onto their dollars, or bought them at inflated exchange rates, if they could find a seller at all. No one knows for sure when the tide started to turn, or the exact moment when American gold started its slow but seemingly irreversible loss of luster. But now, many shops in China no longer accept dollar-based credit cards issued by foreign banks (the customer pays in dollars, but the shopkeeper is paid in renminbi) and foreigners cannot convert American dollars into renminbi beyond a given quota.

157 In the past, people held dollars for no immediate purpose. Today, they are more likely to keep them only if they need them to send their children abroad for school, travel or to do business in another country. Over all, the government is becoming more worried about the safety of its investments in the United States, which are largely in Treasury bonds and quasi-sovereign securities issued by Fannie Mae and Freddie Mac. Beijing recently called for a greater role in international trade for the special drawing rights currency of the International Monetary Fund. But China is also fully aware that the United States can veto an I.M.F. decision. China’s call was more meant to sound an alarm to the United States. Many Chinese people increasingly fear the rapid erosion of the American dollar. The United States may want to consider offering inflation-protection measures for China’s existing investments in America, and offer additional security or collateral for its continued investments. America should also provide its largest creditor with greater transparency and information. We still call the dollar American gold. But the United States should not assume that this will never change. Victor Zhikai Gao is an executive director of the Beijing Private Equity Association and a director of the China National Association of International Studies. http://www.nytimes.com/2009/05/14/opinion/14Gao.html?th&emc=th

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Opinion

May 14, 2009 OP-ED CONTRIBUTOR The Almighty Renminbi? By NOURIEL ROUBINI THE 19th century was dominated by the British Empire, the 20th century by the United States. We may now be entering the Asian century, dominated by a rising China and its currency. While the dollar’s status as the major reserve currency will not vanish overnight, we can no longer take it for granted. Sooner than we think, the dollar may be challenged by other currencies, most likely the Chinese renminbi. This would have serious costs for America, as our ability to finance our budget and trade deficits cheaply would disappear. Traditionally, empires that hold the global reserve currency are also net foreign creditors and net lenders. The British Empire declined — and the pound lost its status as the main global reserve currency — when Britain became a net debtor and a net borrower in World War II. Today, the United States is in a similar position. It is running huge budget and trade deficits, and is relying on the kindness of restless foreign creditors who are starting to feel uneasy about accumulating even more dollar assets. The resulting downfall of the dollar may be only a matter of time. But what could replace it? The British pound, the Japanese yen and the Swiss franc remain minor reserve currencies, as those countries are not major powers. Gold is still a barbaric relic whose value rises only when inflation is high. The euro is hobbled by concerns about the long-term viability of the European Monetary Union. That leaves the renminbi. China is a creditor country with large current account surpluses, a small budget deficit, much lower public debt as a share of G.D.P. than the United States, and solid growth. And it is already taking steps toward challenging the supremacy of the dollar. Beijing has called for a new international reserve currency in the form of the International Monetary Fund’s special drawing rights (a basket of dollars, euros, pounds and yen). China will soon want to see its own currency included in the basket, as well as the renminbi used as a means of payment in bilateral trade. At the moment, though, the renminbi is far from ready to achieve reserve currency status. China would first have to ease restrictions on money entering and leaving the country, make its currency fully convertible for such transactions, continue its domestic financial reforms and make its bond markets more liquid. It would take a long time for the renminbi to become a reserve currency, but it could happen. China has already flexed its muscle by setting up currency swaps with several countries (including Argentina, Belarus and Indonesia) and by letting institutions in Hong Kong issue bonds denominated in renminbi, a first step toward creating a deep domestic and international market for its currency.

159 If China and other countries were to diversify their reserve holdings away from the dollar — and they eventually will — the United States would suffer. We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar’s value doesn’t lead to a rise in the price of imports. Now, imagine a world in which China could borrow and lend internationally in its own currency. The renminbi, rather than the dollar, could eventually become a means of payment in trade and a unit of account in pricing imports and exports, as well as a store of value for wealth by international investors. Americans would pay the price. We would have to shell out more for imported goods, and interest rates on both private and public debt would rise. The higher private cost of borrowing could lead to weaker consumption and investment, and slower growth. This decline of the dollar might take more than a decade, but it could happen even sooner if we do not get our financial house in order. The United States must rein in spending and borrowing, and pursue growth that is not based on asset and credit bubbles. For the last two decades America has been spending more than its income, increasing its foreign liabilities and amassing debts that have become unsustainable. A system where the dollar was the major global currency allowed us to prolong reckless borrowing. Now that the dollar’s position is no longer so secure, we need to shift our priorities. This will entail investing in our crumbling infrastructure, alternative and renewable resources and productive human capital — rather than in unnecessary housing and toxic financial innovation. This will be the only way to slow down the decline of the dollar, and sustain our influence in global affairs. Nouriel Roubini is a professor of economics at the New York University Stern School of Business and the chairman of an economic consulting firm. http://www.nytimes.com/2009/05/14/opinion/14Roubini.html?th&emc=th

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13.05.2009 IMF demands stress tests for EU banks

In its regional economic outlook for Europe, the IMF warned about the severity of the recession, despite recent signs of improvement, and that Europe needs a much bigger degree of co-ordination, both in economic stimulus, and bank rescue. In particular, the report advocated the use of transparent stress test, rather than the opaque system with which governments have evaluated their own stragtegies. The IMF specifically recommends ring-fence of troubled assets, and the closure of non-viable banks. See also the FT for a good summery of the report. Les Echos quotes one insider saying that “it is amusing to find that each European country has the sentiment that its banking sector is better off than those of its neighbours or that they have taken initiatives earlier than others.” An illuminated an depressing news story in FT Deutschland shows how the Europeans are actually doing the stress tests. The finance ministers last month decided that they wanted to do it in principle, but Germany prevailed with its position that the tests should be carried out in utmost secrecy so as not to damage the banks. Germany agrees to stress testing only for as long any information is done on an aggregate level (this is really bad news. It means that governments will continue to hide the problem, and that bank resolution is much further down the road). Lenihan to explain Irish ‘bad’ bank in Europe Finance minister Brian Lenihan is setting off for a tour in Europe to explain how the Irish bad bank, the National Asset Management Agency (NAMA), will operate. The FT writes that minister’s main task will be to convince sceptics the agency will be free of favouritism and political interference. Ireland has just gone through 10 years of judicial tribunals that exposed a culture of corruption in planning and development. People are worried that developers may use Nama to walk away from their debts, leaving the taxpayer to pick up the tab. It is vital for Nama to demonstrate its independence and its capacity to manage and protect taxpayers’ money.

161 Record abstention expected for European elections Four weeks ahead of the European elections polls suggest record abstentions, reports Le Monde. Voters are reluctant to go to the ballots, even though the EU is today much more present than five years ago and the influence of the European Parliament’s role as co-legislator will grow significantly under the Lisbon Treaty. But this is apparently not enough. Amato’s Action group ACED called yesterday on MEPs to give clear indications on policy choices they will support when legislating and where they stand on the adoption of the Lisbon Treaty so that voters can state their preferences and help to shape future common policies and the modernisation of its institutions. The European left fails to capitalise from financial crisis The financial crisis has so far not benefited the left in Europe, notes Les Monde. Regulation, a strong role for the state, reducing inequalities – key ideas of the traditional left – are now at the centre of the rescue packages even in countries with right wing governments. But no country, with the exception of Iceland, is moving to the left. On the contrary. Polls suggest that the left have lost ground and many agenda points, such as the Protecting Europe, have been taken up by the right. Martin Wolf on Obama’s conservatism In his FT column, Martin Wolf makes the point that Obama is a deeply conservative politician when it comes to the economy. This is evidenced by the appointment of Geithner and Summers, as well as his insistence that he seeks stability in the financial sector, rather than quick resolution. Wolf says the stress tests were undertaken to be sufficiently credible but not overly painful. In his analysis he casts doubt on whether this approach is sufficient. Wolfgang Munchau on green shoots In his column in FT Deutschland, Wolfgang Munchau warns that the debate about green shoots is potentially counterproductive, as it induces governments to do less, not more. He says the cyclical crisis, in terms of economic output, reached its peak during Q42008 and Q12009, and that the numbers are indeed getting better. There will be a return to positive growth rates in the second half of the year, but not a sustainable recovery, especially for Germany, which remains too export-dependent. Germany also used to rely on Americans to generate sufficient growth for its export strategy, but this is no longer going to work. More anti-Barroso moves Jean Quatremer reports in his blog about attempts by some Socialists and Greens, including Daniel Cohn Bendit, to forge a red Green alliance with the specific goal to block Barroso. Cohn Benedit is quoted as saying that Barroso was supported by a Grand Coalition of Socialists and Christian Democrats. There are lots of tactical and technical problems to be resolved. A Red-Green alliance is certainly not a done deal yet.

162 An interesting proposal (not going to happen though) Domingo Cavallo and Joaquín Cottani write in Vox that economists’ opinions diverge greatly on how to resolve China’s “dollar trap”. They suggests all US creditors need to do is demand that the US government swap nominal US Treasury bills, notes, and bonds for inflation-adjusted instruments. This will reduce the incentive of the US government to “inflate its way out of debt”, protect the value of emerging market reserves and redcue the risk of a resurgence in world inflation. http://www.eurointelligence.com/article.581+M5becf5b6900.0.html#

IMF urges stress tests on European banks By Scheherazade Daneshkhu in , Tony Barber in Brussels and Peter Thal Larsen in London Published: May 12 2009 15:15 | Last updated: May 12 2009 19:00 Europe should follow the US in conducting stress tests on individual banks, the International Monetary Fund said on Tuesday as it warned that economic recovery in the region next year depended on bolder and more forceful policy action. Fresh moves by European banks to clean up the banking system and face their recapitalisation needs were essential to restoring trust in the financial system, according to the report on Europe published by the Washington-based agency. “Further actions by policymakers, particularly in the financial sector, are needed to restore market trust and confidence,” said Marek Belka, director of the IMF’s European department and a former Polish prime minister. He called on banks and regulators to identify, quantify and ringfence toxic assets and to recapitalise through the private sector “but with public support if needed”. The German government will on Wednesday endorse plans to rid the country’s banks of their toxic assets – its latest attempt at tackling the crisis of confidence that is weakening Europe’s largest economy. Lamenting the lack of pro-active Europe-wide measures by the region’s institutions, the IMF said it was essential for the stress tests to be co-ordinated. It called on the London-based Committee of European Banking Supervisors to set common parameters for national regulators in Europe to avoid the risk of competitive distortion. “We need more Europe and not less Europe,” said Mr Belka. “Europe is the most economically integrated market economy in the world and yet the policies to address the crisis have been undertaken at a national level.” The IMF said that crisis measures, such as bank deposit insurance schemes, regulatory and supervisory actions, “have been unhelpfully diverse”. Europe’s financial regulators and central banks are carrying out stress tests on their national banks. Unlike the US’s recent stress tests of 19 banks, however, the criteria

163 used and their outcome will not be disclosed publicly, nor will the balance sheets of individual institutions be examined. “The exercise does not attempt to assess specific institutions’ needs for recapitalisation,” the CEBS said on Tuesday. Many bankers and investors believe full public disclosure is necessary to restore market confidence in financial institutions. EU regulators see the task of cleaning up the “toxic asset” problem as the most effective way of restoring confidence in the banking sector and restoring credit flows to pre-crisis levels. But EU officials say many European banks have been reluctant to acknowledge that they are likely to need extra recapitalisation measures in the future. Repeating last month’s World Economic Outlook forecasts, the fund expects Europe’s advanced countries to contract by 4 per cent this year with the beginnings of recovery only in spring 2010. On monetary policy, the IMF saw little scope for further interest rate cuts following the European Central Bank’s cut last week to 1 per cent from 1.25 per cent. “We are coming quite close to the point where the efficiency of interest rate actions is exploited,” said Mr Belka. In this context, so-called unconventional measures, such as credit easing was becoming “more essential.” IMF urges stress tests on European banks http://www.ft.com/cms/s/0/36084216-3ef5-11de-ae4f- 00144feabdc0.html

Berlin backs toxic assets plan By Bertrand Benoit in Berlin Published: May 12 2009 13:14 | Last updated: May 13 2009 09:21 The German government on Wednesday adopted a “bad bank” scheme to rid the country’s institutions of their toxic assets in its latest attempt to tackle the crisis of confidence that is crippling the financial sector and weakening Europe’s largest economy. Yet mounting hostility against the plan from within the Social Democratic party, junior partner in the coalition of Angela Merkel, chancellor, means it could still undergo substantial changes before implementation. The draft bill – foresees the creation of several, institute-specific bad banks. Any bank that chooses to will be able to park its least liquid assets – and the risks associated with them – for up to 20 years. In exchange, these special-purpose vehicles would issue the bank with a bond whose value would be guaranteed by Soffin, the federal authority that manages the government’s bank rescue fund created last October. By pushing the text through cabinet on Wednesday, the government hopes parliament can turn it into law by early July at the latest, the last opportunity to pass the legislation before a summer recess and the September 27 general election. People close to Ms Merkel’s Christian Democrats told the FT the bill would not meet resistance among the party’s MPs. Yet Social Democratic legislators led by Carsten

164 Schneider, budget expert in the SPD parliamentary group, have expressed serious misgivings about the scheme. Mr Schneider thinks few banks would take advantage of the bad bank scheme as it stands and that participation should be made compulsory. He also favours a forced recapitalisation of the banks that would result in the government taking equity in the institutes it supported. “I would be very happy to increase Soffin’s reserves,” Mr Schneider said on Monday. “Another €80bn [$109bn, £72bn] would be perfectly OK” if it solved the problem. By taking the illiquid assets off the banks’ balance sheets and replacing them with a state-guaranteed security, the finance ministry hopes to break the vicious spiral that has forced financial institutions to hoard more and more capital to offset the fast-shrinking value of their toxic assets, limiting their willingness to lend to business. At the same time Berlin is confident the model will be politically acceptable in an election year,, because it can be plausibly presented as leaving the bulk of the financial risk associated with the toxic assets with the banks and their shareholders. Under the ministry’s model, the assets would be transferred from the “good” to the “bad” banks at book value. At the same time, independent auditors would be appointed to determine the assets’ “intrinsic” value, expected to be lower. “A great deal will hinge around the ‘intrinsic’ value and the methodology auditors use to determine it,” said a lawyer with knowledge of the draft. Separately, the finance ministry is working on a second, more complex scheme directly tailored to the needs of the country’s public-sector Landesbanken, which have suffered from the toxic asset meltdown. Copyright The Financial Times Limited 2009 Bertrand Benoit, “Berlin backs toxic assets plan” http://www.ft.com/cms/s/0/05a02882-3eeb-11de-ae4f- 00144feabdc0.html

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Alarm Sounded On Social Security Report Also Warns Of Medicare Collapse By Amy Goldstein Washington Post Staff Writer Wednesday, May 13, 2009 The financial health of the Social Security system has eroded more sharply in the past year than at any time since the mid-1990s, according to a government forecast that ratchets up pressure on the Obama administration and Congress to stabilize the retirement system that keeps many older Americans out of poverty. The report, issued yesterday by the trustees who monitor the government's two main forms of help for the elderly, shows that Medicare has become more fragile as well and is at greater risk than Social Security of imminent fiscal collapse. Starting eight years from now, the report says, the health insurance program will be unable to pay all its hospital bills. The findings put a stark new face on the toll the recession has taken on the two enormous entitlement programs. They also intensify a political debate, gathering strength among Democrats and Republicans, over how quickly President Obama should tackle Social Security when health-care reform is his administration's most urgent domestic priority. In announcing the results of the trustees' annual forecast with other Cabinet members, Treasury Secretary Timothy F. Geithner said, "The president explicitly rejects the notion that Social Security is untouchable politically." Still, he reiterated that the administration intends to "work to build a bipartisan consensus to ensure the long-term solvency of Social Security" only after it collaborates with Congress to slow health-care spending and enable more Americans to obtain medical insurance. Congressional Republicans and some Democrats seized upon the findings to argue that the administration should work rapidly to ward off the looming insolvency of Social Security and Medicare. Sen. Judd Gregg (R-N.H.), who withdrew from nomination as Obama's commerce secretary, said yesterday's report shows that the recession is "accelerating the arrival of a massive, trillion-dollar entitlement crisis on our doorstep." He added: "Trying to kick the can down the road will not make it go away. We need to take meaningful action now." Specifically, the trustees' report predicts that the trust fund from which Social Security payments are made will be unable to pay retirees full benefits by 2037, four years earlier than forecast a year ago. In particular, the trustees single out the financial weakness of the part of the program that subsidizes disabled Americans, saying that fund will run out of money in 2020. Only three times in the past 15 years have the trustees predicted that Social Security would run out of money sooner than previously expected. Last year, they forecast no change from the 2007 prediction, and in 2007, they predicted that the fund would last a year longer than they had previously thought.

166 Yesterday's report also said the Social Security trust fund will begin to spend more money than it takes in through tax revenue in 2016, one year sooner than predicted a year ago. Administration officials said that if Congress were to act immediately, the impending gap could be filled three ways: by raising workers' Social Security payroll taxes by 2 percentage points, from 12.4 percent to 14.4 percent; by reducing benefits by 13 percent; or a combination of the two approaches. The officials briefed reporters on the condition of anonymity on the technical aspects of the trustees' findings. Medicare's financial health, the report shows, deteriorated less sharply in the past year than Social Security's, but it remains the more urgent problem. The trust fund that pays for hospital care under Medicare is now predicted to run out of money in 2017, two years earlier than forecast a year ago. That fund does not involve the parts of Medicare that cover doctor's visits or coverage for prescription drugs. The nation's economic downturn has added to the fragility of Medicare and Social Security because worsening unemployment means that fewer workers are contributing to the two trust funds through payroll taxes. Since the recession began in December 2007, the country has lost 5.7 million jobs. But even if the economy were stronger, the programs would be facing pressure in coming years as the large baby-boom generation reaches old age and people tend to live longer, leaving comparatively fewer workers to pay benefits for a large cadre of retirees. Health and Human Services Secretary Kathleen Sebelius sought to use the report to build momentum for health-care reform, reiterating the administration's contention that the best way to strengthen Medicare's finances is to, as she put it, "fix what's broken in the rest of the health-care system." If Americans have health insurance and receive adequate medical care when they are younger, she said, they will be healthier and less expensive patients when they become old enough to join Medicare, usually at age 65. Some key lawmakers in both parties have said they want to devise a plan to keep the retirement program solvent by increasing the retirement age, slowing the growth in the size of retirement checks to wealthy Americans and bringing in new revenue. Several Democrats and Republicans would prefer to create an independent commission to propose Social Security reforms, but congressional leaders, particularly in the House, have balked, saying the matter should be handled by Congress's regular committees. Last week, House Majority Leader Steny H. Hoyer (D-Md.) said Congress could start work on the retirement program this fall if it passes health-care legislation by late summer -- a timetable that others called unrealistic. Yesterday, Hoyer said he was encouraged that Geithner, the Treasury secretary, "stated the administration's support for moving forward with Social Security reform after health-care reform has passed." Staff writer Lori Montgomery contributed to this report. http://www.washingtonpost.com/wp- dyn/content/article/2009/05/12/AR2009051200252_pf.html

167 Politics

May 13, 2009 Recession Drains Social Security and Medicare By ROBERT PEAR WASHINGTON — Even as Congress hunted for ways to finance a major expansion of health insurance coverage, the Obama administration reported Tuesday that the financial condition of the two largest federal benefit programs, Medicare and Social Security, had deteriorated, in part because of the recession.

As a result, the administration said, the Medicare fund that pays hospital bills for older Americans is expected to run out of money in 2017, two years sooner than projected last year. The Social Security trust fund will be exhausted in 2037, four years earlier than predicted, it said. Spending on Social Security and Medicare totaled more than $1 trillion last year, accounting for more than one-third of the federal budget. The fragility of the two programs is a concern not just for current beneficiaries, but also for future retirees, taxpayers and politicians. Lawmakers say they would never allow Medicare’s trust fund to run out of money. But beneficiaries could be required to pay higher premiums, co-payments and deductibles to help cover the costs. The projected date of insolvency, a widely used measure of the benefit programs’ financial health, shows the immense difficulties Mr. Obama and Congress will face in trying to shore them up while also extending health coverage to millions of Americans. The labor secretary, Hilda L. Solis, noted that 5.7 million jobs had been lost since the recession began in December 2007. With fewer people working, the government collects less in payroll taxes, a major source of financing for Medicare and Social Security.

168 A resumption of economic growth is not expected to close the financing gap. The trustees’ bleak projections already assume that the economy will begin to recover late this year. The Treasury secretary, Timothy F. Geithner, said the only way to keep Medicare solvent was to “control runaway growth in both public and private health care expenditures.” And he said Mr. Obama intended to do that as part of his plan to guarantee access to health insurance for all Americans. But if cost controls do not produce the expected savings, Congress is likely to find it difficult to preserve benefits without increasing taxes. Just hours before the trustees of Medicare and Social Security issued their annual report, suggesting that the nation could not afford the programs it had, the Senate Finance Committee finished a hearing on how to pay for the expansion of health insurance coverage that Mr. Obama seeks. Mr. Obama has said he does not want to finance expanded health coverage with more deficit spending. Rather, he says, Congress must find ways to offset the costs, so they do not add to the deficit over the next decade. Federal deficits and debt are soaring because of the recession and federal efforts to shore up banks and other industries while trying to revive the economy with a huge infusion of federal spending. “The financial outlook for the hospital insurance trust fund is significantly less favorable than projected in last year’s annual report,” the Medicare trustees said. “Actual payroll tax income in 2008 and projected future amounts are significantly lower than previously projected, due to lower levels of average wages and fewer covered workers.” In coming years, the trustees said, Medicare spending will increase faster than either workers’ earnings or the economy over all. The trustees predicted that, for the first time in more than three decades, Social Security recipients would not receive any increase in their benefits next year or in 2011. In 2012, they predicted, the cost-of-living adjustment will be 1.4 percent. The updates are calculated under a statutory formula and reflect changes in the Consumer Price Index, which was unusually high last year because of energy prices. If there is no cost-of-living adjustment for Social Security, about three-fourths of Medicare beneficiaries will not see any change in their basic premiums for Part B, which covers doctors’ services. The monthly premium, now $96.40, is usually deducted from Social Security checks, the main source of income for more than half of older Americans. The trustees said that one-fourth of Medicare beneficiaries would face sharply higher premiums: about $104 next year and $120 in 2011. This group includes new Medicare beneficiaries and those with higher incomes (over about $85,000 a year for individuals and $170,000 for couples). Seventy-five percent of beneficiaries will not pay any increase, so the remaining 25 percent have to pay more to keep the trust fund at the same level, Medicare officials said. The aging of baby boomers will strain both Medicare and Social Security, but Medicare’s financial problems are more urgent.

169 The trustees predict a 30 percent increase in the number of Medicare beneficiaries in the coming decade, to 58.8 million in 2018, from 45.2 million last year. But the projected increase in health costs and the use of medical care is a more significant factor in the growth of Medicare. The trustees predict that average Medicare spending per beneficiary will increase more than 50 percent, to $17,000 in 2018, from $11,000 last year. Representative Pete Stark, the California Democrat who is chairman of the Ways and Means Subcommittee on Health, said the Medicare report “underscores the urgent need for health reform.” http://www.nytimes.com/2009/05/13/us/politics/13health.html?_r=1&th&emc=th

170 The State of Housing Markets Around the World: Not Bottoming Yet? May 12, 2009 GPG:Only two countries (Germany and Switzerland) out of 32 main property markets saw positive momentum in 2008 (a slower downward house price movement or faster upward movement), while 28 countries saw momentum deteriorating. 8 out of 32 countries saw house prices rise, adjusting for inflation, while 20 countries experienced house price falls with the sharpest in Latvia (37%), Lithuania (27%), the US (20%), the UK (18%), Iceland (16%), Ireland (12%), and the Ukraine (Kiev) (12%) . Downward price momentum accelerated in Q4 2008. (GPG) Property cycles in Canada and the EU tend to lag the US by several years While stock market recoveries often precede an economic recovery, a key driver of property occupancy—employment—is often one of thelast economic indicators to turn. This suggests that 2009 will remaina difficult year for commercial and residential property globally (Jones Lasalle) U.S: The U.S. Housing Market remains depressed with home prices 30% below their mid 2006 peak as per the S&P Case Shiller Indexes. With home sales showing some signs of stability, the pace of price decline has abated, though the glut of unsold inventories and foreclosures will prolong the downward pressure on prices. UK: UK housing market witnessed a record contraction in house prices in Q1 2009, and prices continue to fall as per the Halifax Index. Though buyer sentiment has shown signs of improvement, the outlook for U.K. housing sector remains weak due to tight supply of credit. Canada: The Canadian housing market is remains weak, with home prices declining on a national basis as the economic downturn is affecting housing demand. Despite overbuilding, the supply overhang is lower than during the 90s and the pace of slowing in starts, prices and homes sales slowed in March and April from Dec/Jan levels China: The Chinese housing market is showing some signs of stability with increasing sale volumes and a decline in inventories. Home prices have fallen significantly Japan: Residential prices continue to decline in Japan due to declining sales and elevated inventory levels. In an effort to raise sales volumes, the government is offering tax breaks for homebuyers. Asia: The economic downturn continues to affect housing markets in Asia, with declining prices and sales transactions in , Hong Kong and South Korea. (PREI) Australia's housing market softened in 2008 and Q1 2009 on the exit of speculators due to high credit costs, but an ongoing housing shortage may keep a floor under prices - especially as support for first homebuyers fortifies owner-occupier demand. New Zealand is on track for the second straight annual price decline, the first since the 1950s Middle East: house prices have fallen as much as 42% over Q4 2008 and Q1 2009 and are likely to drop further as new homes are completed amid waning demand in the Persian Gulf business hub. Property markets in Abu Dhabi, Qatar and others are also

171 softening on tighter liquidity, slower growth but supply shortages may constrain price falls (Citi) CEPS: EU follows US housing with 2-year lag Gros: Strong housing-consumption correlation in EMU; spillover risks to real economy http://www.rgemonitor.com/80/Housing_Bubble_and_Bust?cluster_id=7126

2008 in review: the downturn accelerated at year end Global Property Guide Last Updated: Mar 02, 2009

It was a dismal year for house prices, according to publicly-available house-price time- series for the year 2008. Most worrying is that the downturn is still accelerating. The collapse of the world’s housing markets in 2008 can be seen from three points of view, and unfortunately, all of them reinforce the bad news. • During 2008, the downward price momentum accelerated, as compared to 2007. Only 2 countries saw positive momentum in 2008 (a slower downward house price movement than last year, or faster upward movement), while 28 countries saw their housing market momentum deteriorating, compared to the previous year. The two countries with a positive momentum were Germany and Switzerland (please see accompanying tables, see column with the arrows). • During 2008, house prices fell in most countries. During 2008 only 8 out of 32 countries saw house prices rise, after adjustment for inflation, while 20 countries experienced house price falls.

In contrast, during the year 2007, the downturn was just beginning, and only 6 countries saw house prices fall, while 24 countries saw house prices rise (all figures inflation-adjusted).

Many house-price falls during 2008 were extremely severe. Countries with house price falls of over 10% during 2008 were Latvia (Riga) (37%), Lithuania (Vilnius) (27%), the US (20%), the UK (18%), Iceland (16%), Ireland (12%), and the Ukraine (Kiev) (12%) (all figures inflation-adjusted). • During the final quarter (Q4) of 2008, the downward price momentum significantly accelerated, as compared to Q3, suggesting that the situation is deteriorating. During 2008’s final quarter, 9 countries saw house price falls of 5% or more during just that quarter. Price drops of more than 10% during this single quarter occurred in three countries - in Latvia (Riga), which saw price falls of 15%, in Ukraine (Kiev) (13%), and in Hong Kong (15%). Other countries with Q4 house-price falls of 5% and over, included the UAE (8%), Lithuania (7%), Iceland (7%), Singapore (6%), Bulgaria (5%), and the UK (5%) (all figures

172 inflation-adjusted, except UAE). These price falls were much greater than during the previous quarter, Q3. During that previous quarter, only two countries experienced house-price falls (inflation-adjusted) of 5% or more, and no countries experienced house-price falls of more than 10%. Regional survey Europe has major problems

Source: Various series, data descriptions and sources here

The Baltic countries of Latvia and Lithuania suffered the hardest price falls both in nominal and real terms. In Riga, Latvia, the average price of standard-type apartments plunged 37% during 2008. Prices have been going down in Latvia since late 2007, after

173 a remarkable increase of about 70% in 2006. The most alarming decline took place in the 4th quarter, when prices declined by 15%, the steepest quarterly drop in real terms in any country. These price falls were triggered by increased interest rates, and by the tightened credit rules which Latvia imposed in 2007. Average prices of apartments in Vilnius, Lithuania, fell by 27% during 2008. House prices started slowing in mid-2007, and crashed in early 2008. House prices in the UK plummeted by 18% in 2008. Although mortgage interest rates dropped slightly, to 4.48% in December 2008, the number of loan approvals for house purchases fell 58% in 2008. There is serious trouble in Iceland (house price fall of 16% during 2008), Ireland (12%), Ukraine (12%), Malta (9%), Portugal (8%), France (8%) Finland (7%), Norway (6%) and in Spain (6%). North America’s woes In the US, the centre of the global financial crisis, in 2008 house prices fell 20% according to the Case-Shiller house price index, which emphasizes urban areas. OFHEO and FHFB figures, which are associated with Fannie Mae and Freddie Mac loans and have somewhat lost credibility, suggest a smaller decline of 6% and 3% respectively, during 2008. The US government recently approved a $ 787 billion economic stimulus package, of which $275 billion will be allocated to rescue the ailing housing market. Canada has been much less affected than the US. Pacific heads down Both Australia and New Zealand saw house price declines during 2008, of 7% and 8% respectively. Asia no longer insulated Housing markets in Asia have not been insulated. Singapore, Hong Kong and Philippines recorded house price falls during 2008. Singapore’s private residential prices dropped 9% during 2008, in sharp contrast to the 26% price increase of experienced during 2007. The developed countries’ economic troubles adversely affected Singapore’s exports, and during 2008, output in the manufacturing sector, particularly of electronics, precision engineering and chemicals, shrank by 10.7%. Singapore was officially in recession in Q3 2008. Hong Kong has been badly hit by the crisis. House prices were down by an average of 6% in 2008. But during the last quarter, Hong Kong experienced a severe decline in prices of 14%. In Makati, Philippines, prime 3-bedroom condominium prices fell by 2% during 2008, after an 11% price rise during 2007. Nevertheless construction of high-rise residential buildings continues, with residential condominium stock rising by 7% during 2008, according to Colliers Philippines. Japan recorded modest Tokyo condominium price rises of 1.2% during 2008. On the other hand, land prices in Japan’s six major cities fell by 6% y-o-y to Sep-2008.

174 Source: Various series, data descriptions and sources here

In Shanghai, China, house price rises slowed to 5% y-o-y by the end of 2008, after peaking at 30% y-o-y to May 2008. However Shanghai is likely to be somewhat exceptional, and Xinhua News Agency reported house prices declines in 70 major cities during 2008. Shenzhen suffered the hardest fall, with prices down by 18% during 2008 UAE on shaky ground In Dubai, UAE, despite the bleak global picture, saw surprisingly large dwelling price rises of 41% during 2008. However during the year’s final quarter, prices fell by 8% in nominal terms. This downturn is attributable to strongly tightening lending criteria, an increase in interest rates, multiple layoffs, and alarm among buyers.

175 Forecast: No recovery in 2009 History suggests that in a crash, housing markets take many years from peak year to full recovery. In view of this and of the pessimistic IMF forecast for the global economy, no real recovery is likely in the global housing markets this year. The IMF has predicted that the world economy will grow by 0.5% in 2009, the lowest level in 60 years. GDP in advanced economies is expected to decline by 2% during 2009. The and Japan will be hit the hardest. Output in the UK may contract by 2.8%, while Japan’s may fall by 2.6%. Growth in emerging economies is expected to slow to 3.3% in 2009, down from 6.3% in 2008. Developing Asia is forecast to be the least affected, with growth of 5.5%. China’s economy is predicted grow by 6.7% in 2009, but this is a substantial decline from 9% growth during 2008. We cannot be optimistic for five reasons: • Valuations still clearly remain stretched in most countries, in terms of price/rent ratios. • Economic growth is slowing or negative in many countries, which is negative for housing values. • There are no signs that banks are becoming more willing to lend. • The unprecedented nature of the financial system’s collapse has greatly added to the difficulties facing the world’s housing markets. • Some national governments are experiencing difficulty in refinancing their national debt, putting their currencies under pressure. Currency instability is likely to aggravate housing sector problems in countries where many loans were taken out in a foreign currency.

The positive news is that the US government and several others are acting with vigour, as has the IMF. Nevertheless, there is a long tough road ahead.

http://www.globalpropertyguide.com/investment-analysis/2008-in-review-the- downturn-accelerated-at-year-end

176 vox Research-based policy analysis and commentary from leading economists A simpler way to solve the “dollar problem” and avoid a new inflationary cycle Domingo Cavallo & Joaquín Cottani 12 May 2009 Economists’ opionions diverge greatly on how to resolve China’s “dollar trap”. This column suggests all US creditors need to do is demand that the US government swap nominal US Treasury bills, notes, and bonds for inflation-adjusted instruments. This will reduce the incentive of the US government to “inflate its way out of debt”, protect the value of emerging market reserves and redcue the risk of a resurgence in world inflation. When China’s Premier Wen Jiabao recently expressed concerns about the future of the US dollar, the currency in which most of his country’s official reserves are denominated, his remarks provoked contrasting reactions among US economists. Some, like Fred Bergsten (2009) of the Institute of International Economics, exhorted the US government to take Mr. Wen’s concerns seriously and listen to Beijing’s suggestion to create a substitution account in the IMF, which would allow Fund members to exchange unwanted dollar balances for SDRs, as part of a gradual process to replace the dollar with a supra-national reserve currency over the long run. (Mr. Bergsten (2007) was particularly enthusiastic about the substitution account idea since it matched a similar proposal he had made in 2007.) Other US economists, including last year’s Nobel laureate Paul Krugman, were less enthusiastic. According to Mr. Krugman (2009), China had fallen into a trap of its own making due to its reluctance to adopt a more flexible exchange rate policy in the past. Since any attempt by China or any other country to diversify away from the dollar too much or too quickly would be self defeating, there was no immediate threat to US or world financial stability, hence no need for the US government or the IMF to intervene on China’s behalf. In our opinion, Mr. Krugman’s view is very simplistic for it fails to take into consideration the effect that a large amount of unwanted dollars and dollar assets will have on inflation once recession fears dissipate. It is possible that Mr. Krugman believes that some increase in inflation is a good thing, as it could help cure the “dollar overhang.” If so, he is not alone. Kenneth Rogoff (2008), the former chief economist of the IMF, has recently written that “a sudden burst of inflation would be extremely helpful in unwinding today’s epic debt morass.” Put in other words, by increasing inflation, the US would “solve” two problems at once. On the one hand, it would debase the value of its national debt, hence preventing it from growing too much relative to GDP. On the other, it would reduce the real value of the debt (unsecured and secured) of financial institutions and other US corporations, hence diminishing the need for explicit haircuts or public bailouts. The problem with this “solution,” aside from the reputational problems it creates for the US government, is that once the inflation genie is out of the bottle, it will be very

177 difficult to put it back in. As for the solution proposed by the Chinese central bank and Mr. Bergsten, there are, unfortunately, several problems. First, the plan requires a complex multilateral negotiation, including a change in the IMF’s Articles of Agreements, which is unlikely to be supported by the US, if anything because the SDR will compete with the dollar as a reserve currency unit. Second, the proposal restricts the menu of potential dollar substitutes to the SDR, itself a basket of currencies with a predominant dollar share. Third, a substitution account in the IMF makes the IMF rather than the US government liable for losses resulting from the depreciation of the dollar vis-à-vis the SDR, a condition likely to be opposed by other Fund members. However, the most important drawback of the China/Bergsten proposal is that it does not really protect US official creditors from a persistent fall in the dollar. This is because in the event of a protracted dollar depreciation, it is highly unlikely that the central banks of Europe, Japan, and the UK will stay put and let their currencies appreciate. More likely, these countries will resist appreciation by engaging in a process of competitive devaluations, the end result of which will be an increase in global inflation. If so, the reserves of China and other emerging makets will lose real value whether they are in dollars or SDRs. More importantly, inflation will be high everywhere in the world, and it will take years of high real interest rates and low growth to bring it down. Fortunately, there is an easier and better way to protect the value of emerging market reserves while reducing the risk of a resurgence in world inflation. This is to reduce the incentive of the US government to “inflate its way out of debt.” For this to happen, all US creditors need to do is demand that the US government swap nominal US Treasury bills, notes, and bonds for inflation-adjusted instruments (TIPS) on demand. Since, at present, the supply of TIPS is very small in relation to the rest of the US national debt, bilateral coordination would be necessary to avoid distorting their value. One of the advantages of this idea is its simplicity. For starters, it can be executed bilaterally rather than multilaterally. This not only makes it easy to implement, but also gives the US government leverage to extract concessions from the other governments. For example, in the case of China, it would be possible for the US to negotiate a quid- pro-quo, whereby China commits to reforms geared to reducing its structural current account surplus—including, but not limited to, a more flexible exchange rate policy. For this reason, it would be preferable that the swap proposal comes from the US rather than from its creditors. But, more important than the practical advantages are the beneficial long term effects of such a policy, particularly in averting the specter of global inflation. By substituting TIPS for nominal bonds, the US government would be sending a strong signal that it does not plan to “inflate its way out of debt,” as disingenuously suggested by Mr. Rogoff but, to the contrary, will commit itself to adopting a more disciplined monetary and fiscal policy going forward. References Bergsten, Fred (2009) “We should Listen to Beijing’s Currency Idea,” Financial Times, April 8 Bergsten, Fred (2007) “How to Solve the Problem of the Dollar,” Financial Times, Dec. 11 Krugman, Paul (2009), “China’s Dollar Trap,” New York Times, April 2 Rogoff, Kenneth (2008) “Embracing Inflation,” The Guardian, UK, December 2 http://www.voxeu.org/index.php?q=node/3551

178 COLUMNISTS Why Obama’s conservatism may not prove good enough By Martin Wolf Published: May 12 2009 19:56 | Last updated: May 12 2009 19:56

“If we want things to stay as they are, things will have to change.” Thus wrote the Sicilian writer Giuseppe di Lampedusa, in The Leopard. This seems to me the guiding principle of the Obama presidency. To many Americans, he seems a flaming radical. To me, he is a pragmatic conservative, albeit one responding to extraordinary times. In his own way, Mr Obama is following the path trodden by Franklin Delano Roosevelt. Nowhere is his conservatism more obvious than in the handling of the economic crisis. What we have seen unfolding, from the president’s choice of Lawrence Summers and Tim Geithner as his principal policy advisers, to last week’s “stress tests”, is classic conservative policymaking. The aim is simply to get the show back on the road. As Mr Obama told The New York Times: “I’m absolutely committed to making sure that our financial system is stable.” Stability is a quintessentially conservative aim. Many radicals on the right and left insist that undercapitalised banks should be recapitalised right now. But Mr Obama sees this as far too risky. The results of the stress tests were a big step along the road the administration is taking. They impose enough pain to appear credible, but not enough to be disruptive. The 10 affected banks will easily raise the needed money: a total of $75bn (€55bn, £59bn). Their market valuations duly soared. Douglas Elliott of the Brookings Institution has provided a comparative analysis of how the US regulators reached their conclusions.* He contrasts their numbers with those of the International Monetary Fund, in its latest Global Financial Stability Report, and Nouriel Roubini of RGE Monitor and New York University. He also allows for the fact that the IMF and Mr Roubini look at all losses in US banking, while the tests apply to 19 institutions that hold some 70 per cent of US banking assets. Estimated losses for 2009 and 2010 by the US regulators, the IMF and Mr Roubini are $535bn, $321bn and $811bn, respectively. So regulators were noticeably more risk- aware than the IMF, albeit less so than Mr Roubini. Against these losses are set the expected earnings (after dividends) over these years, plus a provision for 2011 losses. Here the regulators estimate earnings at $363bn, against an assumed $210bn for the IMF

179 and Mr Roubini. This means the reduction in capital is estimated at $172bn by the regulators, $111bn by the IMF and $601bn by Mr Roubini. But, after allowing for planned capital-raising and excess earnings in the first quarter of 2009, the final reduction in capital is just $62bn for the regulators and a mere $1bn for the IMF, but as much as $491bn for Mr Roubini. There are two important numbers in the above analysis: possible losses, and the buoyancy of earnings. Yet there is a final number of no less significance: how much capital does a bank need? The answer is: how long is a piece of string? Since many of these banks are deemed too big to fail, taxpayers are risk-bearers of last resort. The capital requirement depends partly on how well the government wants to be cushioned against possible losses and partly on how well bond-holders want to be insured against the possibility that government might refuse a rescue.

At the end of 2008, the ratio of total common equity to US banking assets was 3.7 per cent. Without the explicit and implicit insurance provided by government, it would surely have been higher. As the IMF notes, in the mid-1990s, before the leverage boom, the ratio was 6 per cent. In the 19th century, before deposit insurance, it was much higher still. The conclusions are three: first, the government’s exercise is more conservative on losses than that of the IMF, albeit far less so than Mr Roubini’s; second, most of the capital to be raised will come from the earnings of a banking system able to borrow on the favourable terms arranged by the central bank and then to lend more expensively to its customers; and third, the target capital ratios – Tier 1 risk-weighted capital of 6 per

180 cent of assets and Tier 1 common equity capital of 4 per cent – are not especially onerous. The purpose of the exercise was indeed conservative: to make it credible, though not certain, that the existing banking system and assets can survive the likely battering. This has been done well enough to satisfy the markets. But these banks will also be unable to expand their balance sheet significantly in the near future. The biggest question is how far this exercise will help restore the economy. Commercial banks provide only a quarter of financial sector credit in the US, down from close to 40 per cent in the mid-1990s (see chart). Much of the rest came from various forms of securitisation. Unless and until the latter markets reopen fully, private sector credit is likely to be constrained. How far that constraint is binding depends on how far highly leveraged borrowers are willing to borrow, particularly when the collateral against which they borrow has lost value. For this reason, it is the huge stimulus – the least conservative parts of the economic package – that will deliver the recovery. These are also the least upsetting to the interests of powerful lobbies, particularly in finance. More radical approaches – allowing more banks to default, for example – would have increased uncertainty in the short run and so undermined the return to stability Mr Obama craves. But here the president must reckon on a longer-term danger: that the rescued financial system will, in time, start to lay the foundations for another and possibly still bigger financial crisis in the years ahead. Ensuring the rescue of a financial system packed even more than before with complex and “too-big-to-fail” institutions may well be the cautious response to this crisis. But it leaves the government with the even more onerous task of imposing effective regulation in future. Unhappily, the record of regulation of generously insured financial systems is extremely poor. The mobilised self-interest of highly rewarded players easily overwhelms the constraints imposed by far less well-rewarded and almost certainly less able regulators. The more the crisis unfolds, the more evident it is that incentives in the financial system were (and are) badly distorted. I sympathise with the conservative approach to crises, but not if it leaves in place the plethora of perverse incentives that created them. At the end of this, then, there will be one big test: will the number of institutions thought “too big to fail” be as large as now and, if so, how will they be controlled? If the answers are still not clear, there will need to be yet more change. *Implications of the Stress Tests, May 11 2009, www.brookings.edu Write to [email protected] Martin Wolf Why Obama’s conservatism may not prove good enough http://www.ft.com/cms/s/0/5e7dd89c-3f1c-11de-ae4f-00144feabdc0.html

Douglas J. Elliott The Brookings Institution May 11, 2009 Implications of the Bank Stress Tests http://www.brookings.edu/~/media/Files/rc/papers/2009/0511_bank_stress_tests_elliott/ 0511_bank_stress_tests_elliott.pdf

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12.05.2009 Poland is thinking about delaying euro entry

It looks like the real obstacle to fast-track euroisation are the overly rigid accession roles, but domestic politics in the countries concerned. The Polish finance minister Jacek Rostowski has told the FT about euro entry: “If we move it by one year that’s not the end of the world”. Neither Mr Rostowski, nor the article, give any concrete reason other than “the crisis”, though the article makes the point that Poland’s economy is much less hit than those of other countries. It is conceivable that Mr Rostowski thinks that Poland might not meet the entry criteria due to the crisis, but he did not say so. Latvian GDP down by 18% A Fistful of euros reports that Latvian GDP fell by 18% in the first quarter, year-on- year, with manufacturing down 22%, retail 25%, and hotels and restaurants down 34%. In the fourth quarter, GDP fell by 10.3%, year-on-year. The blog notes that the country has gone through an extreme boom-bust ride, with growth of over 10% for most of the decade. A new website for the EU A very useful new webservice has been launched, www.votewatch.eu, an independent website that tracks voting records of MEPs and ministers to introduce some transparency into Europe’s opaque political system. For each MEP, for example, it lists the number of speeches, attendance rates, how often they voted with their group. Green shoot watch Germany FT Deutschland has a nice package about Green Shoots this morning. A news report says that the downward drift in industry has been stopped, with industrial orders up 3.3%, industrial production unchanged, and exports up a notch in March, compared with February. A second article looks at the impact on unemployment, which is

182 estimate to go up from a level of about 3.5m, to 4.5m to 5m next year, even with those green shoots sprouting everywhere. Spain,G10 Spanish forward looking indicators are also showing a slight improvement in March, according to El Pais. The article also reported on the G10 meeting of central bankers, who expressed cautious optimism about the recovery. Trichet is quoted as saying that economy had reached an inflection point. The consensus appeared to be that the worst in terms of GDP decline is probably over, but that the recovery will be slow, not V- shaped. France In France the latest figures show that manufacturing production fell by an 17.8% in the first quarter of 2009, much worse than expected, reports Les Echos. The French statistical office initially forecasted a stabilisation in February of -0.1% against the previous month, but had to revise the figures downward to -0.8% due to new seasonal adjustments. Statistical models react badly under these exceptional circumstances is the explanation. For March the latest figures estimate a 1.1% fall. Heavily hit is the metal industry with an annual fall of -16.7% in the first quarter while construction only fell by 7.1%. While production has been falling at a staggering speed, employment only follows slowly. For now many companies prefer to adjust working time rather than employment. Jean Marc Vittori writes that companies experiment with offers such as “partial unemployment” with 100% compensation, “total partial unemployment” or top-up payments for sabbaticals just to avoid licensing. The article argues that the reason to avoid licensing is not only because it is costly (which it is) but also for the company to be flexible enough for the upturn. Green shoots of what exactly? Tim Duy, hat tip Mark Thoma, writes that the talk about green shoots, and turning the corner lacks specifics. He asks what corner exactly are we turning? He sees two overlapping downturns: a structural downturn due to the rebalancing of US households, and a cyclical downturn that started in the second half in 2008. The cyclical downturn may be ending, but the structural downturn will remain in force for quite some time to come. A former IMF chief economist about the current IMF chief economist Simon Johnson writes in his blog that if the IMF is getting louder and clearer in its warning that the US/UK approach to economic policy will end in disaster. In a post entitled “Is Larry Summers the next Gordon Brown?” he says that both countries are going to heavy on fiscal policy, and too soft on bank resolution, which is very likely to prolong the crisis. Wondering about second rounds effects Another green shoot sceptic is Kevin O’Rourke, writing in the Irish Economy Blog. In a comment about the IMF’s World Economic Outlook he wonders to what extent will declining output and rising unemployment create second round problems in the financial sector?

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The Baseline Scenario: What happened to the global economy and what we can do about it Is Larry Summers The Next Gordon Brown? By Simon Johnson Gordon Brown, the British Prime Minister, is in big trouble. It turns out that a medium-sized industrialized like the UK can be run in pretty much the same way as a traditional emerging market – fiscal irresponsibility (cyclically-adjusted general government deficit now forecast at 12.2 percent of GDP for 2010) gives you a boom for a while, but the eventual day of reckoning is economically painful and politically disastrous. If you also need to deal with an oversized bubble finance sector, that makes the adjustment even more painful. It is of course sensible to use fiscal stimulus to offset a fall in private demand, and to some extent this can be effective – with a lag. But if you lose control over public spending and borrow too heavily (helped by the fact people like to hold your currency), it ends badly. From the beginning, we’ve expressed concern here that the entire Summers Plan was overweight fiscal, i.e., not enough resources for recapitalizing banks and addressing housing directly (for the context of this assessment, see our full baseline view). Back in December/January, this was a strategic choice worth arguing about; now it’s a done deal and following the (very) limited recapitalization outcome of the bank stress tests, it seems likely that household and firm spending will remain sluggish. If that is the case, the Administration’s logic implies throwing another big fiscal stimulus into the mix – and the Summers’ team is already preparing the groundwork. The IMF is now warning against the risks of this approach, albeit using carefully worded language. In a 20 minute presentation at the Carnegie Endowment on April 30th, Olivier Blanchard made statements that are striking coming from the IMF’s chief economist (webcast; slides: http://www.imf.org/external/np/speeches/2009/pdf/043009.pdf ; fan chart for growth forecast). Remember that the IMF is the custodian of the official consensus on the global macroeconomy and financial system – so if their baseline view is in the same ballpark as your stress test results, the IMF is telling you to be more pessimistic. They can nudge a powerful government, like the US, in a particular direction – but not too hard in public on a politically sensitive issue such as fiscal sustainability (or lack of capital in the banking system). Blanchard is clear that the IMF sees the need to “fix the financial system”. He also assumes this will happen slowly, and indicates this slowness is not helpful for the recovery. The implication is that the US will resort to even more fiscal stimulus if the recovery proves sluggish – look at his slide on p.7, dealing with fiscal sustainability (this is discussed at about minute 11 in the webcast). This presentation of country averages is an IMF way of talking about difficult country-specific situations without being indelicate – and the point here is to push you to think about the nonconvergent (red…) debt path with contingent liabilities (i.e., what the government is committing to the banking system without acknowledging the fact); the yellow path for debt, with slow economic growth, also does not look good. Blanchard doesn’t show the US debt forecast – presumably that would be indelicate. But at the 13:13 mark, he warns that the US may be heading in the same fiscal direction as Ireland (!), “the [US budget] numbers are not great but we hope that something will be done.” The content and timing of that ”something” is left vague – add your suggestions below.

184 http://baselinescenario.com/2009/05/11/is-larry-summers-the-next-gordon-brown/#more-3617

Economist's View May 11, 2009 Fed Watch: Turning Which Corner? Tim Duy: Is the economy turning a corner? And, if so, which corner is it turning? In my view, economic activity has been influenced by two separate trends since 2007. One is the structural response to an over-leveraged household sector that pushed the US economy into what was initially a mild recession. The second trend is the sharp cyclical recession that began in earnest in the second half of 2008 as the commodity price shock decimated already weakened households and the deepening credit crunch cut financing for a broad swath of firms. Excess capacity emerged throughout the economy, triggering the familiar phenomenon of rising unemployment. Difficult though they may be, the cyclical dynamics do not last indefinitely - generally speaking, output declines stop well short of zero GDP and unemployment will not rise to 100%. Market participants are rightly anticipating the economy is turning the corner on the cyclical trend. But I suspect we have a long path ahead of us on the structural challenge poised by overleveraged households - suggesting that the green shoots we hear so much about will yield little more than stunted growth. This is why Bernanke and Co. are more likely to fertilize the fields than plan for the next harvest. If there is one picture that sums up the cyclical story of the past year, it is the path of real consumption:

The sharp deceleration has come to an end, of that there can be little doubt. Nor should there be much surprise. The collapse in commodity prices, lower interest rates to allow mortgage refinancing for those homeowners still above water, and tax cuts all joined to provide powerful support for household budgets allowing consumption to stabilize despite the massive job losses experienced in recent months. The stabilization in consumer demand will eventually slow the pace of job cuts. Indeed, this is already evident in the data - analysts have pointed to peak of initial claims as a key hurdle in the race to recovery. To be sure, it is difficult if not impossible to characterize the data flow as "good." But it is certainly less "bad." The path to Great Depression II has hit something of a speedbump. And seeing that, market participants have priced out some of the most cataclysmic scenarios, supporting equities and commodities while pushing bond yields higher.

185 There will be more opportunities for euphoria - do not underestimate the power of pent- up demand to trigger bursts of positive data. There is a portion of the population who are not credit constrained, biding their time for the perfect moment to buy a new car or schedule a vacation. Indeed, such bursts of data are more likely than not following a sharp decline in activity (the 2.2% gain in consumption spending in 1Q09 is such an example). I believe, however, that those bursts of data will not be sustainable. Far from it - at a minimum, the ability of households to carry activity forward is at its end, which by itself would leave the economy floundering . I think it is difficult to ignore the implications of the growth of consumer dominance in defining patterns of economic activity:

The story of the last 25 years has been an increasing role for household spending, rising to perhaps a peak of conspicuous consumption, with the motto "a filet mignon in every stainless steel oven, a RV in every garage." Patterns of economic development - more to the point, capital formation - have favored taking advantage of this trend. Countless business plans are based on the expectation that this trend will continue. The baby boomers have endless wealth (not so anymore, if it ever was), there is a never ending supply of equity rich Californians to support our [insert locality] housing market, etc. Those plans will be stressed, to say the least, if the trend stalls. The implications for a reversal are even more significant. And for those that believe reversal is necessary, note that the reversal has really not even begun. What took 25 years to build may take another 25 years to destroy. How sure are we that the trend is at an end? My thought is that the factors that supported the trend - a steady march down in the saving rate to zero and a steady march up in household debt, coupled with monetary policy that had room to go from 15% short rates to zero over nearly three decades, are at an end. Even if you believe that savings rates will not rise to 12%, the inability to sustain below zero rates puts a limit on household spending growth (as well as debt accumulation). And with underwriting conditions tightening - a permanent tightening, given the changing regulatory environment - the role of debt financing in the life of the consumer is sure to stagnate. The challenge then is to transition the economy away from the debt-supported consumption trend that looks no longer viable to a trend more reliant on investment and external spending. This, however, is easier said then done. How quickly can 25 years of growth directed at consumer spending be reversed? And reversed to what, especially if the rest of the world continues to struggle? I see little hope of an "immaculate conception" of a fresh, sustainable pattern of economic activity. Until the transition path reveals itself, fiscal policy will be necessary to fill the economic hole likely to exist if

186 the savings proclivities of households continue to exceed the investment intentions of firms. Ironically, the "best" road to growth is also the riskiest from a policy perspective - a rapid expansion of emerging market activity. Such an expansion, however, would once again place the US in competition for global resources, and threaten a reversal of the commodity and interest rate trends that have been so important to supporting US consumers. Indeed, just the whiff of recovery has supported oil prices, promising an abrupt end to one of the factors supporting US consumers. In the worst case scenario, a flight of capital away from the Dollar (in response to more promising investments abroad) would generate an inflationary and structural shock that would leave the Fed juggling between renewed recession and higher inflation. In short, the optimal external shock would be one only partially supportive; anything more would push the globe to a revisiting of the commodity price surge of early 2008. Looking for a decoupling story now, however, seems like almost a naïve dream. What is the Fed's next move? One email crossed my inbox after the April employment report suggested some thinking that the Fed could hike rates as early as November. Such a scenario (absent a stability threatening run on the Dollar) must come from a spectacularly optimistic take on incoming data. Data, I might add, that is a reflection of the massive crutch provided by the Federal Reserve and US Treasury, not necessarily a sea change in the underlying economic environment. Look too how quickly bond rates began to climb after the Fed declined to expand Treasury purchases at the last FOMC meeting. More generally, consider this tidbit on Federal Reserve Chairman Ben Bernanke's thinking back in 2003: The 2003 FOMC transcripts showed then-Governor Ben Bernanke very tuned into financial markets as he pressed for earlier release of Fed forecasts and a willingness to lower interest rates to zero. From the June 2003 FOMC meeting, when the Fed lowered the target fed funds rate to 1%: “I wonder if you might give some thought to whether or not it would make sense tactically to say publicly that we are willing to lower the federal funds rate to zero if necessary…I think it would have a beneficial effect on expectations in that there would no longer be a feeling in the market that we had reached the end of our rope.” “It’s extremely important that we do what we can to maintain the supportive configuration in financial markets. That means continuing our easy monetary policy and, even more important, using our statement to signal our willingness to keep policy easy so long as there is a risk of further disinflation and continuing economic weakness." A year and a half after the end of the 2001 recession, Bernanke was looking at the possibility of lowering rates to zero in order to maintain support for financial markets. And comparatively, financial markets were leaps and bounds healthier in 2003 than now. Is a rate hike really feasible this year - or even next - given the current state of dependence of the financial system on government largess? Moreover, consider the disinflation worries in 2003 and fast forward to last week: Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular,

187 businesses are likely to be cautious about hiring, implying that the unemployment rate could remain high for a time, even after economic growth resumes. In this environment, we anticipate that inflation will remain low. Indeed, given the sizable margin of slack in resource utilization and diminished cost pressures from oil and other commodities, inflation is likely to move down some over the next year relative to its pace in 2008. However, inflation expectations, as measured by various household and business surveys, appear to have remained relatively stable, which should limit further declines in inflation. Now consider the output gap over the last decade:

The current gap already far exceeds that of the last disinflationary scare, and Bernanke expects it to continue to expand further, and then diminish only gradually. As long as the gap continues to expand, Bernanke's bias will be in favor of additional easing. The only question is whether he remains content to allow TALF funds to slowly trickle into the economy, or speeds the pace of policy with expansions of longer dated Treasury purchases. Given Bernanke's past behavior, expecting patience on his part seems unrealistic. Moreover, the last jobs report provides less room for optimism than observers suggest. Importantly, Jim Hamilton notes the decline in hours worked appears unabated; threat of a currency collapse aside, there will be no policy tightening, only easing, until hours worked moves unquestionably and sustainably in a positive trajectory. Bottom Line: The economy looks to be turning a corner relative to the downward cyclical force of last year. But this is only a partial victory, as the factors that that started us down this path - namely, a debt-supported consumer spending dynamic - remain in play, and will likely remain in play for years, arguing for a long period of slow growth, punctuated by short-lived bursts of positive data. In such an environment, and considering the importance of government support to sustain financial stability, the odds favor continued policy easing. Those looking for a more positive scenario are pinning their hopes on either an unlikely rapid return to past patterns of consumer behavior, an unlikely rapid evolution in patterns of economic activity that are not consumer dependent, or a decoupling of emerging market economic activity from the US (which could pose a different set of policy challenges). http://economistsview.typepad.com/economistsview/2009/05/fed-watch-turning-which- corner.html

188

Bank Stock Sales Add Billions in New Capital By Binyamin Appelbaum Washington Post Staff Writer Tuesday, May 12, 2009 The nation's largest banks are taking advantage of the recent stock market rally to raise billions of dollars in new capital, allowing the firms to improve their financial health much more quickly and cheaply than government officials had expected. Capital One of McLean joined four other large banks yesterday in announcing new sales of common stock that together exceed $7 billion. Large banks have announced more than $19 billion in share sales since the government's release of stress test results last week. The success of the sales is relieving the government from months of duty as nearly the sole source of funding for the troubled industry. It also has reduced speculation that the government could be forced to provide so much money to some banks that it would end up with a large ownership stake, effectively nationalizing them. Citigroup still plans to give the government a significant ownership stake, and it remains possible that other banks could be forced to follow if they cannot raise enough money from private sources. "Markets appear comfortable with the survivability of at least the largest 19 banks," Paul Miller, a banking analyst with FBR Capital Markets, wrote in a note to clients yesterday. "The threat of nationalization, at least for some, appears to be off the table." Capital One and three of the other banks, BB&T of North Carolina, U.S. Bancorp of Minnesota and Bank of New York Mellon, said they would use the money to help repay cash infusions by the Treasury Department. Regulators said last week that all four companies have enough money in their capital reserves to weather a long and deep recession, allowing the banks to seek permission from regulators to repay the government's existing investments. The companies hope to escape a variety of federal restrictions on aid recipients, including limits on executive compensation. A fourth bank, KeyCorp of Ohio, is raising money to help meet the government's demand that it build a stronger capital reserve against unexpected losses. Capital One, which operates branches in the Washington area as Chevy , said it would raise about $1.55 billion by issuing 56 million shares of common stock. The company owes Treasury about $3.6 billion. Capital One still must show that it can issue debt without the benefit of a government guarantee before it is eligible to repay Treasury. The company also will need to show regulators that repayment would not further crimp its lending. BB&T, which has a large presence in the Washington area, said it would raise $1.5 billion to help repay the government's investment of $3.1 billion from the Troubled Assets Relief Program. The company also cut its dividend to 15 cents per share from 47 cents to conserve capital. The bank had kept its dividend amid cuts by most of its rivals, rendering the

189 move to cut it now a striking expression of BB&T's determination to repay the government as soon as possible. "We firmly believe this action is in the long-term best interests of our shareholders and our company because of the risk and uncertainty associated with being a TARP participant," chief executive Kelly King said explaining the cut. U.S. Bancorp said it would raise $2.5 billion toward repaying the government's investment of $6.6 billion. The company, which already has issued non-guaranteed debt, said it would formally apply for permission to repay Treasury. Bank of New York Mellon said it would raise $1 billion and seek U.S. approval to repay a $3 billion government investment. KeyCorp's situation is the most complicated. The company was ordered by the government to increase by $1.8 billion its holdings of common equity, a buffer that protects common shareholders from unexpected losses that might otherwise cause a company to fail. KeyCorp said it would issue $750 million in stock as the first step toward increasing that buffer. http://www.washingtonpost.com/wp- dyn/content/article/2009/05/11/AR2009051101088.html

190 Business

May 12, 2009

We’re Dull, Small Banks Say, but Have Profits By DAVID SEGAL INDIANAPOLIS — It’s unlikely that any group of professionals is happier to highlight the dullness of their work than small-town bankers. At a recent conference held here by the Indiana Bankers Association, attendees said it over and over: our business is plodding and boring and we would not have it any other way. “Banking should not be exciting,” said Clay W. Ewing, president of retail financial services at German American Bancorp, a community bank in Jasper. “If banking gets exciting, there is something wrong with it.” It is an ethos squarely at odds with the risk-addicted style of megabanks, like Citigroup and Bank of America, that trafficked in the subprime mortgages and complex financial products that helped drive the country into the grimmest recession in decades. But to the deep chagrin of Mr. Ewing and others at the conference, the public, politicians and the media have made little distinction between the stress-tested behemoths and the 7,630 community banks across the country — the vast majority of which have watched the crisis like bystanders at a 10-car pileup. As a result, community bankers have felt compelled in recent months to mount public relations campaigns to emphasize their fiscal health and in some cases to announce they rejected Troubled Asset Relief Program, or TARP, funds. Some have held cookouts, others have held “reassurance” meetings in their lobbies, hoping to educate customers and prevent panics. All are dealing with banker jokes and the occasional wisecrack. “I was on vacation in California and this guy I had just met said, ‘So, traveling on that bailout money, huh?’ ” said Blake Heid, of First Option Bank in Paola, Kan., which didn’t take any bailout money. “I didn’t find that very amusing.” Though they greatly outnumber the national and regional banks, community banks have barely registered in any of the fallout from the credit crisis, in part because they hold less than 10 percent of the $13.8 trillion in bank assets nationwide. The 50 or so bank failures have been largely clustered in a few states, like Florida, Arizona and California, where the bursting housing bubble had the greatest impact. In states like Indiana, where property values never soared, community banks have been rock solid. The last failure in the state was in 1992. To spend time with these Indiana community bankers is to step into an alternate universe, where everything sounds a little strange because it makes perfect sense. You hear things like, “If you don’t understand the risk you’re taking, don’t take it.” And, “We want to be around for decades, so we’re not focused on the next quarter.” Forget “too big to fail.” These banks consider themselves too small to risk embarrassment. They are run by people who grew up in the towns where they work, and their main fear is getting into a financial jam that will shame them in the eyes of their neighbors. The steep profits earned by national banks didn’t turn their heads in the last decade because they were inherently skeptical of double-digit growth rates.

191 “We like a nice, gentle, upward slope,” said Donald E. Goetz, the president of DeMotte State Bank, an 11-branch operation in the northwest part of Indiana. “This kind of growth, like you see in the stock market” — Mr. Goetz ran his hand through the air, tracing the shape of a mountain range — “that doesn’t interest us.” One recent morning Mr. Goetz gave a tour of his bank, which included a bulletin board with fliers for a fire department fish fry and the Kankakee Valley Women’s Club flower sale. There is a lot of bric-a-brac in his wood-paneled office and a Thomas Kinkade painting of a green-gabled stone house after a snow fall, titled the “Olde Porterfield Gift Shoppe.” “There is one set of footprints, going in,” he said, pointing to the painting. “That’s how we feel as a business sometime. We’re walking alone.” Mr. Goetz, who was wearing a tie and a short-sleeve shirt, started as a teller at DeMotte right after he graduated from college in 1976, and he’s been president since 1988. He is a stolid guy who, when asked what he does for fun, offered two words: “Yard work.” He sounds somewhat aggrieved. His bank, which opened in 1917, didn’t make any subprime loans, nor did it take any bailout money. Even when bank stocks were soaring, not one of his 246 shareholders needled him to earn more than the 3 to 4 percent dividend that DeMotte has generated for years. Still, he’s had to train employees in the art of assuaging the fears of jittery customers. He programmed the blinking signs outside his branches to read “Safe, Strong, Secure.” Despite these efforts, he’s fielded some customer calls at night, to his home. In rare cases, people withdrew their savings. “We had three or four people panic,” he said. “A couple of them said, ‘It’s not the bank. We just don’t trust the government.’ And I told them, ‘If the government fails, the money you’re taking out of this bank won’t be worth anything.’ ” Mr. Goetz, like a lot of his competitors, is livid about the mortgage shenanigans born of the securitization craze. But he thinks his public relations problem had many authors. “The media, Congress, the president, everyone just keeps saying ‘the banks, the banks, the banks,’ like we’re all the same thing,” he said. “Well, we’re not all the same thing.” Explaining that distinction has been especially challenging for community banks that signed up for TARP funds, which initially were pitched by the government as a way to shore up healthy banks. Only later, after the American International Group bonus fiasco, community bankers say, did the TARP acquire a stigma. “We heard a lot of smart-alecky comments,” said James C. Latta, president of the Idaho Banking Company in Boise, Idaho, which took $6.9 million in TARP funds. “A lot of ‘Wish I had a bailout.’ ” At DeMotte, Mr. Goetz is bracing for a steep increase in a crucial overhead cost: the bill from the Federal Deposit Insurance Corporation, which is basically an insurance fund underwritten by banks. Last year, DeMotte paid $42,000 into the fund. This year, because of failures in other parts of the country and particularly among national banks, that sum will rise to $500,000 or more. “Isn’t that the American way?” he says, folding his arms. “Whoever is left standing, whoever was prudent, is always the one who has to pick up the pieces.” http://www.nytimes.com/2009/05/12/business/12small.html?th&emc=th

192 Environment

May 12, 2009 In German Suburb, Life Goes On Without Cars By ELISABETH ROSENTHAL VAUBAN, Germany — Residents of this upscale community are suburban pioneers, going where few soccer moms or commuting executives have ever gone before: they have given up their cars. Street parking, driveways and home garages are generally forbidden in this experimental new district on the outskirts of Freiburg, near the French and Swiss borders. Vauban’s streets are completely “car-free” — except the main thoroughfare, where the tram to downtown Freiburg runs, and a few streets on one edge of the community. Car ownership is allowed, but there are only two places to park — large garages at the edge of the development, where a car-owner buys a space, for $40,000, along with a home. As a result, 70 percent of Vauban’s families do not own cars, and 57 percent sold a car to move here. “When I had a car I was always tense. I’m much happier this way,” said Heidrun Walter, a media trainer and mother of two, as she walked verdant streets where the swish of bicycles and the chatter of wandering children drown out the occasional distant motor. Vauban, completed in 2006, is an example of a growing trend in Europe, the United States and elsewhere to separate suburban life from auto use, as a component of a movement called “smart planning.” Automobiles are the linchpin of suburbs, where middle-class families from Chicago to Shanghai tend to make their homes. And that, experts say, is a huge impediment to current efforts to drastically reduce greenhouse gas emissions from tailpipes, and thus to reduce global warming. Passenger cars are responsible for 12 percent of greenhouse gas emissions in Europe — a proportion that is growing, according to the European Environment Agency — and up to 50 percent in some car-intensive areas in the United States. While there have been efforts in the past two decades to make cities denser, and better for walking, planners are now taking the concept to the suburbs and focusing specifically on environmental benefits like reducing emissions. Vauban, home to 5,500 residents within a rectangular square mile, may be the most advanced experiment in low-car suburban life. But its basic precepts are being adopted around the world in attempts to make suburbs more compact and more accessible to public transportation, with less space for parking. In this new approach, stores are placed a walk away, on a main street, rather than in malls along some distant highway. “All of our development since World War II has been centered on the car, and that will have to change,” said David Goldberg, an official of Transportation for America, a fast-growing coalition of hundreds of groups in the United States — including environmental groups, mayors’ offices and the American Association of Retired

193 People — who are promoting new communities that are less dependent on cars. Mr. Goldberg added: “How much you drive is as important as whether you have a hybrid.” Levittown and Scarsdale, New York suburbs with spread-out homes and private garages, were the dream towns of the 1950s and still exert a strong appeal. But some new suburbs may well look more Vauban-like, not only in developed countries but also in the developing world, where emissions from an increasing number of private cars owned by the burgeoning middle class are choking cities. In the United States, the Environmental Protection Agency is promoting “car reduced” communities, and legislators are starting to act, if cautiously. Many experts expect public transport serving suburbs to play a much larger role in a new six-year federal transportation bill to be approved this year, Mr. Goldberg said. In previous bills, 80 percent of appropriations have by law gone to highways and only 20 percent to other transport. In California, the Hayward Area Planning Association is developing a Vauban-like community called Quarry Village on the outskirts of Oakland, accessible without a car to the Bay Area Rapid Transit system and to the California State University’s campus in Hayward. Sherman Lewis, a professor emeritus at Cal State and a leader of the association, says he “can’t wait to move in” and hopes that Quarry Village will allow his family to reduce its car ownership from two to one, and potentially to zero. But the current system is still stacked against the project, he said, noting that mortgage lenders worry about resale value of half-million-dollar homes that have no place for cars, and most zoning laws in the United States still require two parking spaces per residential unit. Quarry Village has obtained an exception from Hayward. Besides, convincing people to give up their cars is often an uphill run. “People in the U.S. are incredibly suspicious of any idea where people are not going to own cars, or are going to own fewer,” said David Ceaser, co-founder of CarFree City USA, who said no car-free suburban project the size of Vauban had been successful in the United States. In Europe, some governments are thinking on a national scale. In 2000, Britain began a comprehensive effort to reform planning, to discourage car use by requiring that new development be accessible by public transit. “Development comprising jobs, shopping, leisure and services should not be designed and located on the assumption that the car will represent the only realistic means of access for the vast majority of people,” said PPG 13, the British government’s revolutionary 2001 planning document. Dozens of shopping malls, fast-food restaurants and housing compounds have been refused planning permits based on the new British regulations. In Germany, a country that is home to Mercedes-Benz and the autobahn, life in a car- reduced place like Vauban has its own unusual gestalt. The town is long and relatively narrow, so that the tram into Freiburg is an easy walk from every home. Stores, restaurants, banks and schools are more interspersed among homes than they are in a typical suburb. Most residents, like Ms. Walter, have carts that they haul behind bicycles for shopping trips or children’s play dates.

194 For trips to stores like IKEA or the ski slopes, families buy cars together or use communal cars rented out by Vauban’s car-sharing club. Ms. Walter had previously lived — with a private car — in Freiburg as well as the United States. “If you have one, you tend to use it,” she said. “Some people move in here and move out rather quickly — they miss the car next door.” Vauban, the site of a former Nazi army base, was occupied by the French Army from the end of World War II until the reunification of Germany two decades ago. Because it was planned as a base, the grid was never meant to accommodate private car use: the “roads” were narrow passageways between barracks. The original buildings have long since been torn down. The stylish row houses that replaced them are buildings of four or five stories, designed to reduce heat loss and maximize energy efficiency, and trimmed with exotic woods and elaborate balconies; free-standing homes are forbidden. By nature, people who buy homes in Vauban are inclined to be green guinea pigs — indeed, more than half vote for the German Green Party. Still, many say it is the quality of life that keeps them here. Henk Schulz, a scientist who on one afternoon last month was watching his three young children wander around Vauban, remembers his excitement at buying his first car. Now, he said, he is glad to be raising his children away from cars; he does not worry much about their safety in the street. In the past few years, Vauban has become a well-known niche community, even if it has spawned few imitators in Germany. But whether the concept will work in California is an open question. More than 100 would-be owners have signed up to buy in the Bay Area’s “car- reduced” Quarry Village, and Mr. Lewis is still looking for about $2 million in seed financing to get the project off the ground. But if it doesn’t work, his backup proposal is to build a development on the same plot that permits unfettered car use. It would be called Village d’Italia. http://www.nytimes.com/2009/05/12/science/earth/12suburb.html?hpw

195

11.05.2009 Iceland’s new government pushes EU accession

Iceland’s new leftish government has formally decided to start a process leading to full EU accession, a decision to be backed up a parliamentary vote next Friday, Coulisse de Bruxelles reports. This will be the second day of session of the new parliament – and a sign of the urgency the Icelandic government attaches to this issue. The government wants to make a formal request for EU accession by July. The latest polls suggest that over 60% of the population is in favour of accession negotiations, with 27% against. It looks like another (not so) Grand Coalition You can do the math. According to the latest opinion poll in Germany, Angela Merkel’s Christian Democrats would get 34%, the SPD get 25%, the Liberals 17%, the Greens, and the Left Party get 10% each. Since everybody rules out a coalition with the Left, this would leave only the following choices: 1. CDU, FDP (if the sum of the two exceeds 50%, or thereabouts, which is the case in the above-mentioned poll) 2. CDU, FDP, Greens (if the sum of CDU and FDP does not exceed 50%) 3. SPD, FDP, Greens 4. CDU, SPD: The Grand Coalition Over the weekend the Greens have ruled out option 2, the Liberals have ruled out option 3. This means either a centre-right CDU/FDP coalition with a wafer-thin majority, or another Grand Coalition. Note, Angela Merkel would be the chancellor in either case. The FT has more. Green shoots Watch The US The green shoots are sprouting everywhere. The New York Times has a story (hat tip Calculated Risk) that Christina Romer, head of the Council of Economic Advisers, predicts a return to positive growth rate in Q4, and an increase in economic

196 growth to nearly 3% in 2010, which is close to trend growth, with unemployment peaking at 9.5%. The blog disagrees, and believes the recovery will be more sluggish, noting that a couple of months ago, commentators were forecasting another Great Depression, while now they are talking about an immaculate recovery. UK The blog entry also links to an article in the Daily Telegraph about a forthcoming, very optimistic assessment by the Bank of England about UK economic prospects. Services The FT has the story that European service sector companies have recovered much of the confidence they had lost last year. 39.5% of service providers expect the volume of their business to improve over the next year, with 21.5% forecasting a decline . according to a poll. Irish construction The downturn in the Irish construction sector in activity may have bottomed out, according to a new survey of activity in the sector, reports the Irish Independent. The Construction Purchasing Managers' Index, a measure of overall performance in the construction sector, still shows that the building sector is shrinking but it is less dramatic in April (32.9) than the previous month (28.1). Employment still declined substantially, while the falls in activity and new business remained sharp but there are early signs of stabilisation. Merkel and Sarkozy cling to their only common agreement – on Turkey and the EU Relatively unreported is the meeting between Angela Merkel and Nicolas Sarkozy this Sunday. Only Le Monde has a short notice with some well known quotes. Merkel reaffirmed her opposition of Turkey’s EU entry and criticised those who oppose the Lisbon Treaty but favour enlargement. Sarkozy could not agree more. Both rejoiced in their common achievements and reaffirmed that France and Germany are still the motor of Europe. Nothing new really, so the question is, what disagreement did they left out?

Is financial innovation worth it? Adam Posen and Marc Hinterschweiger, writing in the Peterson Institute’s Real Time Economic Watch, say that financial innovation is not at all that important – and should certainly not be used as an excuse for going soft on regulation. The produce a chart showing that despite the growth of credit derivatives, US gross fixed capital formation hardly moved. The evidence from what was hailed as financial innovations in recent years suggests parallels with the Chernobyl nuclear power technology.

Munchau on Barroso Wolfgang Munchau writes in the FT that the fish stinks from the head downwards – a fitting descripition for the European Commission, whose president Jose Manual Barroso is now very likely to reappointed for another five year term. He argues that this is a bad choice. Barroso has failed to show any leadership during the crisis, which is one of the factors why the EU has failed to produce a coherent response. Munchau says Borroso has spent most of the last couple of years campaigning for his reelection,

197 rather than doing his job. He agrees with Helmut Schmidt’s recent statement that the ECB is only European institution that current works. Why Steinbruck is immensely popular in Germany It looks as though Peer Steinbruck’s military metaphors in the tax shelter dispute with Austria, Switzerland, Luxembourg and Liechtenstein are becoming increasingly popular in Germany. A good example is an FT Deutschland Oped, written by Stefan Weigel, who fully supports the German finance minister on the grounds that he is justified to protect his tax revenue base. He said Luxembourg should admit openly that it does not care about the origins of the money its banking system receives, and that it should end the hypocrisy to trying to portray itself as the victim here. http://www.eurointelligence.com/article.581+M5762e628361.0.html SUNDAY, MAY 10, 2009 A Return to Trend Growth in 2010? by CalculatedRisk on 5/10/2009 06:44:00 PM From the NY Times: White House Forecasts No Job Growth Until 2010 Speaking on C-SPAN, Christina Romer, chairwoman of the White House Council of Economic Advisers, said that she expected the G.D.P. to begin growing in the fourth quarter of this year. ... Ms. Romer also said that she expected unemployment to rise even after the economy turns, saying that the G.D.P. has to grow at a rate of about 2.5 percent before unemployment will fall. Before that happens, she said, it is “unfortunately pretty realistic” that the unemployment rate could reach 9.5 percent. A reasonable estimate for the G.D.P.’s growth rate in 2010, she said, is three percent. Three percent is pretty close to trend growth. Although three percent is possible, I think a more sluggish recovery is likely. Note: Romer isn't forecasting a "V-shaped" recovery with strong growth coming out of the recession.

The usual engines of recovery - personal consumption expenditures (PCE) and residential investment (RI) - will both be under pressure. With nearly stagnant wages and a rising saving rate (my forecast based on households repairing balance sheets and an aging population), PCE growth will probably be below trend. And for RI, there is far too much inventory for any significant rebound in new home construction. Where will growth come from? Not investment - there is too much capacity.

Meanwhile the banking system is still very fragile, with the Obama administration gambling that the banks will earn their way out of the mess.

I'm still amazed by the bipolar outlooks of forecasters: just a few months ago, many forecasters were openly talking about a 2nd Great Depression (while I was writing about seeing a bottom in a few key leading indicators), and now some forecasters are talking about an immaculate recovery. Amazing. http://www.calculatedriskblog.com/2009/05/return-to-trend-growth-in-2010.html

198

Business

May 11, 2009 Administration Plans to Strengthen Antitrust Rules By STEPHEN LABATON WASHINGTON — President Obama’s top antitrust official this week plans to restore an aggressive enforcement policy against corporations that use their market dominance to elbow out competitors or to keep them from gaining market share. The new enforcement policy would reverse the Bush administration’s approach, which strongly favored defendants against antitrust claims. It would restore a policy that led to the landmark antitrust lawsuits against Microsoft and Intel in the 1990s. The head of the Justice Department’s antitrust division, Christine A. Varney, is to announce the policy reversal in a speech she will give on Monday before the Center for American Progress, a liberal policy research organization. She will deliver the same speech on Tuesday to the United States Chamber of Commerce. The speeches were described by people who have consulted with her about the policy shift. The administration is hoping to encourage smaller companies in an array of industries to bring their complaints to the Justice Department about potentially improper business practices by their larger rivals. Some of the biggest antitrust cases were initiated by complaints taken to the Justice Department. Ms. Varney is expected to say that the administration rejects the impulse to go easy on antitrust enforcement during weak economic times. She will assert instead that severe recessions can provide dangerous incentives for large and dominating companies to engage in predatory behavior that harms consumers and weakens competition. The announcement is aimed at making sure that no court or party to a lawsuit can cite the Bush administration policy as the government’s official view in any pending cases. In the speeches, Ms. Varney is expected to explicitly warn judges and litigants in antitrust lawsuits not involving the government to ignore the Bush administration’s policies, which were formally outlined in a report by the Justice Department last year. The report applied legal standards that made it difficult to bring new cases involving monopoly and predatory practices. As a result of the Bush administration’s interpretation of antitrust laws, the enforcement pipeline for major monopoly cases — which can take years for prosecutors to develop — is thin. During the Bush administration, the Justice Department did not file a single case against a dominant firm for violating the antimonopoly law. Many smaller companies complaining of abusive practices by their larger rivals were so frustrated by the Bush administration’s antitrust policy that they went to the European Commission and to Asian authorities.

199 Ms. Varney’s new policy more closely aligns American antitrust policy on monopolies and predatory practices with the views of antitrust regulators at the European Commission. Herbert Hovenkamp, a leading antitrust scholar regarded as a centrist between those seeking more aggressive enforcement and those who generally argue for restraint, said the guidelines by the Bush administration were “a brief for defendants.” He said that the repudiation of those guidelines by the Obama administration “will almost certainly have a greater impact than the guidelines themselves had.” “This will be bad news for heavyweights in the tech industries — companies like Google and Microsoft,” said Professor Hovenkamp, who teaches at the University of Iowa College of Law. “People aligned with plaintiffs will rejoice. Those aligned with defendants will wring their hands. A lot of law firms will be indifferent because they take money from both sides.” Ms. Varney is expected to say that the Obama administration will be guided by the view that it was a major mistake during the outset of the Great Depression to relax antitrust enforcement, only to try to catch up and become more vigorous later. She will say the mistake enabled many large companies to engage in pricing, wage and collusive practices that harmed consumers and took years to reverse. While Ms. Varney is not expected to mention any specific companies or industries vulnerable under the new policy, those who have talked to her about the speech say she is aiming at agriculture, energy, health care, technology and telecommunications companies. She may also be reviewing the conduct of some in the financial services industry, which is now undergoing a wave of consolidation as a result of the financial crisis. Ms. Varney, who headed the Internet practice group of the Washington-based Hogan & Hartson law firm, served as a commissioner at the Federal Trade Commission in the 1990s after working in the White House during the early years of the Clinton administration. Signaling her intent to revive a moribund antitrust program, she has recruited a collection of senior aides, many of whom are seasoned antitrust litigators or worked in the Clinton administration and the Federal Trade Commission and were involved in many prominent cases, including the one against Microsoft. They include Molly S. Boast, William Cavanaugh, Gene Kimmelman, Carl Shapiro and Philip J. Weiser. Antitrust policy is set by Washington in two ways: by the interpretation of laws announced by the Justice Department and the Federal Trade Commission through guidelines for the courts and private litigants, and by the enforcement cases that those agencies decide to bring. The government’s guidelines are often cited by lawyers and given considerable weight by judges in antitrust cases, including those lawsuits that the government does not participate in. It is not unlawful for a company to gain control of a market. It becomes unlawful if the company engages in conduct to exclude or harm competitors with no business justification.

200 Conservative antitrust experts, some judges and defendants in such cases have said that the line is too difficult to draw and that it is better to let rivalries play out in the marketplace than in the courts. After more than a year of hearings and studies, the Justice Department in 2008 published a 215-page report analyzing Section 2 of the Sherman Antitrust Act, explaining the government’s approach to the monopolistic and predatory practices of companies. Reflecting deep skepticism of the role of government in the marketplace, the 2008 report made formal a set of policies that had largely been followed by the Justice Department, but not by the Federal Trade Commission, during the Bush administration. When the report was issued, Thomas Barnett, then the head of the antitrust division and the architect of the guidelines, said that they were meant to articulate “clear standards” for determining whether certain types of conduct by large companies would harm competition. In a rare split with the Justice Department, three of the four commissioners at the Federal Trade Commission denounced the guidelines, calling them “a blueprint for radically weakened enforcement” against anticompetitive practices.

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Investment Outlook Bill Gross | May 2009

2 + 2 = 4 A photograph of Bernard Baruch looms ominously on the far corner of my PIMCO office wall. Vested, with pocket watch and protruding chin thrust prominently toward the observer, this well-known financier of the early 20th century at times appears almost alive. It was Baruch who almost schizophrenically cautioned investors during the stock market’s speculative blow-off in the late 20s that “two plus two equals four and no one has ever invented a way of getting something for nothing.” Three years later during the depths of economic and financial gloom he opined just the opposite: “Two plus two still equals four,” he said, “and you can’t keep mankind down for long.” Homo sapiens, as it turns out, stayed on the deck for much longer than Baruch envisioned – some historians having suggested that it was only war and not the rejuvenating economic spirits of a capitalistic peace that eventually turned the tide – but his words, first of caution and then of optimism, typify the way that fortunes were, and still are, made in the financial markets: Get your facts straight, apply them to the current valuation of the market, take decisive action, and then hold on for dear life as the mob hopefully comes to the same conclusion a little way down the road.

I stare into Baruch’s eyes almost every day – not that we are simpatico or kindred spirits of any sort – but when I do, it’s as if I can hear him almost whispering to me over the portals of time: “Two plus two,” he commands, “two plus two, two plus two.” The message – fortunately, I suppose – ends there. If you thought I was receiving market calls from the ghost of Bernard Baruch I suspect PIMCO would have far fewer clients than we do today. But his lesson nonetheless remains clear: separate reality from exuberance either on the up or the downside and you have the ingredients for a successful market strategy. Through my years here at PIMCO there have been numerous demarcation points where Baruch’s whispers almost turned into screams. Two plus two screamed four in September of 1981 with long-term Treasury yields approaching 15%, and two plus two boomed four in 2000 when the Dot Coms rose to prices that discounted the hereafter instead of the next 30 years. Similarly, 2007 was a screaming mimi with the subprimes – if only because the liar loans and no-money-down financing were reminiscent of a , , or some other type of wizardry that was bound to lead to tears. 2009 is a similar demarcation point because it represents the beginning of government policy counterpunching, a period when the public with government as its proxy decided that private market, laissez-faire, free market capitalism was history and that a “private/public” partnership yet to gestate and evolve would be the model for years to come. If one had any doubts, a quick, even cursory summary of President Obama’s comments announcing Chrysler’s bankruptcy filing would suffice. “I

202 stand with Chrysler’s employees and their families and communities. I stand with millions of Americans who want to buy Chrysler cars (sic). I do not stand…with a group of investment firms and hedge funds who decided to hold out for the prospect of an unjustified taxpayer-funded bailout.” If the cannons fired at Ft. Sumter marked the beginning of the war against the Union, then clearly these words marked the beginning of a war against publically perceived financial terror. Make no mistake, PIMCO had no dog in this fight, and has infinitesimally small holdings of GM bonds as well. In turn, the rebalancing of wealth from the rich to the “not so rich” is a long overdue reversal, one that I have encouraged in these Outlooks for at least the past several years. But promoting and siding with the majority of the American public in their quest for change does not mean that as investors, we at PIMCO stand star-struck like a deer in front of the onrushing headlights, doing nothing to protect clients. Our task is to identify secular transitions and to preserve and protect capital if indeed it is threatened. Now appears to be one of those moments. The threat, of course, falls under the broad umbrella of “burden sharing” and is a difficult one to interpret and anticipate, if only because the concept is evolving in the minds of policymakers as well. But clearly, as this financial crisis has morphed from Bear Stearns to FNMA, Lehman Brothers, AIG and now Chrysler, the claims of stockholders and in some cases senior debt holders have suffered. Please hear me on this. That is the way it should be. Capitalism is about risk taking and if you’re not a risk taker, you should have your money in the bank, Treasury bills, or a savings bond, not the levered investment of a bank or an aging automobile company. Let there be no company too big, too important, or too well-connected to fail as long as the systemic health of the economy is not threatened. Having acknowledged that, however, let me be clear that these risks, long swept under the rug of prior Administrations, are now rising to a boil. The pressure to “survive well” or simply survive period is now clearly shifting to Wall Street as opposed to Main Street. The worm has turned, and our President, whom I voted for and still strongly support, has shed his predecessor’s regal robes for a populist’s cloak.

How does one invest during such a transition? Investors should recognize that this grassroots trend signals – most importantly – an increasing uncertainty of cash flows from financial assets. Not only will redistribution and reregulation lead to slower economic growth, but the financial flows from it will be haircutted and “burden shared” by stakeholders. In turn, the present value of those flows should reflect an increasing risk premium and a diminishing multiple of annual receipts. PIMCO’s Paul McCulley, famous for a catchy phrase or a light-bulb-generating truism, asked a group of clients the other day to compare FedEx and UPS to the U.S. Post Office, if it were a public corporation. “Which one would you pay more for?” he asked. If FedEx deserves a P/E of 12, wouldn’t the value of the Post Office be substantially less? His point, and mine as well, is that as wealth is redistributed, and the invisible private hand of Adam Smith begins to resemble more and more the public fist of government, then asset values should be negatively affected. First comes the haircutting and burden sharing, most recently evidenced by Chrysler and soon to be played out via the stress testing and equity dilution of government ownership of ailing banks. In those footsteps, however, will follow a slower rate of economic growth, not just in the U.S., but worldwide as heretofore libertarian capitalism is bridled, saddled and taught to trot instead of gallop over the investment plains.

203 This Outlook is not to bemoan this transition, but to recognize it. Slower growth can be a public good if it avoids the cataclysmic effects of double-digit unemployment, escalating foreclosures, and fear of financial insecurity. But the Obama cannon shot will have financial consequences. Do not be deceived by the euphoric sightings of “green shoots” and the claims for new bull markets in a multitude of asset classes. Stable and secure income is still the order of the day. Shaking hands with the new government is still the prescribed strategy, although it should be done at a senior level of the balance sheet. If the government indeed becomes your investment partner, you should keep the big Uncle in clear sight and without back turned. Risk will not likely be rewarded until the global economy stabilizes and the Obama rules of order are more clearly defined. The ghost of Bernard Baruch still counsels that 2 + 2 = 4, but the repercussions of getting something for nothing should dominate the hopes that mankind will get off the deck and revert to a mean or median standard representative of outdated political and economic philosophies. Mohamed El-Erian’s and PIMCO’s “new normal” should trump green shoot exuberance for years to come.

William H. Gross Managing Director

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REPORTAJE: OPINIÓN Hacia un nuevo capitalismo La crisis mundial no marcará en 2009 el final de ciclo del actual sistema económico, pero será la causa de las importantes reformas que deberá afrontar la economía de libre mercado TIMOTHY GARTON ASH 10/05/2009 Qué queremos que surja de la mayor crisis que ha visto el capitalismo en 70 años? Si tuviera que responder con una sola frase, diría que unos modelos nuevos para una economía de mercado social y sostenible. Y eso exige que cambiemos nosotros, además de los Estados. El capitalismo no acabará en 2009 como acabó el comunismo en 1989. Está demasiado arraigado y es demasiado variado y demasiado adaptable para sufrir una muerte tan brusca. Existen hoy en el mundo muchas más variedades de capitalismo que las que hubo en su día de comunismo, y esa diversidad es uno de sus puntos fuertes. El arco iris va desde el salvaje oeste hasta el salvaje oriente, y abarca grandes variantes nacionales de la economía de mercado, como China, que los puristas dirían que no son capitalismo en absoluto. Por consiguiente, algunas versiones del capitalismo capearán el temporal; otras quedarán en ruinas o, al menos, sufrirán reformas sustanciales. A esta última categoría parece pertenecer una versión "neoliberal" extrema de la economía de libre mercado, caracterizada no sólo por la amplia desregulación y privatización, sino también por un espíritu de avaricia digno de Gordon Gekko, y que sólo se practica plenamente en algunas áreas de las economías anglosajonas y poscomunistas. Pero ¿qué pasaría con una versión modernizada y reformada de lo que los pensadores alemanes de posguerra llamaron la "economía social de mercado"? Una economía de libre mercado, sin ninguna duda, pero que exige que el Estado proporcione un firme marco legal y regulador para la empresa privada; la participación de los accionistas, pero también de los afectados por las decisiones; un intento de equilibrar los intereses inmediatos y las consideraciones a largo plazo a la hora de tomar decisiones económicas; el compromiso nacional de que haya un mínimo social para todos los ciudadanos, y un sólido espíritu moral entre quienes se dedican a los negocios. Eso debe combinarse con las demandas del siglo XXI de sostenibilidad ecológica ante el cambio climático y sostenibilidad ética ante la pobreza mundial. Una tarea difícil, no hay duda. Hay que tener en cuenta asimismo el equilibrio entre los niveles nacionales e internacionales de regulación y gobierno. Mervyn King, el gobernador del Banco de Inglaterra, ha dicho que los grandes bancos privados actuales son globales en la vida pero nacionales en la muerte. Cuando llega el momento de rescatarlos, es el Gobierno nacional más directamente relacionado el que toma la iniciativa. Y eso significa que pagamos la factura los contribuyentes nacionales. Sin embargo, toda esa historia de Estados y sistemas no es más que la mitad de la cuestión. Lo que nos metió en el lío actual fue el comportamiento de unos seres humanos concretos, y es el comportamiento de los seres humanos lo que tiene que cambiar, además de la estructuración de los sistemas. Es algo evidente, sobre todo, en el caso de los banqueros, pero no debemos creer que se limita sólo a ellos. La conducta de

205 los banqueros que nos arrojaron al lodo -no todos los banqueros, desde luego, pero sí unos cuantos- quizá no fue ilegal, pero fue egoísta, irresponsable e inmoral. Año tras año, obtenían enormes beneficios personales a partir de unos activos cuya verdadera naturaleza y cuyas perspectivas no comprendían o ignoraban llenos de cinismo. Justificaban sus sueldos y sus primas, desproporcionados para las sumas que casi todo el resto de la gente ganaba en las sociedades a su alrededor, porque estaban "relacionados con el rendimiento", pero ese "rendimiento" se medía con indicadores insuficientes y a lo largo de un plazo demasiado breve. La remuneración de los altos cargos se basaba en la necesidad de marcar unos puntos de referencia competitivos con los rivales, y se oía a algún jefazo quejarse de que otro estaba ganando seis millones de euros al año cuando él sólo ganaba cinco. Y salían tan felices de sus bancos. "La City se ha portado muy bien conmigo", era el eufemismo típicamente inglés con el que definían ese barroco proceso de enriquecimiento. Como ya había ocurrido en otras cosas, los novelistas (como Tom Wolfe) y los cineastas (como Oliver Stone con su Wall Street, protagonizada por el personaje de Gordon Gekko) se adelantaron a economistas y politólogos en el diagnóstico del problema. La justificación clásica de por qué los capitalistas ganan tanto dinero es el riesgo que corren, pero en este caso ni siquiera corrieron el riesgo. Fuimos nosotros. Cuando estalló la burbuja, nosotros, los contribuyentes, tuvimos que hacernos cargo de la factura, y tanto nosotros como nuestros hijos seguiremos pagándola durante décadas. Cerca de donde vivo, en Oxford, se han restaurado unas enormes mansiones victorianas para utilizarlas como viviendas unifamiliares, con todo lujo de detalles y sin reparar en gastos. Hace un año contemplaba las mansiones con ironía y asombro, pero también pensando ingenuamente que sus nuevos propietarios se habían ganado ese estilo de vida neoaristocrático. Ahora, las miro casi con ira. Un amigo que ha dedicado toda su vida a estudiar las economías más pobres del mundo dice que esos banqueros deberían arrostrar consecuencias legales personales por su insensatez y su egoísmo. Sugiere que se cree un delito de banquicidio, comparable al de homicidio en el sentido de que no sería necesario probar que hubo mala intención previa. Una idea maravillosa, pero que no me parece práctica ni, en realidad, deseable, porque significaría violar el principio legal fundamental de que una cosa es un delito sólo si era ilegal en el momento de hacerla. Ahora bien, sí creo que los que son directamente responsables, como sir Fred Goodwin del Royal Bank of Scotland, deberían devolver parte de sus ganancias personales desmesuradas e inmerecidas. Y otros deberían devolver a la sociedad, aunque sólo sea en forma de filantropía, más de lo que, en definitiva, le han quitado. Pero no podemos echarles la culpa de todo. Cada británico o estadounidense corriente que se gastó un dinero que no tenía, alentado por los altísimos precios de la vivienda, la laxitud de los préstamos hipotecarios y la publicidad seductiva, tiene parte de responsabilidad. Como también la tienen, aunque parezca extraño, los superfrugales chinos, cuyos enormes ahorros se reciclaron para permitir -e incluso estimular de forma indirecta- el despilfarro occidental. Hace más de 30 años, Daniel Bell examinó en su libro Cultural contradictions of capitalism la paradoja de que el dinamismo del capitalismo depende de que los individuos vivan con arreglo a unos valores ligeramente distintos en sus facetas personales de productores y consumidores. Tomó prestado el famoso argumento de Max Weber sobre la ética protestante y el espíritu del capitalismo, y lo amplió para sugerir que la faceta productiva se basa en que las personas se rijan por valores como el

206 esfuerzo, la puntualidad, la disciplina y la voluntad de aceptar una gratificación aplazada. En cambio, la faceta consumidora se basa en que sean expansivas y dadas a permitirse caprichos, buscar el placer y vivir el momento. A eso hay que añadir la nueva tensión de que el planeta no puede sostener a más de 6.000 millones de personas que aumentan sin cesar unos niveles de vida obtenidos gracias a los métodos de producción y consumo utilizados hasta ahora. Y para complicar aún más las cosas está el argumento moral de que los ricos del mundo no tienen derecho a negar a los pobres una vida material mejor, que de todas formas no sería más que una fracción de la que disfrutamos nosotros. Lo que todo eso produce no es sólo un interrogante estructural, sino un reto personal para cada uno de nosotros. Un reto que consiste en encontrar un nuevo equilibrio en nuestras dobles vidas como productores y consumidores y, al mismo tiempo, contribuir de forma consciente a una serie más amplia de nuevos equilibrios internacionales entre economía y medioambiente, un oriente superahorrador y un occidente supergastador, un norte rico y un sur pobre. A eso me refiero también cuando hablo de una economía social de mercado que sea sostenible.

207 May 8, 2009 Ten Reasons Why the Stress Tests Are “Schmess” Tests and Why the Current Muddle-Through Approach to the Banking Crisis May Not Succeed Nouriel Roubini | What shall we make of the recently announced results of the stress test? Are they credible? Will they restore confidence in our battered financial system? Will the current approach to resolving the financial crisis work, be effective and minimize the fiscal costs of the financial bailout? For a number of reasons these results are a significant underestimate of the capital/equity needs of these 19 large US banks. Also this underestimate of the losses and the current “muddle-through” approach to the banking and financial crisis may accelerate the creeping partial nationalization of the US financial system, exacerbate moral hazard distortions, not resolve the too-big-to-fail problem, increase the fiscal costs of this financial crisis, make the credit crunch last longer and lead some near insolvent financial institutions to become zombie banks. Let me explain in ten points why I hold such views (see also my two recent op-eds with Matt Richardson in the WSJ and the FT): First, the stress tests are not stressful enough. As discussed in a previous note current levels of unemployment rates are already higher than those assumed in the more adverse scenario; and even assuming that the rate of job losses will slow down over the next few months to a 400-500K monthly range it is highly likely that the US will reach an unemployment rate of 10% by the fall of 2009, a rate of 10.5% by the end of 2009 and a rate above 11% some time in 2010; instead the parameters of the stress tests assumed that the unemployment rate would average 10.3% in the more adverse scenario in 2010, not 2009. Note also that the parameters for the more adverse scenario in the stress tests were a political compromise among the agencies involved in the stress tests; one of these agencies had found more realistic the hypothesis that the parameter for the unemployment rate in the more adverse scenario should be 12% rather than 10.3%. Moreover, the stress tests found that the 19 banks needed $185 bn of additional equity; the published figure of $75 is based on assets dispositions and capital raises of $110 bn that are still under way and, in most cases, not completed yet. Booking such increases in equity before they have occurred does not seem appropriate accounting procedure. Second, the capital/needs of these banks depend on a race between retained earnings before writedowns/provisioning that will be positive given a high net interest rate margin and the losses deriving from further writedowns. It appears that regulators have overestimated the amount of such retained earnings for 2009-2010. The IMF recently estimated that retained earnings (after taxes and dividends) for all US banks – not just these 19 ones – would be only $300 bn total over the 2009-2010 period. The stress tests – instead – assumed much higher retained earnings - $362 bn - for these 19 banks alone for the 2009-2010 period in the more adverse scenario. Since these 19 banks account for about half of US banks assets if one were to use the IMF estimate of net retained earnings for these 19 banks their net retained earnings for 2009-2010 would be $150 bn rather than the $362 bn assumed by the

208 regulators. While the IMF may have been too conservative in its estimates of net retained earnings it appears that regulators may have been too generous to these 19 banks in forecasting their earnings in an adverse scenario. Thus, ex-post capital needs will be significantly higher if net retained earnings turn out to be lower than assumed in the stress tests. While regulators resisted the banks’ attempt to use Q1 earnings (that were fudged via under-provisioning for loan losses, paper gains on securities via changes in FASB rules on mark-to-market, and accounting gains coming from the lower market value of bank liabilities) as proxy for the future profitability of banks it appears that such regulators were too optimistic in estimating what net retained earnings will be in 2009-2010. Third, banks bargained hard to reduce the regulators estimates of needed additional equity. For example, according to press reports Citigroup was initially assessed to need an additional $30bn of equity; such figure was then reduced to $5 billion after aggressive bargaining by the bank. One can only guess how much higher were the regulators initial estimates of the banks’ capital needs and how much lower the published estimates became after the banks lobbied for lower figures. Fourth, the estimates of additional losses on loans - $445 bn - appear to be relatively reasonable even if they could end up being significantly higher in a weaker macro scenario. But estimates of losses on securities - $154bn – are most likely too low. And the results of the stress scenario do not provide details on how much regulatory forbearance has been provided in the estimate of losses on securities; while current market values of some securities may be lower than long term values given an illiquidity premium many banks still keep many of these securities in the level 2 and 3 buckets and use a mark-to-model, rather than a mark-to-market approach to value these assets. Certainly in the last year regulators have been lenient and provided plenty of forbearance – on top of expensive formal guarantees of hundreds of billions of toxic assets for several banks – to reduce the amount of revealed losses on securities. Also, if one were to bring forward to today the writedowns/charge-offs for 2009-2010 estimated by the US regulators (an exercise that the IMF has done for all US banks in its recent Global Financial Stability Report) the TCE ratio for these 19 banks – and all US banks - would be effectively 0.1% today. So, the US regulators estimates of equity needs of these 19 banks are heavily depended on what net earnings before writedowns will be in 2009-2010. Fifth, estimates of net retained earnings before writedowns are massively beefed up by the direct and indirect subsidies that the government is providing to the financial system: with the Fed Funds rate and deposit rates now close to 0% and with banks having been able to borrow since last year about $350 bn at close to 0% interest rates given the FDIC guarantee on new borrowings the bank can now earn a fat net interest rate margin that is a direct subsidy to financial institutions. The Fed is also losing a fortune on its three Maiden Lane funds that purchased toxic assets of Bear Stearns and AIG. On top of this major US financial institutions got a massive direct subsidy from the bailout of AIG. Overall, the US government has committed – between liquidity supports, recapitalization, insurance of bad assets, guarantees – over $13 trillion of resources to the financial system and already provided $3 trillion of such resources to the financial institutions. The financial system is already effectively a ward of the state in spite of the fact that all these direct and indirect subsidies have bailed out both the shareholders and the unsecured creditors of financial institutions. Even taking into account the fact that not all of these resources will represent a net long term loss to the US taxpayer even a conservative estimate of the net subsidy to the banks’ shareholders and unsecured creditors may be above $500 bn. Sixth, in estimating equity needs of these 19 banks the regulators correctly used a measure of capital – Tangible Common Equity or TCE – that is narrower than Tier 1. Tier 1 capital includes many forms of capital – on top of tangible common equity – that are of poor quality as a buffer against losses or outright fishy: preferred equity and in particular intangible

209 assets and goodwill. While Tier 1 capital of US banks was – at the end of 2008 – about $1,550 common tangible equity was only about $560 bn. The regulators estimated equity needs of the 19 banks based on a TCE ratio of 4% (as a percent of tangible assets). However, even 4% implies a leverage ratio for these banks of 25. The IMF instead – properly – considered a scenario where the TCE ratio is increased to 6% that is equivalent to a leverage ratio of 17 that represent the average leverage ratio for all US banks in the mid- 1990s before leveraged shot up in the latest credit bubble. A capital adequacy ratio is also certainly necessary for these banks as they are systemically important: every academic analysis of systemic risk suggests that banks that are systemically important should have much higher capital in order to internalize the externalities deriving from too-big-to-fail distortions. And while Basel criteria for capital adequacy have not been yet revised to include this need for additional capital for too-big-to-fail banks the G20 and the FSF have already acknowledge the need to charge more capital for such large institutions. Indeed, some national regulators have already moved to increase the capital required from their own banks: for example Switzerland has already unilateral imposed a 16% capital ratio for its systemically important banks to be phased in by 2013, a ratio that is double the Basel criteria of 8% for Tier 1 and Tier 2. Thus, it would have been appropriate that US regulators request that these 19 banks – that are all deemed to be systemically important – should aim to achieve a TCE ratio of at least 6% - not 4% - equal to the one prevailing in the mid-1990s for all US banks (not just the systemically important ones). The capital needs of all US banks would have been an additional $225 bn (based on IMF estimates) if the TCE ratio were to be increased from 4% to 6%. For these 19 banks a 6% TCE ratio – the minimum justifiable for systemically important institutions – would imply about an additional $100 bn of common equity compared to the estimates of the regulators. Seventh, considering even only the need for a higher TCE ratio for too-big-to-fail banks – let alone the implications of other factor discussed above that would have increased the estimates of capital needs for US banks – all 19 banks would have required higher TCE. Giving a clean bill of financial health to half a dozen too-big-to-fail banks – including JP Morgan Chase and Goldman Sachs – that have survived this financial crisis only because of the massive direct and indirect subsidies received from the US government is a public disservice in two ways: first, it does not recognize that these banks survived the crisis only because of the government subsidies (liquidity, insurance, guarantees, recapitalization); second, it ignores the fundamental fact that too-big-to-fail banks should have much more tangible common equity than the one that they currently hold. It is reckless behavior by regulators to ignore the too-big-to-fail distortion that derives from excessively low capital ratios and not to start demanding from such systemically important banks additional capital to control for this negative externality. Indeed, the problem with the current approach to the financial crisis is that the too-big-to- fail problem has become an even-bigger-to-fail problem and that moral hazard distortions from government bailouts have been sharply increased via trillions of dollars committed to backstop the financial system. First, while some significant support of the financial system was necessary and desirable to stop bank runs, reduce serious refinancing risks and avoid a more severe credit crunch the extent of the support and subsidy of the financial system has created the mother of all moral hazard distortions. Second, the current approach to crisis resolution has led to an even-bigger-to-fail problem because of the government inducing relatively less weak institutions to take over weaker ones. JP Morgan took over Bear Stearns and then WaMu; Bank of America took over Countrywide and then Merrill Lynch; and took over . And in the battle for Wachovia Citigroup aggressively fought Wells Fargo not because Wachovia was a sound banks (it was indeed insolvent and bust); it did so because taking over Wachovia would have made a too-big-to-fail Citi an even-bigger-to-fail bank with greater likelihood of government bailout. To put two weak –

210 or near-zombie - banks together is like having two drunks trying to hold each other to stand straight. To resolve this even-bigger-to-fail problem a strategy of taking over near-insolvent institutions and then break them up in smaller, systemically-not-important pieces would have been appropriate. Alternatively, charging much higher capital ratios on too-big-to-fail banks – as optimal according to economic theory - would incentivize them to break themselves up in smaller pieces. But neither approach has been so far followed by US policy makers; and we have thus created the mother of all moral-hazard driven bailout distortions. Eighth, the figures published by the US regulators are estimates of losses and capital/equity needs of the top 19 banks (those with assets above $100bn). Smaller US banks will have similar losses and capital needs. Based on the results of the stress tests some bank analysts have estimated that 60% of top 100 US banks (beyond the 19 ones in the stress tests) will need more capital/equity. Note that while large US banks (those with more than $4 billion in assets) have about 49% of their total assets into real estate assets the percentage of real estate assets for small US bank (those with assets below $4 bn) is about 63%. Thus, the losses for such smaller banks may end up being larger (as a % of their total assets) than the ones of large banks. The IMF recently estimated the additional capital needs of all US banks to be $275 bn if the TCE ratio is to increased to 4% and $500 bn if the TCE ratio has to go back to 6% (it average level for all US banks before the credit bubble of the last decade). Ninth, the current muddle through approach to the banking crisis is predicated on the assumption that forbearance and time will heal most wounds of most systemically important banks: generous assumptions on net retained earnings before writedowns – and hope that the economy will rapidly recover - will allow banks to earn their way out of their current massive capital shortages. But while the government will now let banks found to need more equity to raise such equity in the next six months the ability of such banks to do that will be very limited: very few private investors would want to provide capital to a bank with massive expected writedowns, large capital needs and where such private capital investments will be further significantly diluted by a government that will need to increasingly convert its preferred shares into common equity. As it is the government will already soon own 36% of Citigroup and more in the future if Citi needs much more capital and is unable to raise it from private sources. A similar fate awaits Bank of America that now needs to fill an equity gap of almost $35bn. Tenth, to avoid creating Japanese-style zombie large banks that are near insolvent and kept alive by trillions of dollars of government bailout support it would have been better to take different approaches that minimize the long-term government ownership or control of the financial system. There were three possible alternative approaches that made more sense. One option would be a temporary nationalization of such near insolvent large banks: take them over, wipe out common and preferred shareholders, have unsecured creditors take some of the losses (haircuts on their claims and/or conversion of their claims into equity), separate good and bad assets and sell a clean-up bank – possible after breaking it up to create smaller pieces that are not too big to fail - as fast as possible to the private sector. This was the strategy followed for Indy Mac that was taken over last summer by the FDIC and sold back to a group of private investors in about six months. Such temporary nationalization option is feasible and orderly even for systemically important banks as long as Congress is willing to pass soon the new insolvency regime for large financial institutions. A second option would be the approach favored by a number of economists of separating each troubled bank into a good bank and a bad bank and placing bad assets and unsecured claims into the bad bank while providing significant equity into the good bank to the unsecured creditors that would have losses on their bad bank claims. This solution

211 combines separating good and bad assets and converting unsecured claims into equity and it minimizes the fiscal costs of a distressed bank resolution. A third option would be to induce unsecured creditors – under the threat of a receivership that becomes credible once a special insolvency regime for too-big-to –fail banks is implemented - to convert their claims into equity. Then, the bad assets of the bank can be taken off the balance sheet of the bank via the PPIP program or a number of other alternative ways to separate good and toxic assets. Each one of these three proposed solutions implies that unsecured creditors of banks take some losses and convert their claims into equity. Instead, the paradoxical result of the current US approach is that – in order to avoid a temporary nationalization of insolvent banks and in order to prevent unsecured creditors of banks from taking any losses – the result is a creeping and increasing partial nationalization of the financial system: the government will have to inject more preferred shares into troubled banks and convert more of its preferred shares into common equity. So, even without a temporary government takeover of the insolvent banks, we will end up with a longer-term partial government ownership of many large banks. To avoid this creeping partial nationalization inducing the banks creditors to convert their claims into equity would be a more sensible solution that minimizes the fiscal costs of the crisis, reduces the moral hazard of government bailouts and keeps more of the banking system into private hands. The logic of the current muddle through approach is clear (leaving aside the fact that Wall Street is still partially capturing the US regulators and policy makers): providing unlimited liquidity and deposit guarantees to avoid bank runs and refinancing risks; subsidize banks and their rebuild of capital via near zero funding rates, a steep intermediation curve and rising net interest rate margins; hope that the economy recovers faster than otherwise expected (as the green shoots are rising) so that eventual bank losses are lower; hope that forbearance and time will heal most wounds by reducing the eventual level of charge-offs and writedowns and letting bank rebuilt capital via earnings before provisions; ignore moral hazard distortions in the short run while the banking crisis is still simmering and try to reduce such distortions in the medium term with a new and better regime of supervision and regulation of financial institutions; avoid takeovers of large institutions that would be disorderly in the absence of a special insolvency regime for such large banks; avoid the risk that, even in the presence of such special insolvency regime, unintended consequences of a takeover of a large bank lead to Lehman-like consequences; hope that fiscal costs of massive subsidies and bailouts of banks are contained if a virtuous cycle of economic recovery and restoration of confidence in the financial system rapidly emerges; subsidize restoration of securitization (with the TALF) and subsidize the separation of toxic assets from the banks’ balance sheet via government leverage and non-recourse loans (PPIP); avoid a more severe credit crunch via sensible supervisory and regulatory forbearance (mark-to-market suspension of FASB rules; closing regulators’ eyes on the true value of loans and assets; avoid forcing banks to recapitalize too fast and let capital adequacy ratios to slip in the short run; etc.); deal with the too-big-to-fail problem only if/when the crisis is over with higher capital charges once banks can better afford them ; eventually reform the system of regulation and supervision of the financial system. However, the current muddle through approach of colossal regulatory forbearance and bailout of the financial system has some serious risks and shortcomings (see my two recent op-eds with Matt Richardson in the WSJ and the FT for an elaboration): it significantly increases the fiscal costs to the taxpayer of bailing out financial institutions (their shareholders and creditors); it creates the mother of all moral hazard distortions as literally trillions of dollars of financial resources have been used to backstop the financial system and bailout reckless bankers and traders and investors; it ends up with a persistent and possibly long-term government control and partial ownership of parts of the financial

212 system; it does not resolve the too-big-to-fail problem as big banks are not broken up or given incentives to break themselves up; it risks to keep alive zombie banks leading to a more persistent credit crunch, economic stagnation, deflation and debt deflation; it leads to problems of medium term fiscal sustainability as the large fiscal cost of the bailout of the financial system creates serious public debt dynamics problems over time; it creates a serious exit strategy problem for monetary policy as the tripling of the monetary base and the central bank purchase of toxic and illiquid assets risks to eventually lead to price inflation or to another asset and credit bubble unless the massive creation of liquidity is mopped up as soon as the real economy recovers; and it may end up with a cosmetic reform of the regime of regulation and supervision of the financial system as soon as the financial crisis looks like beginning to bottoming out. Indeed many Wall Street voices are starting to argue that the crisis is over, that bull times are back, that they don’t need further government support (while still being on the government dole in twenty different Fed/FDIC/Treasury bailout/subsidy programs/funds), that they can repay TARP money (using the $350 bn of funds that they borrowed at near 0% interest rates with a FDIC full guarantee of interest and principal), that the government should not over-regulate the financial system, that controls on bankers compensation are misguided, that no fundamental change of the financial system and of its regulation is needed. This is the self-serving chatter that we are starting to hear from the same reckless lenders, bankers and investors whose greed and wildly distorted bonus/compensation schemes – together with regulators that were asleep at the wheel and believing in self- regulation that means no regulation – caused the worst economic recession and financial crisis since the Great Depression. This is the new spin of those whose fake (as not being risk-adjusted) gains/profits/bonuses were privatized in the bubble times when fake wealth and bubble profits were created and whose trillions of dollars of losses have now been fully socialized and paid for by the taxpayer. Their arrogance is only second to their shameless Chutzpah. One can only hope that policy makers will resist these siren calls can and design a reform of the regime of regulation and supervision of financial institutions (more capital, less leverage, more liquidity, incentive compatible compensation with a bonus/malus system, higher capital charges to deal with – and possibly break-up – too-big-to-fail financial institutions, global regulatory standards that prevent jurisdictional arbitrage, etc.) that reduce the risk that a financial crisis of this proportion will happen again. http://www.rgemonitor.com/roubini- monitor/256694/ten_reasons_why_the_stress_tests_are_schmess_tests_and_why_the_cu rrent_muddle-through_approach_to_the_banking_crisis_may_not_succeed

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SCANDAL 's Secretary Spills His Secrets by Vanity Fair May 5, 2009, 11:59 PM Bernie Madoff was a sexist, egomaniacal, short-tempered control freak—yet everybody loved him. That is according to his secretary of more than 20 years, Eleanor Squillari, who co-authored a 9,000-word article in the June issue of Vanity Fair. After spending two months helping the F.B.I. gather evidence against her former boss, Squillari, a 59-year-old mother of two from Staten Island, returned a call from V.F.’s Mark Seal, who had contacted her in connection with the eye-opening Madoff story he wrote in the magazine’s April issue. Seal and Squillari ended up collaborating on a first- person account of Squillari’s time with Madoff, whom she knew as well as anyone outside his family. The article, entitled “Hello, Madoff!,” is accompanied by more than a dozen intimate photos of Madoff and his family from as far back as the 1970s. Among the topics that Seal and Squillari cover are: Bernie’s views on stealing: • Squillari recalls an unusually prescient conversation she had with Madoff years earlier, after a client’s secretary had been arrested for embezzlement. “You know, [he] has to take some responsibility for this,” Madoff told Squillari. “He should have been keeping an eye on his personal finances. That’s why I’ve always had Ruth watching the books. Nothing gets by Ruth.” Squillari says she was surprised when he added: “Well, you know what happens is, it starts out with you taking a little bit, maybe a few hundred, a few thousand. You get comfortable with that, and before you know it, it snowballs into something big.”

Eleanor Squillari on the Staten Island Ferry. Photograph by Stephen Wilkes Bernie’s personality

214 • The way Madoff handled stress was “by saying something nasty: You look terrible. You’re gaining weight. You’re stupid. I never took anything he said to me personally, because I knew it wasn’t about me, it was about him.” • Madoff’s behavior changed drastically in the weeks before his arrest. “He seems to be in a coma,” Squillari told people who walked by his office and saw him staring off into space. He began taking his blood-pressure every 15 minutes, refused to look at his mail, and was constantly meeting with the heads of his feeder funds and Frank DiPascali, “the go-to guy for the investment-advisory business” (the vehicle for Madoff’s Ponzi scheme). Bernie’s sleazy side • “Bernie was irresistible to women” and “had a roving eye.” Squillari once caught him perusing the escort ads in the back of a magazine, and he frequently visited massage parlors. “Once, I looked in his address book and found, under M, about a dozen phone numbers for his masseuses. ‘If you ever lose your address book and somebody finds it, they’re going to think you’re a pervert,’ I said.” • Madoff was flirtatious and had a habit of making sexually suggestive remarks: “‘Oh, you know you’re crazy about me,’ he would say to me. Sometimes when he came out of his bathroom, which was diagonal to my desk, he would still be zipping up his pants. If he saw me shaking my head disapprovingly, he would say, ‘Oh, you know it excites you.’ If a pretty young woman came in, he’d say, ‘Do you remember when you used to look like that?’ I’d tell him, ‘Knock it off, Bernie,’ and he’d go, ‘Ah, you still look good.’ Then he’d try to pat me on the ass.”

Ruth and Bernie Madoff on the yacht of real-estate tycoon Norman Levy, circa 2000. By Carmen Dell’Orefice Bernie’s relationship with his wife • Bernie’s wife, Ruth, “wanted to be perfect for him. She would never allow herself to gain weight or have a hair out of place, and she always kept an eagle eye on him, especially when he was around young, attractive women.” However, “if Bernie said something to Ruth that annoyed her, she’d say, ‘Go fuck yourself,’ or ‘I don’t give a shit.’ That’s the way they talked to each other.” The operations on the 17th floor, home to the Ponzi scheme • The staff on 17 “were mostly low-level, clerical women, many of them working mothers, who probably made no more than $40,000 a year. They were young and naïve, with no background in finance, so they weren’t able to connect the dots.” Squillari was friendly with two of those women and says, “Whenever I went downstairs, they were always busy doing paperwork while [their boss] Annette [Bongiorno] watched them like a hawk. Once, I remember, Annette had the phones removed from her employees’ desks after she became concerned that they were making personal calls. She treated them like children.”

215 The aftermath of Bernie’s arrest • In the days after her husband’s arrest, called Squillari multiple times and encouraged the secretary to provide her with certain information without notifying the bankruptcy trustees, which Squillari said she couldn’t do. “Instead, I told the F.B.I. what had just happened. I was working for them now, not for Ruth and Bernie Madoff.” • Looking back on things, Squillari believes Madoff meticulously planned out the particulars of his arrest. She believes he wanted the F.B.I. to find the appointment book he left on his desk, and he wanted his sons to find the $173 million in checks made out to certain employees and friends that prosecutors cited when trying to revoke his bail (he never actually intended to send them out, Squillari says). Vanity Fair’s June issue, which contains the full text of “Hello, Madoff,” is on newsstands in New York and Los Angeles today, and nationwide on May 12.

216

REPORTAJE: Primer plano Trichet se sube al helicóptero El BCE se suma a la Reserva Federal e intenta reanimar la economía con una nueva receta: inundar de dinero el mercado CLAUDI PÉREZ 10/05/2009 La economía suele transmitir la sensación de que los problemas son muy complejos; de que no hay respuestas fáciles. Ésa es sólo una verdad a medias. En los últimos sesenta años, cuando la actividad económica se quedaba atascada, se bajaba el precio del dinero y listo. Un crédito más barato allana el camino de la recuperación, estimula las ganas de consumir e incentiva la inversión empresarial; cuando eso sucede, las Bolsas descorchan el champán. El papel de los banqueros centrales consistía en llevarse el ponche antes de que la fiesta se acabara: cuando aparecían signos de recalentamiento, se encarecía el dinero y así se conseguía enfriar la economía. Sencillo. Al menos en teoría. Sólo hay un problema: el ruido y la furia de la crisis actual han acabado con ese mantra - el precio del dinero como varita mágica; los banqueros centrales como sumos sacerdotes tocados con un halo de infalibilidad-, que difícilmente va a volver a funcionar igual. Los tipos están próximos al 0% y la economía, lejos de recuperarse, se asoma a la deflación, una caída continuada de precios con un potencial devastador. Aún puede escucharse el zumbido del aire que sale de las burbujas que provocaron la crisis. Los bancos siguen sin dar créditos a pesar de los anabolizantes en forma de ayudas públicas y multimillonarias inyecciones de liquidez. Y sin crédito la economía se colapsa. Los consumidores compran menos. Las empresas reducen la producción y despiden empleados. En última instancia, ese círculo vicioso puede complicarse sobremanera si finalmente llega la deflación, un fenómeno económico que remite a la década pérdida de Japón en los años noventa y, en última instancia, a la temida Gran Depresión. ¿Cómo romper esa espiral? Una vez más se trata de un berenjenal complicadísimo, al menos en apariencia. Sin embargo, la penúltima receta ensayada aúna una deliciosa sencillez y una enorme potencia visual: puede bastar con darle a la máquina de imprimir dinero, subirse a un helicóptero y tirar billetes desde allí arriba. Poco más o menos. El helicóptero es el último invento de una política económica que lo ha intentado casi todo y se iba quedando sin munición. La rebaja fulminante de los tipos desde el inicio de la crisis no es suficiente. La respuesta clásica -tan keynesiana- del gasto público para compensar la anemia de la demanda privada tampoco acaba de dar resultados. Bombardear liquidez a los bancos es otra respuesta de libro para una economía atorada: ha servido como anestesia, pero no para curar la trombosis financiera. Cuando no funcionan los medicamentos para curar a un paciente, hay quien apuesta por nuevos fármacos, potencialmente peligrosos porque están sin testar, pero que pueden abrir las puertas de la recuperación. Algo de eso hay en el último y desesperado intento por tratar de reactivar los mercados. La economía es un juego de símbolos. La gracia de las metáforas del helicóptero y de la máquina de imprimir dinero es que no son ningún invento del periodismo: las han

217 acuñado los propios banqueros centrales, que son, supuestamente, quienes tienen que sacar a la economía y al sector financiero -o viceversa- del lío en el que se han metido. La obsesión de las autoridades monetarias por el control de los precios es conocida. Pero la tasa de inflación en las mayores economías del mundo -EE UU, Japón y la eurozona- se deslizará a territorio negativo durante 2009. Los precios ya bajan en algunos países: en España, sin ir más lejos. Y las expectativas de inflación (lo que la gente espera que pase con los precios de consumo) giran hacia terreno negativo por primera vez en la eurozona, según la agencia Moody's. La Reserva Federal estadounidense (Fed) hace mucho que diagnosticó correctamente que los principales y más inmediatos peligros no están ahora en las subidas de precios. Al frente de la Fed figura Ben Bernanke, un distinguido conocedor de la Gran Depresión a quien apodan Helicopter Ben desde que en un discurso de 2002 aludiera a la posibilidad de "tirar dinero desde un helicóptero" -una frase acuñada por el economista Milton Friedman- si aparecía el fantasma de la deflación. "EE UU tiene una tecnología, las impresoras de billetes, que le permite producir los dólares que quiera sin apenas coste", dijo en un discurso profético, titulado Deflación: eso no va a pasar aquí. En otras palabras: siempre puede usarse la máquina de imprimir billetes -acompañada de una expansión fiscal y la rebaja de tipos- para engrasar la economía y los mercados con dinero fresco. Bernanke ha activado esa solución y todos los grandes bancos centrales del mundo le están siguiendo en mayor o menor medida. El más ortodoxo de ese grupo, el presidente del Banco Central Europeo (BCE), Jean-Claude Trichet, ha sido el último en subirse al helicóptero. La realidad tiene algo menos de fuerza que las metáforas de Bernanke. No se trata de imprimir dinero físicamente; tan sólo electrónicamente. Las medidas aprobadas -con los habituales eufemismos impronunciables: "relajación cuantitativa", "facilidades crediticias", esas cosas- se basan en la compra de activos públicos o privados, lo que supone engordar el balance de los bancos centrales. Pero el efecto es el mismo que el de subirse al famoso helicóptero y soltar billetes: dinero directo al corazón de la economía, el sistema financiero. Adiós a la deflación y a la carestía del crédito... si todo funciona correctamente. Es decir, si los bancos no se guardan ese efectivo y lo ponen a trabajar. La teoría dice que una vez los tipos alcanzan la zona cero, la política monetaria pierde tracción. Como el precio del dinero no puede bajar más, para que el banco central siga influyendo en la economía debe acometer acciones no convencionales. Y en esa heterodoxia andan metidos Bernanke, Trichet y compañía, que buscan ampliar su fondo de armario con nuevas medidas anticrisis. Las posibilidades son numerosas, pero el objetivo es siempre el mismo: desatascar el crédito a los consumidores y a los empresarios para que la economía salga del letargo y se aleje de la más mínima posibilidad de deflación, que se ha convertido en algo así como el nuevo demonio de todas las pesadillas de los banqueros centrales. EE UU se ha lanzado a comprar deuda pública. Eso encarece los bonos (hay más demanda) y reduce su rentabilidad (hay que pagar menos para venderlos). El efecto es doble: la Fed pone dinero contante y sonante en el bolsillo de los titulares de esos activos, que debería reactivar unos mercados mortecinos. Además, la rentabilidad de los bonos baja y arrastra los tipos de interés reales del resto de la economía: endeudarse será más barato, las empresas invertirán más y los estadounidenses comprarán más coches, más neveras: volverán a tirar de la tarjeta como solían.

218 La zona euro ha optado por otra solución. El BCE comprará cédulas hipotecarias (activos respaldados por hipotecas), en un movimiento menos agresivo, que llega más tarde que en el caso de otros bancos centrales y en cantidades menores. El objetivo es mejorar la financiación de los bancos, cuyo papel es más importante en la eurozona. Pero la consecuencia es exactamente igual: más dinero en manos de las entidades financieras, más posibilidad de liberar esos recursos en forma de créditos. Y tipos de interés a la baja, ayudados por la barra libre de liquidez, una modalidad de crédito que ahora se amplía de seis meses a un año y que garantiza todo el efectivo que quiera la banca al tipo de interés oficial -siempre que aporte garantías suficientes-. Ésa es la teoría. Pero toda teoría tiene defensores y detractores. Primero, los contras: "Todo esto va a ser una desilusión. Lo único que puede funcionar en la situación actual son poderosas medidas fiscales adicionales. No hay helicópteros que valgan: sólo los Gobiernos firmando cheques pueden arreglar esto", asegura James K. Galbraith, profesor de la Universidad de Texas e hijo del mítico economista John K. Galbraith. Es cierto que no hay evidencia empírica de que el uso de la máquina de imprimir dinero vaya a funcionar. En Japón se probó en los años noventa -en pequeñas cantidades- y eso no logró evitar una larga crisis. La compra de activos en Reino Unido y EE UU apenas ha tenido consecuencias hasta ahora. Pero también hay voces optimistas. "Las medidas van en la dirección correcta. Y es un éxito que incluso en Europa una institución tan reticente como el BCE haya puesto en marcha la relajación cuantitativa. La política monetaria está haciendo todo lo que está en su mano, asumiendo riesgos que hasta hace poco eran inconcebibles A partir de ahí, hay que llevar estas medidas hasta donde sea sensato, porque están poco testadas y suponen asumir riesgos", asegura el ex presidente de la CNMV Manuel Conthe. "En todo caso, los peligros de cometer excesos son remotos y además son corregibles", señala. Tomás J. Baliño, ex subdirector del FMI, añade que las medidas adoptadas "deberían ayudar a facilitar el crédito y animar la demanda en la eurozona, junto con algunos otros datos positivos que se van anunciando a nivel global. El BCE, la Fed y otros bancos centrales acompañan así a la expansión fiscal que han encarado tanto los países de la zona como el resto del mundo. El conjunto de esas medidas debería ayudar a moderar la recesión y salir antes de ella". La efectividad del penúltimo cartucho de la política monetaria presenta numerosas dudas. En primer lugar por razones de credibilidad. Los bancos centrales llevan años cantando las bondades de las políticas antiinflacionistas. Su reto ahora es "prometer de forma creíble que van a ser irresponsables", escribió hace una década el Nobel Paul Krugman para describir la fallida experiencia japonesa. Hay más riesgos: tratando de corregir la burbuja actual puede empezar a hincharse la burbuja del futuro. "El incremento del dinero en circulación puede alimentar la inflación si no se corrige en cuanto la economía empiece a mostrar signos de recuperación", apunta el economista belga Paul De Grauwe. "Aunque confío en que el BCE no cometa ese error", cierra. Lo más curioso es que en el fondo todo empieza y acaba en la banca. Así de financiera es la economía de este siglo. Los bancos llevan más de 20 meses como principales sospechosos de la crisis, y a la vez como lacerantes víctimas: las turbulencias no hacen distingos entre activos buenos y malos, entre entidades buenas y malas cuando el pánico corre como la pólvora. Y esta es una época de grandes miedos. La abulia en la que está instalado el sistema bancario es la mayor incógnita acerca del éxito de la máquina de imprimir dinero: las autoridades no dejan de repetir -con escaso éxito- que sólo cuando el sector financiero salga del pozo empezará la salida del túnel para la economía real.

219 "El drama para los bancos centrales es que a pesar de esta insólita agresividad, la efectividad de las medidas depende de que la banca utilice esta lluvia de liquidez para prestar más. La solución a la crisis sigue pasando por arreglar el sector financiero, y eso no está en manos de los banqueros centrales, sino de los Gobiernos y los supervisores", afirma desde Londres Javier Pérez de Azpillaga, economista de Goldman Sachs. "A pesar de los retrasos y la timidez de algunos, los bancos centrales han hecho los deberes. Gracias. Pero la pelota está ahora en el tejado de los Gobiernos y de la política fiscal. El BCE no puede hacer el trabajo en solitario", añade Charles Wyplosz, del Graduate Institute de Ginebra. Desde Nueva York, el economista Guillermo Calvo se alinea con los que piensan que la máquina de imprimir dinero puede dar aire a la economía. Pero para ello hacen falta cifras masivas, que lleven la liquidez puertas afuera del sector bancario. La paradoja es que bancos centrales como el BCE se juegan su independencia si toman esa senda con determinación y rapidez. "Me temo que Trichet prefiere seguir esperando en lugar de prevenir las malas noticias. Y la situación tiene toda la pinta de empeorar", avisa Calvo. La crisis actual tiene infinidad de lecturas. Entre otras muchas, es la historia de cómo los responsables de la política económica se convencieron de que lo tenían todo bajo control para después descubrir horrorizados (y mientras el mundo sufría las nefastas consecuencias de sus decisiones) que no era así, ataca Krugman en El retorno de la economía de la depresión. La entrada de los bancos centrales en territorio comanche es un examen en toda regla a su credibilidad, a su capacidad para volver a agarrar las riendas de la economía. Bernanke y Trichet se juegan su prestigio y tal vez algunos párrafos en los aburridos manuales de historia económica. Aunque para la economía quizá valga la apostilla del crupier: no va más.

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ENTREVISTA: Econonía global JACQUES DE LAROSIÈRE Coordinador del informe europeo de regulación bancaria "El sistema financiero español sirve de modelo a la reforma" "El modelo europeo de banca ha resistido mejor la crisis" ALICIA GONZÁLEZ 10/05/2009 Jacques de Larosière nació al estallar la Gran Depresión, en noviembre de 1929. Ahora, el ex gobernador del Banco de Francia y ex director gerente del FMI acaba de coordinar un informe a nivel europeo con recetas para lidiar con la Gran Recesión. Expuso esas reformas en el Foro de Liderazgo de IE Business School. Pregunta: Después de meses trabajando sobre las causas de la crisis, ¿ha descubierto si hay una solución definitiva? Respuesta: [Sonríe] Espero que hayamos encontrado algunas soluciones, aunque no sea "la" solución. La verdad es que hemos trabajado duro durante cuatro meses sobre los orígenes de la crisis y las reformas que reducirán el problema en el futuro. Esperemos que eviten la repetición del desastre que estamos viviendo. P. ¿Hasta qué punto el sistema financiero español ha inspirado las reformas propuestas? R. Nos ha inspirado medidas muy precisas. Una de las cosas que admiramos, y que hemos incorporado a las recomendaciones, es el sistema de provisiones dinámicas. España tuvo la sabiduría de obligar a los bancos a provisionar reservas extra en años de crecimiento para tener un colchón cuando el ciclo empeorara y sin infligir demasiado daño a la economía. Es una muy buena idea que recomendamos para todos los demás. P. ¿Y los límites al coeficiente de apalancamiento? R. La limitación global al endeudamiento tiene algunas ventajas, pero también inconvenientes. Es una herramienta bastante rudimentaria, que no distingue entre la calidad de los activos y que tampoco es garantía de nada. Le recuerdo que los bancos americanos tenían un ratio global de endeudamiento y han sido los más afectados por la crisis. En mi opinión, hay cuestiones más importantes a vigilar, como las operaciones fuera de balance, las inversiones por cuenta propia, si la duración de los créditos está respaldada por pasivos suficientes o la calidad de los activos. P. ¿La nacionalización temporal de los bancos es una buena solución? R. No hay duda que algunas operaciones de rescate se han traducido de hecho en una nacionalización. Si me pregunta si me gusta, ya le digo que no, porque es una clara manifestación del fracaso del sistema. Pero para evitar el completo colapso del sistema, probablemente era el único camino. La clave ahora va a ser que los Gobiernos fijen una estrategia de salida de esas participaciones y dar entrada a otros accionistas. P. ¿La estabilización de la crisis hace las reformas más difíciles o más fáciles? R. Más fáciles, sin duda. Ahora no le puedes imponer a los bancos requisitos adicionales de capital porque agravarían su crisis. Cuando las cosas mejoren, entonces se puede pensar en el largo plazo y en aplicar las medidas del informe. Pero también es verdad

221 que cuando la situación mejora, los Gobiernos tienden a pensar que los buenos tiempos han llegado para quedarse y se muestran reticentes a aplicar estas medidas, porque reducen la euforia del crecimiento. Por eso debe haber reguladores independientes que vigilen que no caigamos en las políticas laxas del pasado. P. ¿Es el momento de una agencia de rating europea, impulsada incluso con dinero público? R. Creo que es hora de que haya de verdad más competencia en un mercado dominado por las agencias estadounidenses y sería bueno para el mercado. Ahora bien, ¿deberían ser los Gobiernos los que lo organicen? Ahí tengo dudas, porque ellos mismos serían objeto de calificación por parte de las agencias y puede haber un conflicto de intereses, lo que no haría más que acentuar los problemas relacionados con las agencias de calificación en los últimos años. Yo preferiría que la industria financiera de Europa, de Asia se unieran de forma espontánea para mejorar la competencia y crear esa agencia alternativa. Aunque no es fácil. P. Aunque usted mismo sea banquero, ¿no cree que hay que cambiar el sistema de remuneración en el sector? R. Nosotros creemos que no es tarea de un comité de expertos fijar el nivel de remuneración de los banqueros, pero sí creemos que la moderación debería ser la nueva característica del modelo. Los incentivos que ha tenido parte del sector han sido equivocados porque han favorecido los resultados a muy corto plazo. Creo que hay un consenso generalizado entre los países en este sentido y muchas asociaciones bancarias ya se están moviendo en esa dirección. P. ¿Eso implica que no se exigirán beneficios crecientes? R. Ésa es otra cuestión, aunque los dos temas estén relacionados. Creo que es un problema de gobernanza empresarial. Los consejos no deberían pedir a sus responsables más y más beneficios y dividendos. Quizá eso ha jugado un papel importante en lo peligrosas que han llegado a ser algunas inversiones en activos. Ahora, con bancos que de facto han sido nacionalizados, eso sin duda cambia. EE UU, por ejemplo, ha impuesto una limitación a los banqueros de entidades rescatadas por el Gobierno. Algo tiene que cambiar, sin duda. P. Supervisores y reguladores tienen una clara responsabilidad en esta crisis, pero las únicas dimisiones han sido en la banca. R. No hay una única responsabilidad en esta tragedia. El problema es que esas responsabilidades están menos delimitadas que, por ejemplo, la del consejero delegado de una empresa que quiebra. El sistema fue diseñado de forma colectiva y eso hace más difícil poner nombres. Es cierto que el sistema regulatorio contenía un conjunto de incentivos erróneos y que la supervisión no sirvió para advertir de los problemas de los balances. Pero los responsables de la política económica en todo el mundo tampoco atajaron los desequilibrios macroeconómicos, origen de la crisis, y que los bancos centrales promovieron una gran expansión del crédito con la brusca bajada de los tipos de interés. Así que si se quiere poner nombre a los culpables, hay que hacer una larga lista. [Risas]. P. Pero había mercados enteros sin ningún tipo de control, como el de los seguros contra el impago de la deuda (Credit Default Swaps, CDS).

222 R. Los CDS tenían una debilidad particular, que aún a día de hoy no está clara, y es la relación entre el producto y el conocimiento del riesgo que entraña, porque su funcionamiento no responde a las reglas del mercado tradicionales. Tanto el G-20 como nuestro informe insisten en que es necesario un sistema más transparente. Y ése es el inicio de la normalización de los mercados. P. ¿Es la única clave? R. Hay otra, y es la vigilancia macroeconómica. Hemos propuesto la creación de un consejo de vigilancia macro a nivel europeo que estaría compuesto por los banqueros centrales de cada país bajo la supervisión del BCE y con la asistencia de las tres autoridades independientes que proponemos crear. Su misión sería detectar los peligros potenciales del sistema y, una vez alertados, si los organismos afectados no hacen nada para corregirlo, el informe pasa al Consejo de Ministros de los Veintisiete, se hace público y pasaría a ser un problema político. P. ¿Ha acabado la crisis con el modelo de negocio anglosajón? R. El modelo de banca de inversión puramente dicho, yo diría más bien el modelo americano, ha desaparecido en cierta forma. Voluntariamente o por obligación, los bancos de inversión se han convertido en bancos comerciales. Podemos decir que la desregulación es cosa del pasado, ahora nos movemos hacia modelos más clásicos de banca, de corte europeo, en los que una misma firma agrupa negocios de banca minorista, empresarial, de gestión de patrimonios e incluso de banca de inversión. Yo creo que el modelo europeo ha resistido mejor durante la crisis que los otros y las cosas se van a mover hacia un modelo más equilibrado. -

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May 9, 2009 NEWS ANALYSIS Fine Line for Obama on How to Convey Hope on Economy By DAVID E. SANGER WASHINGTON — The formula for restoring national confidence — part good policy, part good politics, part good luck — can be hard to find. It eluded Herbert Hoover after the Crash of ’29, Lyndon B. Johnson after the Tet offensive, Jimmy Carter after the energy shock and George W. Bush after Iraq turned from quick victory to bloody insurgency. But President Obama has to try to do just that in a time of crisis. As the government announced this week that the nation’s largest banks had steered away from the precipice and that job losses were beginning to slow, Mr. Obama has carefully begun trying to mine any national leader’s most precious commodity in a crisis: optimism. His past references to “glimmers of hope” were modestly upgraded at the White House on Friday, with his declaration — which he stumbled over, taking some of the assertiveness out of the line — that “the gears of our economic engine do appear to be slowly turning once again.” His aides have been reaching tentatively for similar metaphors, then adding, as Mr. Obama quickly did, that real recovery is months, if not years, ahead. Fear and aversion to risk have been part of the economy’s problems since the downturn began, and Mr. Obama’s aides have been highly attuned to the risks of a downward spiral of pessimism. In recent weeks, his economic team has begun flagging signs that the worst could be over, even as it carefully released the results of its bank examinations in a way that suggested a desire to reassure the financial markets and consumers. They got a bit of backing this week from the Federal Reserve chairman, Ben S. Bernanke, who forecast that the economy was likely to begin growing again by the end of the year. “Remember this central paradox of financial crisis,” Lawrence H. Summers, Mr. Obama’s top economic adviser in the White House, said in mid-March, when every arrow was pointing down, “that while the problem was caused by excessive complacency and excessive optimism, what we need today is more optimism and more confidence.” Mr. Obama’s own words on Friday signaled that he was worried about the perils of getting out ahead of the numbers. He spent more time talking about the letters he received from the desperate and out-of-work than he did dwelling on the decline in the pace at which Americans are losing their jobs. After all, 539,000 job losses in a single month is not exactly cause for celebration, even if it represents an improvement over the previous month. “There’s a kind of artistry to this, isn’t there?” said Robert Dallek, the presidential historian best known for chronicling how Lyndon Johnson, the consummate

224 politician, never led the public out of its view that everything was falling apart. “You don’t want to come out and say the recession is over. You want to do a version of Churchill’s line about how this isn’t the end, or the beginning of the end, but rather the end of the beginning.” In Mr. Obama’s case, polls showed that a significant chunk of the public was predisposed to look for the bright side. The proportion of Americans who said the country was moving in the right direction rose to 41 percent in a New York Times/CBS News poll last month, from 15 percent in January just before his inauguration, even though by nearly every measure the economy was getting worse during that period. But there are plenty of skeptics out there, from economic historians who know that history is littered with false recoveries, to those who argue that Mr. Obama has engineered a turnaround at the cost of phenomenal deficits and a huge new role for the government in the private sector. Robert Reich, President Bill Clinton’s secretary of labor and one of Mr. Obama’s critics on the left, was on television Friday arguing that to create this sense of optimism Mr. Obama’s team essentially put its finger on the scale when weighing the ability of the banks to survive a deeper downturn. Given the depth of the concerns about the stability of the financial system and the debates about whether Mr. Obama was being tough enough on the banks, administration officials recognized that they could not afford the kind of mistake they made in early February, when Timothy F. Geithner, new to his job as Treasury secretary, provided vague assurances that the banks would be saved but said he was not prepared to give details. He was hammered in the markets and derided as inexperienced. So when it came to releasing the results of the bank stress tests, much was done differently. When the tests were first announced in late February, administration officials said that bank-by-bank results would not be announced. It quickly became clear that would court disaster: Banks that were given a clean bill of health would scream that news to the markets, leaving the rest of the 19 appearing to be in far direr straits. Inside the administration, according to two officials, Mr. Geithner argued that the results had to be announced in considerable detail. And this week Mr. Geithner defended the soundness of the administration’s approach. “A huge part of the dynamic of a crisis is confidence,” Mr. Geithner said in a telephone interview on Friday. He was influenced in part by his days as a young Treasury official in the American Embassy in Japan, where he saw what happened when the Japanese government talked up the economy but failed to act. He said Mr. Obama was opting for “directness and candor and openness about the scope of the problem,” but steering clear of “talking up the numbers” in ways that predict what the future will bring. But administration officials said they recognized that the numbers that resound most with Americans were the unemployment statistics, and those were usually the last to recover. They are also subject to surprise downturns, which explains Mr. Obama’s hesitance to describe the job-loss figures on Friday as the beginning of an improving trend. “The hardest part of this is balancing optimism with credibility,” said Mr. Dallek. “Hoover’s ‘Happy days are here again’ wasn’t credible. Bush’s ‘Mission accomplished’ became a running joke. No one wants to make that mistake again.” http://www.nytimes.com/2009/05/09/business/economy/09assess.html?_r=1&th&emc=th

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Fannie Loses $23 Billion, Prompting Even Bigger Bailout Chance of Repaying Taxpayers Is Slim By Zachary A. Goldfarb Washington Post Staff Writer Saturday, May 9, 2009 Fannie Mae reported yesterday that it lost $23.2 billion in the first three months of the year as mortgage defaults increasingly spread from risky loans to the far-larger portfolio of loans to borrowers who have been considered safe. The massive loss prompts a $19 billion investment from the government to keep the firm solvent, on top of a $15 billion investment of taxpayer money earlier this year.

The sobering earnings report was a reminder of the far-reaching implications of the government's takeover in September of Fannie Mae and the smaller Freddie Mac. Losses have proved unrelenting; the firms' appetite for tens of billions of dollars in taxpayer aid hasn't subsided; and taxpayer money invested in the companies, analysts said, is probably lost forever because the prospects for repayment are slim. But the government remains committed to keeping the companies afloat, because it is relying on them to help reverse the continuing slide in the housing market and keep mortgage rates low. Even as the government bailout of banks appears to be leveling off, the federal rescue of Fannie and Freddie is rapidly growing more expensive. Fannie Mae said that the losses will continue through at least much of the year and that it "therefore will be required to obtain additional funding from the Treasury." Analysts are estimating that the company could need at least $110 billion. Freddie Mac, which has been in worse financial shape than Fannie Mae and has obtained $45 billion in taxpayer funding, will report earnings in coming days. Fannie's most recent loss compares with a $2.2 billion loss in the first quarter last year, before the government takeover. Fannie Mae, of the District, and Freddie Mac, of McLean, have been growing ever more dependent on federal largesse. The Federal Reserve has bought $366 billion of their mortgage investments and $70 billion of their debt, and has pledged to buy hundreds of

226 billions of dollars more of both. The Treasury has pledged $200 billion to each company to keep them solvent and already bought $124 billion of their mortgage investments. In total, the government has committed about $2 trillion to supporting Fannie and Freddie and buying the securities they issue. Over the next 10 years, the government's rescue of Fannie Mae and Freddie Mac is expected to cost $389 billion, exceeding the cost of investments in banks and other financial firms by the government's Troubled Assets Relief Program, according to a recent study by Subsidyscope, a project of the Pew Charitable Trusts. The group based its calculations on Congressional Budget Office figures. The federal government seized Fannie Mae and Freddie Mac last September out of concern that they would collapse and threaten the entire financial system. Since then, the companies have been called on to carry out large parts of the government's plan to spur a housing recovery by modifying mortgages and taking anti-foreclosure steps. Fannie Mae said these programs are likely to have "a material adverse effect on our business, results of operations and financial condition, including our net worth." But, it said, the program could yield long-term benefits. "If, however, the program is successful in reducing foreclosures and keeping borrowers in their homes, it may benefit the overall housing market and help in reducing our long-term credit losses." But in a filing, Fannie Mae said, "We expect that we will not operate profitably for the foreseeable future." The plight of Fannie Mae and Freddie Mac contrasts with the findings of federal "stress tests" done on the country's largest banks. The government announced Thursday that the tests showed that only one bank, GMAC, required additional public aid, with the tab at $9.1 billion. Fannie Mae's earnings results also contrast with reports in recent weeks by the biggest banks that they are returning to profitability. Even the ailing insurer American International Group said Thursday that it may not need more taxpayer dollars. Many banks that have received bailout funds said they will try to pay the government back. But that doesn't hold true for Fannie and Freddie. Their financial situation is so weak that they may have to borrow government money to pay dividends due to the government on money borrowed previously. Yet even if the companies were profitable, they might not be able to pay back the money because the dividend payments are so onerous. "The scenario where these guys can earn money to pay that back is remote," said Bose George, an analyst a New York investment bank Keefe, Bruyette & Woods. Jim Vogel, an analyst at FTN Financial, said the amount of taxpayer money that must flow to Fannie and Freddie will be clear in the coming months. He said it will depend on whether government efforts to keep people in their homes can make significant headway even as rising unemployment makes it more difficult for many to afford their loans. "We need more to pass to see how people react to all the different plans to help people with mortgages and how people react to a prolonged period of unemployment," Vogel said. According to analysts, Fannie Mae's financial assumptions aren't as bleak as those embodied in the government's stress tests of major banks. For the tests, the government assumed that the percentage of loans going bad in a portfolio would range from 1.5

227 percent to 4 percent. Fannie Mae assumes that only 1.45 percent of loans will be bad, suggesting that the company would have to come up with much more money to cover losses if a worse scenario comes to pass. A major reason for concern about Fannie Mae and Freddie Mac is the size of their exposure to the mortgage market, analysts said. Fannie Mae and Freddie Mac own $5.4 trillion in assets, and all of those are mortgages, the worst-performing kind of loan. By comparison, the total assets -- from mortgages to credit card loans -- held by the 19 big banks that underwent stress tests was $7.8 trillion.

228 The Dynamically-Hedged Economy II: by Doug Noland, 08/mayo/2009 All attention this week was focused on the bank stress tests. Importantly, market perceptions have shifted dramatically to the view that banking system problems are manageable and that policymakers have found the right balance in their approach. The reported total capital shortfall was nowhere near as dire as, not long ago, many had feared. Indeed, several weeks back no one would have even contemplated Wells Fargo and Morgan Stanley on the same morning tapping the market for a combined $11bn of common equity capital. And with markets having somewhat recovered - and even the impaired financial players having regained access to the capital markets- the marketplace has now largely taken the cataclysmic market "tail" risk scenario off the table. The equities VIX index dropped this week to the lowest level (31) since before the failure of Lehman, mirroring the ongoing collapse in Credit spreads. My obsession with the Credit system began in the early nineties, as I studied the complex process of impaired banking system rejuvenation. Beginning early in that decade, innovation and rapid expansion propelled Wall Street finance into a major force of system Credit creation. Securitizations, the GSEs, and derivatives markets in particular - contemporary Wall Street risk intermediation - combined to play a momentous role in system reliquefication. This was much to the delight of the traditional banks - first promoting their recovery and later spurring incredible growth in earnings, stock prices and compensation. This new Credit system structure developed into the historic Wall Street finance and mortgage finance Bubbles. Today, myriad forms of government risk intermediation and market intervention are spurring system Credit creation and reliquefication. I have labeled the most recent phase of risk intermediation distortions and Credit excess the "Government Finance Bubble." One will miss important dynamics by focusing on bank Credit. It is worth noting first quarter bond issuance data from the Securities Industry and Financial Markets Association (SIFMA). Total Bond issuance (muni, Treasury, mortgage-related, corporate, agency, and ABS) jumped to $1.420 TN during the period. This was a notable 71% increase from a dismal 4th quarter to the strongest issuance since Q2 2008 ($1.598TN). If the first quarter's pace is maintained, total 2009 issuance of $5.680 TN would trail only 2003 and 2007. First quarter bond sales were actually up 3.2% from Q1 2008, led by a 60% y-o-y increase in Treasury issuance ($326.8bn). On a quarter-over-quarter basis, Agency issuance was up 332% to $413.7bn; Mortgage-Related issuance increased 69% to $364.8bn; and Corporate issuance surged 188% to $215.1bn. Exemplifying the scope of the unfolding Government Finance Bubble, Treasury and Agency debt issuance combined for an incredible $740.5bn during the first quarter, up 59% y-o-y to a record annual pace of $2.962 TN. This morning Fannie Mae reported a worse-than-expected first quarter loss of $23.2bn. In just three quarters, Fannie has reported losses totaling $77.4bn. No worries, however. Fannie's debt spreads this week tightened another 12 to 31 bps (down from November's 159bps) and Fannie MBS spreads narrowed an additional 9 to 83 (down from November's 232bps). Despite unprecedented losses and massive capital shortfalls, the GSEs have nonetheless become major players in the unfolding Government Finance Bubble. An insolvent Fannie requested an additional $19bn of government assistance.

229 Today from Fannie: "In March, Fannie Mae provided $93.3 billion in liquidity to the market through Net Retained Commitments of $5.4 billion and $87.8 billion in MBS Issuance... March refinance volume increased to $77 billion, nearly twice the refinancing volume reported in February and our largest refinance month since 2003. We expect that our refinance volumes will remain above historical norms in the near future... Fannie Mae began accepting deliveries of refinance mortgage originations under the Making Home Affordable program in April 2009." Fannie's "Book of Business" (retained mortgages and MBS guarantees) expanded at a 12.3% rate during March to $3.144 TN (largest increase since February 2008). Fannie MBS guarantees grew at a 15.4% annualized rate during March to $2.640 TN. The $31.4bn increase in guarantees was the largest in 13 months. The company's "New Business Acquisitions" jumped to $92.8bn from February's $53.8bn and January's $28.8bn. The current wave of mortgage refinancings is the strongest since the powerful - and system reliquefying - 2002/'03 refi boom. The few analysts that even care are generally discounting the systematic impact of refinancings. They argue that there is today dramatically less equity available to extract and spend. From an economic perspective, I don't have a big issue with this analysis. But from a systemic risk perspective, the unfolding refi boom is anything but inconsequential. By the end of the year, I would not be surprised to see upwards of $1.0 TN of "private" mortgage exposure having been shifted to the various government-related agencies (Fannie, Freddie, Ginnie, FHA, and FHLB). The wholesale transfer of various private sector risks to "Washington" is a key facet of the Government finance Bubble. Nowhere is such redistribution accomplished as effectively and surreptitiously than with a mortgage marketplace incited to refinance by (Fed-induced) collapsing yields. Think in terms of our government placing its stamp of guarantee on hundreds of billions of risky, illiquid and unappealing mortgage securities - transforming them into coveted "money"- like agency securities. Such dynamics work wonders... Previous holders of these mortgages receive cash, while the entire marketplace benefits from higher mortgage prices. Some years back I titled a Bulletin "The Dynamically-Hedged Economy." The gist of the analysis was that the Financial Sphere was the driving force of the Economic Sphere - and not vice-versa. Derivatives and leveraged speculation "ruled the world." Credit system and speculative Bubble dynamics had nurtured powerful and self-reinforcing dynamics. A financial sector embracing risk and leverage was spurring liquidity excess, higher asset prices, a more robust economic expansion, buoyant confidence, animal spirits, and an only greater degree of self-reinforcing Credit and speculative excess. As we witnessed last autumn, an abrupt reversal of these dynamics fomented system illiquidity and near systemic breakdown. Selling begat more selling - especially from the expansive derivatives marketplace. There was absolutely no way that system liquidity could absorb the combined selling pressure associated with speculative deleveraging and the hedging of systemic risks. The system is again rocked by yet another Bubble-related convulsion: today, it's the self- reinforcing unwind of bearish bets and systemic risk hedges. Washington's unprecedented measures to intermediate risk and boost marketplace liquidity have spurred a self-reinforcing wave of bearish positions and hedges liquidation. This dynamic has had a major impact in the Credit, equities and, seemingly, more recently in the currency and commodities markets. I would add that this unwinding process tends to

230 generate liquidity throughout the marketplace. And, let's face it, there is nothing like a big short squeeze to get the animal spirits flowing on the long side. Most will interpret these dynamics bullishly. I would caution that we are witnessing only the latest variant of Acute Monetary Disorder and destabilized markets. The more bearish analysts argue that current economic underpinnings do not support surging stock and debt prices. Of course they don't, but that's not really the key issue. Rather, the question is whether the return of liquidity and securities market inflation will stoke sufficient confidence (from both spenders and lenders) to spur sustainable economic recovery. Here I must lean heavily on my analytical framework. In the short-run, I have to presume that major financial sector and market developments will work to stimulate the real economy (as they have repeatedly in the past). At the same time, it's my view that the economy today is unusually susceptible to an artificial and fleeting recovery. The unwind of bearish hedges will at some point have run its course, concluding a period of major artificial liquidity generation. Moreover, I question the sustainability of the Government Finance Bubble (fiscal and monetary) overall. The markets are setting themselves up for disappointment. I would posit that the more energized the markets and economy the greater the amount of Credit issuance that will need to be absorbed by the markets (debt and currency). So far, it is mainly Treasury yields that are rising. Government Finance Bubble dynamics would seem to dictate, however, that agency debt and MBS yields could provide the key to both artificial economic recovery and inevitable disappointment. And I would not expect a sinking dollar to support agency securities or Treasuries http://www.safehaven.com/article-13299.htm

231 FRIDAY, MAY 08, 2009 Employment: Comparing Recessions and Diffusion Index by CalculatedRisk on 5/08/2009 09:25:00 AM Note: earlier Employment post: Employment Report: 539K Jobs Lost, 8.9% Unemployment Rate.

This graph shows the job losses from the start of the employment recession, in percentage terms (as opposed to the number of jobs lost). For the current recession, employment peaked in December 2007, and this recession was a slow starter (in terms of job losses and declines in GDP). However job losses have really picked up over the last 6 months (4 million jobs lost, red line cliff diving on the graph), and the current recession is now the worst recession since WWII in percentage terms after 16 months - although not in terms of the unemployment rate. In the early post-war recessions (1948, 1953, 1958), there were huge swings in manufacturing employment and that lead to large percentage losses. For the current recession, the job losses are more widespread. In April, job losses were large and widespread across nearly all major private- sector industries. BLS, April Employment Report

232 Here is a look at how "widespread" the job losses are using the employment diffusion index from the BLS.

BLS diffusion index is a measure of how widespread changes in employment are. Some people think it measures the percent of industries increasing employment, but that isn't quite correct. From the BLS handbook: The diffusion indexes for private nonfarm payroll employment are based on estimates for 278 industries, while the manufacturing indexes are based on estimates for 84 industries. Each component series is assigned a value of 0, 50, or 100 percent, depending on whether its employment showed a decrease, no change, or an increase over a given period. The average (mean) value is then calculated, and this percent is the diffusion index number. So it is possible for the diffusion index to increase (like manufacturing increased from 12.7 to 26.5) not because industries are hiring, but because fewer industries are losing jobs. Think of this as a measure of how widespread the job losses are across industries. The further from 50 (above or below), the more widespread the job losses or gains reported by the BLS. Before September, the all industries employment diffusion index was close to 40, suggesting that job losses were limited to a few industries. However starting in September the diffusion index plummeted. In December, the index hit 20.5, suggesting job losses were very widespread. The index has recovered since then (28.5 in April), although job losses are still widespread. The manufacturing diffusion index has fallen even further, from 40 in May 2008 to just 6 in January 2009. The manufacturing index recovered slightly to 26.5 in April. http://www.calculatedriskblog.com/2009/05/employment-comparing- recessions-and.html

233 Opinion

May 8, 2009 OP-ED COLUMNIST Stressing the Positive By PAUL KRUGMAN Hooray! The banking crisis is over! Let’s party! O.K., maybe not. In the end, the actual release of the much-hyped bank stress tests on Thursday came as an anticlimax. Everyone knew more or less what the results would say: some big players need to raise more capital, but over all, the kids, I mean the banks, are all right. Even before the results were announced, Tim Geithner, the Treasury secretary, told us they would be “reassuring.” But whether you actually should feel reassured depends on who you are: a banker, or someone trying to make a living in another profession. I won’t weigh in on the debate over the quality of the stress tests themselves, except to repeat what many observers have noted: the regulators didn’t have the resources to make a really careful assessment of the banks’ assets, and in any case they allowed the banks to bargain over what the results would say. A rigorous audit it wasn’t. But focusing on the process can distract from the larger picture. What we’re really seeing here is a decision on the part of President Obama and his officials to muddle through the financial crisis, hoping that the banks can earn their way back to health. It’s a strategy that might work. After all, right now the banks are lending at high interest rates, while paying virtually no interest on their (government-insured) deposits. Given enough time, the banks could be flush again. But it’s important to see the strategy for what it is and to understand the risks. Remember, it was the markets, not the government, that in effect declared the banks undercapitalized. And while market indicators of distrust in banks, like the interest rates on bank bonds and the prices of bank credit-default swaps, have fallen somewhat in recent weeks, they’re still at levels that would have been considered inconceivable before the crisis. As a result, the odds are that the financial system won’t function normally until the crucial players get much stronger financially than they are now. Yet the Obama administration has decided not to do anything dramatic to recapitalize the banks. Can the economy recover even with weak banks? Maybe. Banks won’t be expanding credit any time soon, but government-backed lenders have stepped in to fill the gap. The Federal Reserve has expanded its credit by $1.2 trillion over the past year; Fannie Mae and Freddie Mac have become the principal sources of mortgage finance. So maybe we can let the economy fix the banks instead of the other way around. But there are many things that could go wrong. It’s not at all clear that credit from the Fed, Fannie and Freddie can fully substitute for a healthy banking system. If it can’t, the muddle-through strategy will turn out to be a recipe for a prolonged, Japanese-style era of high unemployment and weak growth.

234 Actually, a multiyear period of economic weakness looks likely in any case. The economy may no longer be plunging, but it’s very hard to see where a real recovery will come from. And if the economy does stay depressed for a long time, banks will be in much bigger trouble than the stress tests — which looked only two years ahead — are able to capture. Finally, given the possibility of bigger losses in the future, the government’s evident unwillingness either to own banks or let them fail creates a heads-they-win-tails-we-lose situation. If all goes well, the bankers will win big. If the current strategy fails, taxpayers will be forced to pay for another bailout. But what worries me most about the way policy is going isn’t any of these things. It’s my sense that the prospects for fundamental financial reform are fading. Does anyone remember the case of H. Rodgin Cohen, a prominent New York lawyer whom The Times has described as a “Wall Street éminence grise”? He briefly made the news in March when he reportedly withdrew his name after being considered a top pick for deputy Treasury secretary. Well, earlier this week, Mr. Cohen told an audience that the future of Wall Street won’t be very different from its recent past, declaring, “I am far from convinced there was something inherently wrong with the system.” Hey, that little thing about causing the worst global slump since the Great Depression? Never mind. Those are frightening words. They suggest that while the Federal Reserve and the Obama administration continue to insist that they’re committed to tighter financial regulation and greater oversight, Wall Street insiders are taking the mildness of bank policy so far as a sign that they’ll soon be able to go back to playing the same games as before. So as I said, while bankers may find the results of the stress tests “reassuring,” the rest of us should be very, very afraid. http://www.nytimes.com/2009/05/08/opinion/08krugman.html?th&emc=th May 5, 2009, 5:11 pm Nothing to say Andrew Leonard and Calculated Risk want to know why I didn’t blog about dinner at the White House. Um, because the conversation was off the record. http://krugman.blogs.nytimes.com/2009/05/05/nothing-to-say/

Hacer hincapié en lo positivo PAUL KRUGMAN 09/05/2009 ¡Hurra! ¡La crisis bancaria se ha acabado! ¡Vamos a celebrarlo! Bueno, vale, quizás no. Al final, la publicación que se hizo el jueves de las pruebas de resistencia bancaria a las que tanto bombo se ha dado supuso un anticlímax. Todo el mundo sabía más o menos lo que iban a decir los resultados: algunos grandes actores tienen que recaudar más capital, pero en general los niños, quiero decir, los bancos, están bien. Incluso antes de que se anunciaran los resultados, Tim Geithner, el secretario del Tesoro, nos dijo que serían "tranquilizadores".

235 Pero que ustedes se sientan de verdad tranquilizados o no depende de lo que sean: un banquero o alguien que intenta ganarse la vida con otra profesión. No me voy a meter a debatir la calidad de las pruebas de resistencia en sí, excepto para repetir aquello que muchos observadores han señalado: los reguladores no tenían los recursos necesarios para realizar una valoración realmente minuciosa de los activos de los bancos y, en cualquier caso, permitieron a los bancos negociar lo que los resultados iban a decir. No fue lo que se dice una auditoría rigurosa. Pero centrarse en el proceso puede hacernos perder de vista el conjunto. Lo que estamos viendo aquí en realidad es una decisión por parte del presidente Obama y de sus funcionarios de lidiar con la crisis financiera, con la esperanza de que los bancos puedan llegar a recuperarse. Es una estrategia que puede que funcione. Después de todo, ahora mismo los bancos están prestando a unos tipos de interés elevados y no están pagando apenas intereses por sus depósitos (con garantía del Gobierno). Si se les da el tiempo necesario, los bancos podrían volver a nadar en dinero. Pero es importante ver la estrategia tal y como es y entender los riesgos. Recordemos que fueron los mercados, y no el Gobierno, los que en realidad declararon que los bancos estaban faltos de capital. Y aunque los indicadores del mercado de la desconfianza en los bancos, como los tipos de interés aplicables a los bonos bancarios y los precios de la cobertura de riesgo crediticio, han caído un poco en las últimas semanas, siguen rondando niveles que se habrían considerado inconcebibles antes de la crisis. Como consecuencia, lo más seguro es que el sistema financiero no funcione con normalidad hasta que los actores cruciales recuperen una solidez financiera mucho mayor que la actual. Aun así, la Administración de Obama ha decidido no hacer nada drástico para recapitalizar los bancos. ¿Puede la economía recuperarse incluso con bancos débiles? Tal vez. Los bancos no van a ampliar el crédito en un futuro próximo, pero los prestamistas respaldados por el Gobierno han salido al paso para llenar el vacío. La Reserva Federal ha ampliado su crédito en 1,2 billones de dólares durante el pasado año; Fannie Mae y Freddie Mac se han convertido en las principales fuentes de financiación hipotecaria. Así que quizás podamos dejar que la economía arregle a los bancos y no al contrario. Pero hay muchas cosas que podrían salir mal. No está claro del todo que el crédito de la Reserva Federal, Fannie y Freddie puedan sustituir completamente a un sistema bancario sano. Si no pueden hacerlo, esta estrategia de lidia terminará siendo la receta para una época prolongada de desempleo elevado y crecimiento débil, al estilo japonés. De hecho, un periodo de varios años de fragilidad económica parece probable pase lo que pase. Puede que la economía no siga desplomándose, pero cuesta ver de dónde podría venir una recuperación de verdad. Y si la economía permanece en crisis durante mucho tiempo, los bancos tendrán unos problemas mucho mayores de lo que las pruebas de resistencia -que contemplan sólo los dos próximos años- son capaces de evaluar. Finalmente, dada la posibilidad de que haya mayores pérdidas en el futuro, la evidente falta de voluntad del Gobierno para hacerse con la propiedad de los bancos o para dejarles quebrar crea una situación en la que nosotros perdemos de todas, todas. Si todo va bien, los banqueros ganarán mucho dinero. Si la actual estrategia fracasa, los contribuyentes se verán obligados a financiar otro rescate. Pero lo que más me preocupa del derrotero que está tomando esta política no es ninguna de estas cosas. Es mi presentimiento de que las perspectivas de que se lleve a cabo una reforma financiera fundamental están evaporándose. ¿Se acuerda alguien del caso de H. Rodgin Cohen, un famoso abogado de Nueva York al que The New York Times describía como "una eminencia gris de Wall Street"? Salió fugazmente en

236 los titulares en marzo cuando por lo visto rechazó el cargo de subsecretario del Tesoro a pesar de ser uno de los candidatos favoritos. Pues bien, a principios de esta semana, Cohen dijo que el futuro de Wall Street no diferirá mucho de su pasado reciente, y declaró: "No estoy ni mucho menos convencido de que el sistema tenga algún fallo inherente". Oye, ¿y ese pequeño detalle de que ha causado la mayor recesión económica mundial desde la Gran Depresión? Peccata minuta. Estas palabras dan miedo. Son indicio de que, aunque la Reserva Federal y la Administración de Obama sigan insistiendo en que están decididas a imponer una regulación financiera más estricta y una mayor supervisión, los entendidos de Wall Street se están tomando las suaves medidas bancarias tomadas hasta el momento como una señal de que pronto podrán volver a jugar los mismos juegos que antes. Así que, como he dicho, mientras los banqueros sigan pensando que los resultados de las pruebas de resistencia son "tranquilizadores", los demás deberíamos estar muy, pero que muy, asustados. http://www.elpais.com/articulo/economia/Hacer/hincapie/positivo/elpepueco/20090509e lpepieco_6/Tes

Friday, May 8, 2009 10:32 PDT Did dinner with Obama pay off for the White House? So just what exactly, besides roast beef, did Obama feed Paul Krugman and Joseph Stiglitz at their dinner with the president on April 27? Check out these passages from the two Nobel Prize-winning economists' latest opinion pieces (italics mine): Paul Krugman: What we're really seeing here is a decision on the part of President Obama and his officials to muddle through the financial crisis, hoping that the banks can earn their way back to health ... It's a strategy that might work. After all, right now the banks are lending at high interest rates, while paying virtually no interest on their (government-insured) deposits. Given enough time, the banks could be flush again. Can the economy recover even with weak banks? Maybe. Joe Stiglitz: The good news is that we may be at the end of a free fall. The rate of economic decline has slowed. The bottom may be near -- perhaps by the end of the year ... The American government, too, is betting on muddling through: the Fed's measures and government guarantees mean that banks have access to low-cost funds, and lending rates are high. If nothing nasty happens -- losses on mortgages, commercial real estate, business loans, and credit cards -- the banks might just be able to make it through without another crisis. In a few years time, the banks will be recapitalized, and the economy will return to normal. This is the rosy scenario. Now, I don't mean to suggest that the two critics have miraculously been transformed into administration lapdogs. Neither Krugman nor Stiglitz is happy with the muddle-through approach. Krugman fears, with justice, that the downside of success will be the abandonment of

237 "fundamental financial reform." Stiglitz believes that bank bondholders need to be forced to take haircuts, and that it's already time to be readying another dose of stimulus. But that being said, Krugman's admission that the White House's current plan "might work" is, to my recollection, the nicest thing he's said about the Obama administration's approach to the banking crisis since Inauguration Day. As for the dinner itself, Newsweek's Michael Hirsh has some more details, from attendee Alan Blinder, who appears to treat the "off-the-record" status of the dinner with a little less rigor than Krugman and Stiglitz. Also in attendance: Paul Volcker, who has one foot in and one foot out of the administration as the head of Obama's largely cosmetic economic recovery board; Princeton economist and former Fed vice chairman Alan Blinder; Columbia's Jeff Sachs; and Harvard's Ken Rogoff. Representing the home team, as it were: Obama's chief economic adviser Larry Summers, Treasury Secretary Tim Geithner and Chief of Staff Rahm Emanuel. Why did Obama hold the meeting? "I think he wanted to hear the [opposing] arguments right in front of him," says Blinder. "All I can say is if the president of the United States devotes that much personal time, and it was about two-hour dinner, he must want to hear what people outside the administration are saying and hear what his own people say in rebuttal to that. Why would you do that if you aren't at least turning over your mind what to do next?" But after Krugman and Stiglitz made their now-familiar case for nationalizing the banks and forcing other dramatic changes, Obama gave no indication he was changing his policies, Blinder added. ― Andrew Leonard

Monday, May 4, 2009 11:27 PDT Obama's dinner with Stiglitz and Krugman In David Leonhardt's epic interview with President Obama, published in this past weekend's New York Times Magazine but which actually took place on April 14, the president says he has "enormous respect" for economist Joseph Stiglitz and that "I actually am looking forward to having these folks in for ongoing discussion." Now we learn from Newsweek, (via Taegan Goddard) that: On the night of April 27, for instance, the president invited to the White House some of his administration's sharpest critics on the economy, including New York Times columnist Paul Krugman and Columbia University economist Joseph Stiglitz. Over a roast-beef dinner, Obama listened and questioned while Krugman and Stiglitz, both Nobel Prize winners, pushed for more aggressive government intervention in the banking system.

238 Not even a whisper of this momentous news made it into Paul Krugman's blog, which seems to me to represent a misuse of the medium. I'm sure the conversation was designated off-the-record, which makes it understandable why we have no blow-by- blow from Krugman, but still: I promise all HTWW readers that if I ever have dinner with the president, I will at least mention it in this blog. What else are blogs for if not to tell people about your cool dinner dates? Oh, but would I have loved to have been a mouse in that dining room. KRUGMAN: If you do not nationalize Citigroup and Bank of America, you will have proven to the American people that the White House is owned, lock-stock-and-barrel, by Wall Street! STIGLITZ: The Geithner plan to fix the banking system is outright robbery of the American people, Mr. President! OBAMA: How do you like your roast beef? Raw and bloody, I presume? Please, have some more. One thing we do know: Paul Krugman's oppositional stance was not ameliorated by the meeting, at least as judged by his last two blog posts, here and here. Although one does wonder if Obama's harsh attack Thursday on the hedge funds who refused to budge on Chrysler was in any way influenced by the two Nobel Prize-winning economists. In any case, although I feel inclined to agree with Newsweek's Evan Thomas that "it will take more than a few dinner parties to avoid the fate of presidents who lost touch with reality," I'm still glad to hear that alternate points of view are making it into the White House. ― Andrew Leonard http://www.salon.com/tech/htww/2009/05/04/obama_dinner/index.html

239

Prisoners of the White House Smart decisions don't grow in a vacuum. The most successful presidents recognize the fact and encourage debate—and even rivalry—between their advisers. They do their best to consider the options fully. All the same, it's harder than many people might imagine for our national leaders to keep the field of opinions from turning into a monoculture.

Aude Guerrucci / Getty Images-pool 'The Spectrum From A to A-Minus'? Not everyone in Washington agrees that Obama's economic team is as diverse as it ought to be Evan Thomas NEWSWEEK Published May 2, 2009; From the magazine issue dated May 18, 2009 It's the curse of the modern presidency. Our chief executives need to make an active, aggressive effort to reach beyond their immediate circle of advisers, to demand fresh thinking and avoid the sycophancy that comes with the Oval Office. Otherwise, they'll only hear what they want to hear—or what their aides tell them. To judge from "War of Necessity, War of Choice," Richard N. Haass's new book on presidential decision- making with regard to Iraq, George W. Bush lived in a bubble, partly of his own making, that walled off creative dissent or even, in some cases, common sense. Mindful of his predecessor, Barack Obama seems to be trying harder to make sure he hears all sides. On the night of April 27, for instance, the president invited to the White House some of his administration's sharpest critics on the economy, including New York Times columnist Paul Krugman and Columbia University economist Joseph Stiglitz. Over a roast-beef dinner, Obama listened and questioned while Krugman and Stiglitz, both Nobel Prize winners, pushed for more aggressive government intervention in the banking system. That sort of outreach is admirable—but it would be a mistake to make too much of it. A couple of hours of conversation is no substitute for methodical inquiry and debate. At present, Obama's economic advice is closely controlled by his chief economic adviser, Larry Summers, who acts as a kind of gatekeeper, determining what Obama sees and hears—and what he does not. Paul Volcker, the wise old hand who ran the Federal Reserve in the 1980s and whipped inflation, chairs an advisory panel that does not

240 appear to do much advising. "Our ruling intelligentsia in economics runs the spectrum from A to A-minus," says a member of the Congressional Oversight Panel on the banking bailout, who requested anonymity when speaking about the administration. "These guys all talk to each other, and they all say the same thing." The most successful presidents encourage debate and even rivalry between their advisers. FDR played his aides against each other. This produced some chaotic results in dealing with the Depression but worked reasonably well during World War II. Some presidents only pretend to encourage dissent. During Vietnam, LBJ used State Department adviser George Ball as his in-house dove—more to placate critics than to listen to his advice. Presidents often overreact to their predecessors. JFK believed that Dwight Eisenhower's national-security apparat was bureaucratic and stultifying. He preferred a more freewheeling, informal model—and got the Bay of Pigs, a botched invasion of Cuba cooked up by the CIA, largely without Pentagon input. Kennedy quickly reimposed structure on foreign policymaking. George W. Bush was appalled by the meandering, college-seminar–style White House discussions run by Bill Clinton. But his insistence on crisp discipline and staying on schedule stifled debate. Obama is looser than Bush. Meetings do not always end on time, and the president likes to play law professor, teasing out illogic and sloppy thinking with probing questions. He insisted on keeping his BlackBerry—though, for security reasons, there are some limits on its use. Obama's style is more informal than his predecessor's. Bush insisted on respect for the office: aides wore coats and ties and saluted smartly, metaphorically and literally. White House photos show Obama in his shirt sleeves or tossing a football in the Oval Office. But all paper flows to him through an elaborate staffing process. He, like all presidents, is the captive of a system that has been designed for efficiency but is inevitably isolating. It will take more than a few dinner parties to avoid the fate of presidents who lost touch with reality. URL: http://www.newsweek.com/id/195666

241 Business May 8, 2009 Ailing Banks Need $75 Billion, U.S. Says By EDMUND L. ANDREWS WASHINGTON — After subjecting the nation’s biggest banks to the most public scrutiny in decades, federal regulators ordered 10 of them on Thursday to raise a total of $75 billion in extra capital and gave the rest a clean bill of health. The long-awaited results of the “stress tests” set off an immediate scramble by major institutions for more capital. By June 8, they must give regulators their plans for raising the money, and raise it by November. The verdict was far more upbeat than many in the industry had feared when the tests were first announced in February. And the banks that came up short will have to raise much less than some analysts had expected as recently as a few days ago. The stress tests were aimed at estimating how much each bank would lose if the economic downturn proved even deeper than currently expected. But regulators gave the banks a break by letting them bolster their capital with unusually strong first- quarter profits and also by letting them predict modest profits even if the economy again turns down. Despite an almost tangible sense of relief among the banks and investors, the report card is unlikely to silence an intense debate over whether the Treasury Department and the Federal Reserve let the banks off too easily and glossed over their problems. Under the worst-case assumptions — an unemployment rate of 10.3 percent next year, an economic contraction of 3.3 percent this year and a 22 percent further decline in housing prices — the losses by the 19 banks could total $600 billion this year and next, or 9.1 percent of the banks’ total loans, regulators concluded. That rate of loss would be higher than any other since 1921. But while the adverse situation was supposed to be unlikely, it is not that much worse than what has happened so far. Unemployment hit 8.5 percent in April and could top 9 percent as early as Friday, when the Labor Department releases its employment report for May. Bank of America was told it would have to come up with $34.9 billion. Wells Fargo will have to find $13.7 billion. And Citigroup will have to produce another $5.5 billion, on top of the $52.5 billion that it had planned to acquire by letting the Treasury become its biggest single shareholder as part of a broader deal. Industry executives reacted with jubilation, as if they had proved their critics wrong and passed the tests with flying colors. “The results off the stress tests should put to rest the harmful speculation we have seen over the past few months,” declared Edward L. Yingling, president of the American Bankers Association, hours before the results were even made public. Investors, who had already bid up share prices of the big banks in reaction to leaks about the results earlier this week, reacted with relief.

242 Regulators and bank executives alike predicted that most of the institutions would be able to build up the necessary capital from private sources — either by selling off assets or by converting shares of preferred stock into ordinary stock. “With the clarity that today’s announcement will bring, we hope banks are going to get back to the business of banking,” Timothy F. Geithner, the Treasury secretary, said Thursday. Wells Fargo immediately announced that it would raise $6 billion through a new stock offering. Morgan Stanley, which was told to raise $1.8 billion, announced plans for a $2 billion stock offering. GMAC, the financing arm of , will need to find $11.5 billion in capital. Last week the government gave GMAC more federal funds after it agreed to be the lender for purchasers of Chrysler vehicles while Chrysler is under bankruptcy protection. Earlier this year, the Treasury Department supplied the company with $5 billion through its Troubled Asset Relief Program. Regulators did not push for the ouster of any chief executives, or demand any specific board shake-ups. They also said they would not subject the rest of the nation’s banks to similar stress tests or require them to have additional capital buffers. But Treasury and Fed officials said they would press banks to improve their governance and would reserve the right to demand changes in management for banks that need substantial additional help from taxpayers. Indeed, Bank of America is expected to announce that it will start recruiting fresh board members in a bid to strengthen oversight over its management. Despite the reassuring picture outlined by Mr. Geithner and the chairman of the Federal Reserve, Ben S. Bernanke, the stress test results hardly silenced critics who have warned that the tests would amount to a whitewash. “It’s window-dressing,” said Bert Ely, a longtime bank analyst based in Alexandria, Va. Mr. Ely was particularly skeptical about letting companies bolster their balance sheets by converting preferred shares to common. “That won’t add one extra dollar to a bank’s capital buffer against losses,” Mr. Ely complained. “It’s just moving capital from one place to another.” From the start, Treasury and Fed officials have steered between what Mr. Bernanke recently described as “Scylla and Charybdis” — being perceived as too easy and too coddling of banks on the one hand, or so tough and antagonistic that investors and consumers alike become even more anxious. But the big question, which remains unanswered, is whether Mr. Geithner and Mr. Bernanke will in fact confront banks over their risk management practices in a way that regulators have been afraid to do for years, or whether regulators will simply revert to business as usual once the crisis eases. Officials also disclosed detailed estimates of potential losses at individual banks, concluding that losses could skyrocket at institutions with particularly risky loan portfolios. At Wells Fargo, which was a major subprime mortgage lender during the housing boom, regulators estimated that losses on first mortgages would hit almost 12 percent of its loan portfolio if the adverse situation proved correct. At Morgan Stanley, regulators estimated, loss rates from commercial real estate loans could potentially exceed 40 percent.

243 But analysts increasingly agree that the economic outlook has brightened considerably in the last month or so. A wide array of recent indicators, from consumer spending and consumer confidence to home sales and credit conditions, now suggest that the economy is stabilizing and that a fragile recovery will begin later this year. Mr. Geithner and top White House officials worked carefully to manage public expectations and avoid the kind of scathing reaction that greeted the Treasury’s first big announcement in February of plans to rescue the banking system. Unlike in February, when both Mr. Geithner and President Obama raised expectations in advance, then unveiled only vague concepts, Mr. Geithner took much of the surprise out of the results by emphasizing early on that all the big banks were solvent. The only question, he said over and over, was whether they had enough capital to withstand a downturn that was even worse than the one already under way. In addition, Treasury and Fed officials remained tranquil as most of the results dribbled out through leaks before the official disclosure. As a result, the results seemed almost anticlimactic when they finally became public. Jackie Calmes contributed reporting. http://www.nytimes.com/2009/05/08/business/08stress.html?th=&emc=th&pagewant ed=print

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May 8, 2009 Stress Tests Results Split Financial Landscape By LOUISE STORY and ERIC DASH At one bank in Alabama, the problem is a construction bust. At two in Ohio, the trouble is real estate. And in San Francisco, at Wells Fargo, the worry is credit cards — a staggering 26 percent of that bank’s card loans, federal regulators have concluded, might go bad if the economy takes a turn for the worse. The stress tests released by the Obama administration Thursday painted a broad montage of the troubles in the nation’s banking industry and, for the first time, drew a stark dividing line through the new landscape of American finance. On one side are institutions like JPMorgan Chase and Goldman Sachs, which regulators deemed stronger than their peers — perhaps strong enough to repay billions of bailout dollars and wriggle free of government control. On the other side are weaker institutions like Bank of America, which now confront the daunting challenge of raising capital on their own or accepting increased government ownership, along with whatever strings might be attached. Time is short: the banks have only until June 8 to draw up their plans for regulators. As the results of the tests streamed in from the Federal Reserve, banks began racing to raise money. Broadly speaking, the test results suggested that the banking industry was in better shape than many had feared. Of the nation’s 19 largest banks, which sit atop two- thirds of all deposits, regulators gave nine a clean bill of health. The remaining 10 were ordered to raise a combined $75 billion in equity capital as a buffer against potential losses should the economy deteriorate. That amount is far less than many had forecast. But the potential losses that federal regulators projected, even at the soundest banks, are eye-popping. Under regulators’ worst-case assumptions, the 19 banks might suffer $600 billion in losses through 2010, on top of the hundreds of billions that have already vaporized in this financial crisis. About 9 percent of all loans might sour — a figure that is even higher than it was during the Great Depression. One in five credit card loans could go unpaid, more than double the typical loss rate. Approximately one in 10 mortgages could sour. The tests also left some crucial questions unanswered, including the big one: What happens if this recession turns out to be even worse than that worst-case situation, and the banks’ losses start growing? The results suggest the big bailouts for the banks are over. But many wonder if banks will be in a position to make the loans needed to revive growth, even under rosier economic assumptions. “Everybody should breathe a sigh of relief,” said Peter J. Solomon, who runs a boutique investment bank and early in his career worked at Lehman Brothers. “Now the question is, So what? Will they lend?”

245 The results shined an uncomfortable spotlight on the most troubled financial institutions: GMAC, the finance arm of General Motors; Bank of America; Wells Fargo; and Citigroup. Several large regional banks — like Regions Financial in Alabama and SunTrust Banks in Georgia, and Keycorp and Fifth Third in Ohio — were also deemed to need large sums of capital. But many banking executives, free to discuss the results publicly for the first time, sought to put a positive spin on the tests. In a rush of conference calls with analysts, they generally characterized the results as a sign that their institutions could weather another downturn in the economy. Many said federal regulators were overly pessimistic in their assessments and insisted that they would move quickly to repay bailout money. “Our game plan is to get the government out of our bank as quickly as possible,” said Kenneth D. Lewis, the chief executive of Bank of America. But even Mr. Lewis acknowledged that his bank faced some serious challenges. Regulators determined that Bank of America needed to raise about $34 billion in equity capital. The bank hopes to raise half of that by selling common stock and converting preferred shares to common stock. It hopes to raise the rest by selling assets like First Republic Bank and Columbia Management, its -based investment unit, and using its future earnings. If that fails, the bank will have to convert some of the $45 billion of preferred stock that the government owns into common shares, increasing the government’s stake. Even before federal regulators announced the results of its stress tests, Wells Fargo announced that it would offer $6 billion in common stock. The government is requiring the bank to raise an additional $13.7 billion. Wells executives — who balked at accepting bailout money last autumn — said they expected to raise the remainder largely through revenue growth that they say they believe will far exceed the expectations of government regulators. But Wells Fargo officials also disputed the government’s conclusions, arguing that the government’s revenue forecasts were “excessively conservative.” “In our analysis, we thought we didn’t need any capital,” said John Stumpf, the bank’s president and chief executive. Citigroup, which for many has come to symbolize the problems plaguing the financial industry, has already been moving quickly to address its problems. Regulators determined that the bank must raise $5.5 billion, on top of recent efforts to raise capital by selling businesses and converting just over half of the $45 billion in bailout funds to common stock. Vikram S. Pandit, the bank’s chief executive, said he would expand the company’s offer to exchange preferred shares of stock for common stock to a broader assortment of private investors. The moves will severely dilute the bank’s shareholders and will leave the government with a 34 percent ownership stake, slightly less than investors expected. “We have had to make some very tough decisions,” Mr. Pandit said. “We are kind of happy we did them along the way.” But a handful of stronger banks are pulling away from their weaker peers and emerging as institutions that could dominate the industry.

246 Goldman Sachs, for instance, has said that it hopes to return the $10 billion it received from the government as soon as possible. On Thursday, regulators said Goldman did not need more capital. JPMorgan Chase, which was also deemed to have enough capital, is pushing to return bailout money as well. Yet it, too, took issue with the results, arguing it was in an even stronger position than the results suggested. “We think we can handle an even more significantly negative environment and still make a profit,” Michael J. Cavanagh, chief financial officer, said. For Washington and Wall Street, the main question is whether investors and depositors will take solace from these results. Banks and administration officials are eager to persuade private investors that the banks are stable enough to invest in. “The golden ring here, if you can catch it, is confidence,” said Tanya Azarchs, the bank rating analyst at Standard & Poor’s. Graham Bowley and Andrew Martin contributed reporting. http://www.nytimes.com/2009/05/08/business/08bank.html?th=&emc=th&pagewanted= print

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U.S. to Wind Down Help for Some Banks Stress Tests Find Most Can Absorb Losses By Binyamin Appelbaum and Neil Irwin Washington Post Staff Writers Friday, May 8, 2009 The government signaled yesterday that its financial rescue efforts may have reached their high-water mark, announcing that the much-anticipated "stress tests" of 19 large banks showed that only one, GMAC, was likely to need additional taxpayer aid and that it would begin to unwind assistance for the healthiest firms. Despite a deepening recession and projections that banks will continue to lose money, the government will require the firms to increase their combined capital by as little as $9.5 billion. The government will require the banks to further strengthen their capacity to absorb losses by adding $74.6 billion to the portion of their capital that comes from common equity. Banks are likely to raise some of that money from investors and some by converting other forms of capital. The announcement at the Treasury Department yesterday culminated a three-month process designed to show that banks are returning to health after a crisis that left much of theindustry dependent on federal aid. Officials said that banks continue to hold vast quantities of ill-considered loans and could suffer losses totaling $600 billion over the next 20 months as the borrowers default. But in showing that the banks can absorb those losses, the administration hopes to restore investors' confidence. If banks can start raising money again, they can increase lending to consumers and small businesses, a critical piece in the government's broader strategy for renewing economic growth. "With the clarity provided by today's announcement, banks should be able to get back to the business of banking," said Treasury Secretary Timothy F. Geithner. First, however, the banks must respond to the results. The government's demand that 10 of the banks raise billions in common equity creates a virtual referendum on nationalization. The banks have six months to persuade private investors to buy new shares of their common stock, or else the firms could be forced to grant the Treasury a voting ownership stake. Financial analysts said they regard the success of those stock sales as a critical indicator of whether the stress tests have restored the market's confidence in the companies. The government hopes to show it does not need to take a stake in banks beyond Citigroup and GMAC. There may not be a long wait to find out. Two banks said last night that they would issue $8 billion in common shares immediately. While the banking industry will remain on federal aid for the foreseeable future, officials also said they would now allow some of the healthiest banks to repay the government's initial capital investments. Nine of the 19 banks were found to have

248 sufficient capital reserves. Firms that repay the government no longer face restrictions on executive compensation. Applicants will first be required to show that they do not need the shelter of a Federal Deposit Insurance Corp. program that helps banks raise money at lower interest rates. But banks may continue borrowing from the Federal Reserve's emergency programs, which do not impose pay restrictions. Geithner said yesterday that regulators saw the Fed programs as serving a different purpose. "They're for the benefit of the economy as a whole," he said. The results also were greeted with relief by Treasury officials who have worried that banks would need more than the $110 billion remaining from the $700 billion rescue program authorized by Congress. That now appears highly unlikely. Indeed, officials are now considering the revival of rescue programs shelved for a lack of funds, according to sources familiar with the discussions. The stress tests were an unprecedented effort by banking regulators to project the future performance of the nation's largest banks. Regulators found that all but two had enough resources to absorb projected losses through 2010 while still complying with the standard requirement to maintain a capital reserve of at least 6 percent of loans and other commitments. GMAC, the nation's largest auto financing company, fell short by the largest margin, needing $9.1 billion in new capital to meet this basic requirement. The company is expected to get a $7.5 billion capital infusion from the government next week, according to people familiar with the matter who spoke on condition of anonymity because it has not yet been announced. Regions Financial of Alabama was found to need $400 million in additional capital. Regulators also subjected banks to a new test, requiring a second, 4 percent capital buffer of common equity -- money derived from the sale of common shares or retained from past profits. Common shareholders dislike other forms of capital, such as money raised by selling preferred shares, because those investors have first claim to the company's profits and are more sheltered in the event of a bankruptcy. Banks with too much capital from other sources have seen their stock prices drop as a result, in some cases threatening their viability. Regulators imposed the new requirement to appease common shareholders. Ten of the banks failed this second test. Bank of America was told to raise about $34 billion in additional common equity. Wells Fargo, which needs almost $14 billion, said last night that it would sell $6 billion in new shares to investors and raise the rest from future profits. Morgan Stanley said it would sell $2 billion in common shares. "It's a test of the credibility of the results, and it's a test of the strength we've seen in the bank market lately, to see if they're willing to put the money in," said Frederick Cannon, a financial analyst with Keefe, Bruyette and Woods. Banks also can increase common equity by issuing common shares to investors who hold preferred shares. The government is the largest such investor, holding $152 billion in preferred shares in the 10 companies.

249 But the banks and the government are eager to avoid converting these shares, which would give the government greater control over the companies. Citigroup, which needs to raise $5.5 billion in common equity, said it would instead issue common shares to private investors who hold preferred shares. "We are seeking nothing further from the government," said Edward Kelly, Citigroup's chief financial officer, adding that the company's capital concerns could finally be put to rest. "This is a milestone for us and the industry." Staff writer Tomoeh Murakami Tse in New York contributed to this report.

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Friedrich Hayek as a Teacher Mises Daily by David Gordon| Posted on 5/8/2009 In 1969, Friedrich Hayek taught at UCLA; he was Flint Professor of Philosophy, a visiting position of great prestige which had in past years been held by Bertrand Russell and Alfred Tarski. I was then a senior and enrolled in his only undergraduate class, Philosophy of the Social Sciences. He also taught a graduate seminar that covered the manuscript of his then forthcoming Law, Legislation, and . I was too shy to ask Hayek whether I could attend this also; but memories of what I was fortunate enough to hear have stayed with me in the forty years since that time. Most of the students - I think there were about thirty-five in the class - hadn't previously heard of Hayek; but it was at once obvious to everyone that their professor was someone of extraordinary intelligence. (One student who already admired Hayek was David Glasner, who went on to become a well-known economist.) At the first session, Hayek told us that in order to understand the philosophy of the social sciences, one needed to know something about the philosophy of science in general. Because he would not be lecturing on this subject, he asked everyone to read a book on the topic, such as his friend Karl Popper's The Logic of Scientific Discovery. He did not just tell us this but went around the room, asking each person to promise to read a book on the philosophy of science. After a number of people had promised, someone asked Hayek why it was necessary for each person to promise individually. Hayek replied that he wanted to make sure everyone had made a commitment. He did not refer to this requirement again, except once to wonder whether those who had chosen Popper's book had quit when they got to the sections on probability theory. Mention of Popper's book brings to mind another time he mentioned it. When he called the book The Logic of Research, a student raised his hand. "Isn't the title The Logic of Scientific Discovery?" he asked. Hayek smiled and responded, "You are quite right that when the book appeared in English translation in 1959, it was under the title The Logic of Scientific Discovery. But you see, when the book was published in Vienna in 1935, it was under the title Logik der Forschung, which translates, "The Logic of Research." It was very hard to catch Hayek out on a factual inaccuracy, although I recall he once erred on the date of Julius Caesar's assassination. Hayek delivered his lectures seated at a desk. He never used notes, but his lectures could easily be printed verbatim. When a student asked a question, Hayek would pause and then deliver an answer in language as equally exact as his lectures. He would sometimes twist his head in order to hear the question better. He said that he found it an interesting

251 historical coincidence that he was deaf in the left ear, and Karl Marx had been deaf in the right ear. The main assigned reading was an anthology edited by May Brodbeck, Readings in the Philosophy of the Social Sciences. She was a positivist, whose views contrasted sharply with Hayek's. As a counterweight, he also assigned his own The Counter-Revolution of Science. (Her positivist views did not prevent her from becoming friends with .) Often, his lecture would be a critical reading of a selection from the anthology. As he countered the positivist missteps, he would flick ashes from the cigarettes he smoked on the pages of the offending article. He was keen to stress methodological , the view that only individuals act. References to collectives such as nations and classes that act must in principle be capable of being reduced to individuals' actions. He thought highly of an article on the topic by J.W.N. Watkins, "The Principle of Methodological Individualism." Like Watkins, Hayek noted that methodological individualism does not require us to indentify specific actors: one can explain social phenomena by appeal to the actions of anonymous individuals. A noted opponent of methodological individualism, Othmar Spann, was one of Hayek's teachers at the University of Vienna. He reversed methodological individualism, holding that the collective was prior to the individual. Spann used an odd diagram, which showed a larger and smaller circle connected at the top by arcs, to illustrate his theory. Hayek said that when Spann put this diagram on the blackboard and had his back turned to the class, students would puts their arms over their heads to make fun of Spann. Some people explain social institutions by appealing to their function. Marxists, e.g., claim that the function of the relations of production is to advance the development of the forces of production. Methodological individualists do not accept this type of explanation, unless the functions can be cashed out in individuals' actions. On this topic, Hayek recommended a famous article by Robert K. Merton, "Manifest and Latent Functions." He said, "Merton is about the best of the sociologists. Of course, this isn't saying very much." Methodological individualism, as Hayek taught it, went together with subjectivism. To explain social phenomena, one had to start from the preferences and perceptions of individual actors. He rejected strongly behaviorist pretensions to characterize thought and perception without reference to private impressions. He said, e.g., that perceived colors could not be identified with an objectively measurable place on the light spectrum. He develops this argument, along with many related ones, in more detail in The Sensory Order. I managed once to make him laugh with a joke about two behaviorists who meet each other. One of them says, "You're fine; how am I?" Of course, appeal to the individual actor does not imply that all social institutions are the product of conscious intentions. To the contrary, Hayek emphasized the importance of unintended consequences; the study of these consequences, he held, was the principal task of social science. He emphasized that Kant's notion of "unsocial sociability" influenced him here. Overall, he said, Kant and Hume were the two philosophers from whom he had learned the most.

252 All readers of Hayek will be familiar with tacit knowledge; and once he gave us a striking example of this. He said that a few years before, he had resumed skiing after a long absence from the slopes. While he was skiing downwards at a fast pace, he suddenly saw a body lying directly in front of him. Without thinking about it, he immediately swerved aside. Hayek emphasized the a priori character of praxeology much less than Mises did. (Though Hayek differed from Mises on this issue of method, he held Mises in the greatest esteem. He recommended Mises's Theory and History very highly.) Usually, people ascribe this shift to Popper's influence; but his comments in class showed that this is not the full story. He was very impressed by W.V.O. Quine, whose famous challenge to the analytic-synthetic distinction, if accepted, is usually taken to rule out synthetic a priori truths. Hayek told me, "I regard Quine as one of our most stimulating philosophers." I do not mean to deny Popper's influence, though: it was clear that Hayek held him in high regard. He told me that Popper's The Open Society and Its Enemies gives a convincing account of Plato and Hegel but is probably too hard on Aristotle. He also, by the way, had a high opinion of Murray Rothbard. When I asked him about America's Great Depression, he said it was an excellent book and gave a convincing interpretation of the Depression. He did not like to speak, though, of a business "cycle," because the term implies that there is a return to the original starting point. This normally does not happen when a depression ends. For the economics of Milton Friedman, he had much less sympathy: he once strongly criticized Friedman's proposal of a negative income tax. As the story about "cycle" shows, Hayek emphasized precise use of words. Once, when a student used "criteria" as a singular noun, Hayek said that when people said "criteria" when they should have said "criterion" and "phenomena" instead of "phenomenon," it hurt his ears. He gave some talks on social and cultural evolution, and it was evident that Darwinian evolution was a strong influence on his thought. Though he recommended the work of his friend Ludwig von Bertalanffy on general systems theory, he dismissed entirely Bertalanffy's skepticism about standard evolutionary theory. The required work for the course was a single paper, due near the end of the course. Hayek gave me some advice on my paper that has been of great help to me in later work. I did a critical review of an article by Ernest Nagel on method in economics. "Remember," Hayek said to me, "point-by-point refutation." In his own critical work, Hayek was not satisfied with a challenge to the main thesis of an opponent. He responded to every argument advanced in the adversary's work. Those who wish to see this method in action should see his famous response to Foster and Catchings, "The 'Paradox' of Saving," in Prices and Production and Other Works (edited by Joseph T. Salerno). It remains only to say that Hayek, despite his ferocity as a critic, was a very easy grader. http://mises.org/story/3458

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08.05.2009 A few surprises from the ECB

It did not happen often during the crisis that a European institution surprises by doing more than expected, but the ECB did just that yesterday. Not surprising were the cut its main interest rate by a 25bp down to 1%, the lowest level ever, and the increase in its refinancing horizon. But a surprise was Jean Claude Trichet’s announcement that the ECB would buy €60bn of covered bonds – Pfandbriefe – structured instruments issued by banks to finance mortgages, and by public authorities; also surprising was the announcement that the repo level of 1% was not the lowest possible level. Covered bonds are structured products similar to mortgaged-backed securities, with the big difference that the risk remains on the issuer’s balance sheet. Even though covered bonds are thus much safer than MBS and other modern credit products, their market was also affected by the crisis, and effectively dried up last year. In engaging in a version of quantitative easing, or credit easing, the ECB follows the Fed and the BoE. The other decision was to extend access to unlimited liquidity for banks at the main rate to maturities up to 12 months (from current six months). From July on, it also grants the European Investment Bank access to its liquidity, which could enable the EIB to boost help for companies, including in eastern Europe. The FT editorial wrote that the ECB is now reaching its limits. “Europe’s banks have yet to own up to their losses; the inevitable day of reckoning will push them to shrink balance sheets. And as the recession deepens, fewer borrowers approach banks and those that do are less creditworthy. Lending is now as constrained by demand as by a supply squeeze.” The ECB cannot beat this recession alone, banks need to be capitalised and demand needs to be stimulated further.

Stress tests – more stress ahead The top 10 US banks need addition capital of only $75bn, according to the stress test results yesterday. The top 19 banks will make losses of some $600bn under the adverse scenario, to be compensated partly by operating earnings of almost $400bn. There is more information on this in the Financial Times. The papers’ market columnist John Auther’s said that this news is not all that good for the bond markets, which 30-year Treasury yields in a US Treasury bond auction yesterday rose unexpectedly to 4.3%.

254 Paul Krugman on the stress tests – and the recovery Paul Krugman asks in his New York Times column whether the crisis is over now, and whether we should go back to partying. He says the Obama administration’s strategy is one of muddling through, hoping that an economic recovery would fix the banks. He said it might work, but probably not. He expects a longish period of sluggish growth. Most of all, he is worried about the prospects of deep financial reform, which is fading. He said the stress may be reassuring to the bankers, but the rest of us should be very afraid.

Yves Smith on the stress tests Yves Smith of Naked Capitalism, a strong critic of the way the US government has handled the financial rescue, yesterday a critical report about the jubilant newspaper coverage of the results. The New York Times other newspapers failed to point out the following three important issues: “1. The fact quite a few of the banks negotiated their fundraising requirements down, calling the integrity of the process into question. 2. No mention that the purpose of this exercise from the outset was to prove the banking system to be solvent. What kind of a test is that? 3. No mention that asset sales (the reason Citi was able to negotiate its fundraising down from $10 billion, and presumably others as well) are almost certain to be a non-starter.”

Socialists want to stop Barroso after all It look for a while that Brussels was going to morph into a politics-free zone, when the European Socialists appeared resigned to accept Jose Manuel Barroso as the next president of the European Commission(we covered a recent interview with Martin Schulz, the Socialist leader recently, who said that Barroso’s re-elected was effectively a done deal). But Poul Nyrup Rasmussen, the former Danish PM and leader of the European Socialists, told FT in an interview said the socialists wanted to stop Barroso to be reelected as president of the European Commission, and put up their own candidate (it looks as they there is a fight with Schulz, who seems to be pushing his personal agenda by supporting Barroso). Daniel Cohn Bendit said the most important thing is to prevent Barroso’s election in the Parliament, which will only be possible if the Left united against him. Steinbruck says Germany cannot afford tax cuts Germany’s Social Democrats say that a recent estimate of €800bn in tax shortfalls during the next four years, would make tax cuts impossible. Angela Merkel and her party are demanding tax cuts – which they always do ahead of elections – while Steinbruck says that given the state of tax revenues, and expected tax revenues, this can simply not be done, in light of the latest tax estimates. He also said it was not possible to cut taxes for low-income earners either. Thomas Fricke on scenarios for Germany In his FT Deutschland column, Thomas Fricke said the prospect of a Great Depression-like collapse of the global economy is now very much reduced. But welcome as this may be, it is not clear at all whether Germany benefits from this, or whether its recover is similar to the sluggish growth post the 2001 recessions, or similar to Japan’s experience in the 1990s. He said a quick global recovery would possibly do the trick, but a slower recovery would not allow German companies to

255 keep their workers due to the recent rise in unit labour costs make it, which has seen a dramatic increase over the last year, back to level that prevailed in the 1990s. (Germany seems to have undone its competitiveness leap during this decade almost completely, according to this statistic). The consequence would be a dramatic increase in unemployment, and a long long quasi-depression. Dollar vs SDRs? What about the euro? Owen F. Humpage, writing in Vox, said China recently called for SDRs to replace the dollar as the international reserve currency and diminish the US economic supremacy. The column argues that because of the huge network benefits associated with using dollars, SDRs are not likely to supplant the dollar anytime soon as an international reserve unit, especially with the euro as a more viable competitor. http://www.eurointelligence.com/article.581+M51ec45b3851.0.html#

256 08.05.2009 Lessons of the Global Financial Crisis: 3. Built to fail By: Satyajit Das

The key lesson of the global financial crisis (GFC) may be that the current economic order is "built to fail". The ability to sustain high rates of economic growth, decreed by governments and central bankers, is questionable. The aggressive increase in debt globally resulted in a sharp increase in sustainable growth rates. $4 to $5 of debt was required to create $1 of growth. Approximately half the recorded growth in the US over recent years was driven by borrowing against the rising value of houses (mortgage equity withdrawals). As the level of debt in the global economy decreases, attainable growth levels also decline. The world used debt to accelerate its consumption. Spending that would have taken place normally over a period of many years was squeezed into a relatively short period because of the availability of cheap borrowings. Business over invested misreading demand and assuming that the exaggerated growth would continue indefinitely creating significant over-capacity in many sectors. The noveau Jeffersonian trinity - "whoever dies with the most toys wins"; "shop till you drop"; and "if it feels good, do it" – has proved to be unsustainable. Growth in global trade and capital flows was also "built to fail". It was built on a financing model where sellers of goods and services indirectly financed the purchase. When the buyer is unwilling or unable to pay, the seller suffers doubly - sales fall and also the money advanced to the buyer falls in value. The GFC has already reduced global trade and cross border capital flows. In late 2008, the World Bank forecasts a fall in global trade volumes for the first time in over 25 years. The Baltic Dry Freight Index, a measure of supply and demand for basic shipping, has fallen 90 % since mid 2008 although it recovered slightly in early 2009. Exports from Japan, Korea, Taiwan and China fell between 10% and 40% in late 2008 also signaling reduced demand for commodities. The Institute for International Finance forecasts net private sector capital flows to

257 emerging markets in 2009 will be less than US$165 billion - 36% of the US$466 billion inflow in 2008 and only one fifth the record amount in 2007. The projected decline in capital flows is around 6 % of the combined gross domestic product of the emerging countries. This compares to a decline of approximately 3.5 % of combined GDP in the Asian financial crisis and 1.5% in the Latin American crisis. Investors in US government bonds have expressed deepening concern about the safety and security of their investments. Yu Yongding, a Chinese economist and former advisor to China’s central bank, warned in 2008 that: "If the US government allows Fannie and Freddie [government sponsored enterprises] to fail and international investors are not compensated adequately, the consequences will be catastrophic. If it’s not the end of the world, it is the end of the current international financial system." Kwag Dae Hwan, head of global investment, of South Korea’s US$220 billion National noted: "The image of US Treasuries as a safe haven has been tainted by the ongoing financial debacle … A big question mark hangs over whether the US can deal with an unprecedented amount of debt. That is unnerving all the investors, including me." As the risk of trade and financial protectionism emerges, globalisation of trade and capital flows is reversing - the "flat world" is rapidly going "pear shaped". Slowing exports, lower growth and loss of jobs are encouraging trade protectionism. Several countries have implemented trade barriers (import tariffs and export subsidies). The fiscal packages in many countries are "economic nationalist" encouraging spending on domestically produced goods and supporting national champions and local industries. The US, France, Germany, Spain have announced bailouts for domestic companies. Asian countries are seeking to weaken the currencies to support exports to maintain global competitiveness. The US Treasury Secretary recently accused China of manipulating its currency drawing angry responses from Beijing. Financial protectionism has also emerged. Governments are supporting domestic banks and increasingly "directing" lending to domestic firms and households. Concerns about immigration are emerging. There have been protests in UK against hiring foreign workers. This has serious implications of countries like Mexico, Eastern Europe, India and the Philippines that depend on worker remittances that are already slowing. In an essay titled "The Great Slump of 1930," published in December of that year, Keynes observed: "We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand." Failure to Summit The current crisis calls into question the ability of government and policy makers to maintain control of the economy – Lenin’s "commanding heights". Governments may not be able to address the deep-rooted problems in the current economic models. Government spending, if it can be financed, may not be able to adequately compensate for the contraction of consumption and lack of investment made worse by over capacity in many industries. Government spending has little multiplier effect or velocity. The badly damaged financial system means that the circulation of money in the economy is at a standstill. While government spending may provide short-term demand boost and capital injections may partially rehabilitate banks, it is far from clear what will happen when all

258 these measures are reversed. Governments and central banks have limited available tools. Keynes famously described monetary policy as the equivalent of "pushing on a string". Given that interest rates are now at or approaching zero in many developed countries, there is no string at all. Fiscal policy could be described as "pulling on the same string". The experience of Japan is salutary. Zero interest rates and repeated doses of fiscal medicine have not restored the health of the Japanese economy that remains mired in a form of suspended animation. The rest of world’s current struggle is to avoid turning "Japanese". In the run-up to the 1929 election, Keynes discovered a seminal political truth about deficit spending. Lloyd George, an economically challenged politician, was delighted when Keynes provided the rationale for spending taxpayers’ money on social programs to bribe voters. Keynes absorbed this lesson well and maintained a constructive ambiguity throughout his life allowing him to appeal to politicians who favoured government spending and those who favoured middle-class tax cuts. Writing in the Financial Times (5 February 2009) Benn Steil, Director of International Economics at the Council on Foreign Relations, succinctly set out current economic thinking: "when the facts are on our side, we pound the facts; when theory is on our side, we pound theory; and when neither the facts nor theory are on our side, we pound Keynes." Correcting global imbalances provides greater challenges. The world has relied heavily on debt fuelled American consumption to drive global growth. With 5% of the world’s population, the US is 25% of global GDP, 20% of global consumption and 50% of global current account deficit. The US needs to decrease consumption, increase savings, reduce debt, export more and import less. The countries with large savings and trade surpluses need to do exactly the opposite, specifically encourage domestic consumption. Currently both surplus and deficit countries are doing the opposite of what is required. The challenge is evident in two telling statistics. Consumption is around 40% of the economy in China against over 70% in the US. Average earnings in China are only 10% of that in the US. The size of the adjustment is substantial. David Rosenberg, an economist from Merrill Lynch, described the process of adjustment: "This is an epic event; we’re talking about the end of a 20-year secular credit expansion that went absolutely parabolic from 2001-2007. Before the US economy can truly begin to expand again, the savings rate must rise to pre-bubble levels of 8%, the US housing stock must fall to below eight-months’ supply, and the household interest coverage ratio must fall from 14% to 10.5%. It’s important to note what sort of surgery that is going to require. We will probably have to eliminate $2 trillion of household debt to get there, this will happen either through debt being written off, as major financial institutions continue to do, or for consumers themselves to shrink their own balance sheets." Corrective action will only deepen the recession and disrupt global funding flows. Wen Jiabao, the Chinese Prime Minister, recently indicated that China’s "greatest contribution to the world" would be to keep it’s own economy running smoothly. This may signal a shift whereby China uses its savings to invest in the domestic economy rather than to finance US needs.

259 Redirection of capital held in central banks and sovereign wealth funds to domestic economies affects the global capital flows needed to finance banking system recapitalisation and spending packages in the debtor countries. Maintenance of the cross border capital flows to finance the debtor countries budget and trade deficits slows down growth in emerging countries and also perpetuates the imbalances. There is now acknowledgement that the economic model itself is the source of the problem. Zhou Xiaochuan, governor of the Chinese central bank, commented: "Over- consumption and a high reliance on credit is the cause of the US financial crisis. As the largest and most important economy in the world, the US should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits." More ominously Chinese President Hu Jintao recently noted: "From a long- term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies." In the GFC, politicians, bureaucrats and central bankers have been exposed to have no more powers than the Wizard of Oz – old desperate men (they are mainly men) behind the curtain running from one lever to another in a desperate attempt to maintain illusions. In the words of the 19th century American humorist Josh Billings: "It is better to know nothing, than to know what ain’t so." Limits to Growth The GFC’s seriousness and gravity is unquestioned. Initially, the world viewed the destruction of financial institutions as an entertaining blood sport. There was a sense of schadenfreude as the Masters of the Universe received their comeuppance. The "financial" crisis has now spread to the "real" economy – jobs, consumption, and investment. It is now everybody’s problem. In the US alone, more than 3.6 million jobs have been lost. In Spain, unemployment has reached the middle teens. Exports and production have fallen in countries as varied as Spain, Japan, South Korea and Taiwan by amounts that beggar belief. An astonishing US$30 trillion of wealth has been obliterated in America alone. Entire countries – Iceland and Ireland – have been savaged. The GFC coincides with another crisis: the GEC or Global Environmental Crisis. "Toxic debt" and "toxic emissions" increasingly clamor simultaneously for politician’s attention. Irreversible climate change, scarcity of vital resources (food and water) and falling biodiversity are not unconnected with the existing economic system. Economists and politicians implicitly assume that high levels of growth drive increased living standards, rescuing people from poverty and social development. No limit to economic growth is recognised. At the launch of the "Redefining Prosperity" project, Tony Jackson, Professor of Sustainable Development at the University of Surrey, writing in the New Scientist noted that a UK treasury official accused the authors of wanting to "go back and live in caves". The project sought to raise concerns about environmental and social limits on economic growth. Ironically, the GFC has illustrated the limits and illusions of economic growth starkly. A lower growth future has political and social implications. For example, China and India are deeply concerned about failing to provide jobs for the millions coming into the workforce each year. One in fifteen migrant workers in China are expected to be out-of-

260 work in 2009. Chinese security leaders have warned about rising social unrest. Demagogic debates about the ideological differences between neo-liberalism, compassionate capitalism and social democracy are unhelpful. In truth, all competing economic philosophies are underpinned by the same reliance on growth and built to fail economic models. The world needs to adjust to a new economic order and a world of reduced expectations. In the short run, the primary focus surely should be to dealing pragmatically with the GFC and its potentially devastating human and social costs. There will be time enough for recriminations and blame. Dead Economists At the fall of the Berlin Wall, when asked - "who won", political scientists cited the triumph of capitalism over socialism. The economist’s response was simply: "Chicago". The reference is to the Chicago Graduate School of Business and its unshakable belief in free markets exemplified in the title of Milton Friedman’s most accessible work – Free To Choose (1990). The GFC marks the end of unquestioned advocacy of free markets. Wang Qishan, Vice Premier of China, tartly observed: "The teachers now have some problems". There is no time for "triumphalism" or "mission accomplished" speeches. The GFC brings into question much of established orthodoxy of economic models and approaches. It calls into question social and political models based on high levels of economic growth and financial rather than real economy driven growth. It also questions the ability of mandarins to control the economic engines. Recently in Canary Wharf, the financial district in London’s docklands, I noticed a small street stand erected by the English Teachers Union to recruit teachers. The two affable recruiters explained that they had heard that there was "a bit of financial crisis". Well-educated and highly motivated bankers who were losing their jobs by the thousands might like to consider a new career teaching. I questioned the adjustment in salaries – a reduction of 60% to 95% - that the change in careers would necessitate. One recruiter’s response stays with me: "If you haven’t got a job then it’s not relevant is it? It was never real money and it wasn’t going to ever last was it?" Different strategies exist for dealing with the GFC. Politicians and theoreticians are enjoying their "I told you so" moments. Crisis denial, advocated by Lars Nonbye, general manager of the Nonbye sign-making company in Denmark, places a ban on any talk about the crisis from work premises. The most productive strategy may be to use the GFC to redirect talent and resources into the real economy and adjust living standards and expectations of economic growth. As Keynes wrote in 1933: "We have reached a critical point. We can ... see clearly the gulf to which our present path is leading….[If governments did not take action] we must expect the progressive breakdown of the existing structure of contract and instruments of indebtedness, accompanied by the utter discredit of orthodox leadership in finance and government, with what ultimate outcome we cannot predict."

© 2009 Satyajit Das All Rights reserved.

261 Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall). This article draws on the ideas first published in Satyajit Das "Built to Fail" in The Monthly (April 2009) 8-13 http://www.eurointelligence.com/article.581+M54f756d50c9.0.html#

262 May 8, 2009 Stress Test Result Watch: Banks Scramble To Issue Common Stock Overview: Official stress test results for following assumptions: 1) The total loss rate for loans calculated by the regulators is 9.1 percent, a level that exceeded that seen in the 1930s. 2) Tier 1 capital ratio of 6% and Tier 1 Common capital ratio of 4%; 3) estimated losses of $600bn over 2009-2010; 4) estimated revenues and reserves build over next 2 years $415bn--> estimated need for additional capital buffer of $185bn by the end of Q4. However, by Q1 higher revenues [and FASB accounting] changed so that the additional total capial requirement amounts to $75bn, of which: BofA $34bn; Wells Fargo: $13.7bn; GMAC 11.5bn; Citigroup $5.5bn (after signalling already that it will request to convert the government's $45bn preferred equity stake into common equity.) Morgan Stanley $1.8bn. Treasury's injected preferred equity stake is $218bn. Remaining TARP funds available are $110bn. Treasury expects $25bn in TARP repayments soon. o May 7: Announced stock issues: Citi will exchange $33 billion of preferred securities and trust preferred securities into common stock. Morgan Stanley to raise $2bn in stock, $3bn in non-insured debt. Wells Fargo plans to sell $6bn in common stock. o IMF: Using a similar methodology as the Fed, the IMF estimates that U.S. banks will take $1,050bn in writedowns including the current $580bn. In order to restore TCE/TCA ratio of 4% U.S. banks need $275bn, for a ratio of 6% they need $500bn. o RGE calculates banks need total of $1.4 trillion in order to establish a 8% total equity/asset ratio, about $650bn for 4% ratio. This figure marks loans and securities at market rather than book value and does not take into account banks' future retained earnings flow. However, the new lending flow is likely to remain impaired as long as undercapitalized banks have to fill their capital positions via retained earnings (zombie bank). o March 30: See also recent FASB mark-to-market changes that improve Q1 profits by up to 15-20% according to Robert Willens (former Lehman director) via Bloomberg. o March 20 Greenspan (via Bloomberg): “Restoration of normal bank lending will require a very large capital infusion from private or public sources.” The need is “north of $750 billion” and can’t be met just from banks’ cash flows, he said. o Douglas Elliott (Brookings): The likely result is that a handful of the 19 banks will need to issue common or preferred stock totaling $100-200 billion in the aggregate. o Cumberland: Want stress tests to tell you something, Mr. Geithner? Give us the details on the commercial real estate sector and each bank’s exposure to it. Different from residential mortgages, fewer CRE loans are securitized and are held at over 90 cents on the dollar on banks books according to market participants.--> interest in TALF program is rising and expected to double in June when legacy CMBS become eligible. o Moody's (via ResCap): Accounting rule changes are a boon for bank investors.

263 o May 5 DealBook: S&P credit rating agency put 22 banks and one thrift on its CreditWatch list with negative implications, citing a “one-in-two likelihood” of a rating downgrade in the next 90 days. o FT Alphaville: tough conditions on banks that want to repay bail-out funds, requiring proof that they can issue debt without government insurance. They may also be required to demonstrate ability to raise equity capital from private investors The new requirements could deter some banks from trying to repay funds early. Banks have issued more than $300bn of debt insured by the Federal Deposit Insurance Corporation. What's next? o Hubbard, Zingales, Scott (via WSJ): Today's system is not well-capitalized. How can we move in the right direction? In a market economy, the government can create the right incentives by using a combination of carrots and sticks. Thus far, the government has only used carrots with the banks. One major carrot is the Troubled Asset Relief Program (TARP). The initial infusions were very generous -- the Treasury got back securities worth $78 billion less than the $254 billion it invested -- as the Congressional Oversight Panel pointed out recently. o cont.: In addition, the FDIC's guarantee of short-term debt was worth $100 billion just for the original nine TARP-participating banks. And the mortgage-related asset guarantees offered to Citibank and Bank of America were worth tens of billions of dollars more. o cont.: A new round of expensive TARP injections -- by converting the government's preferred stock into equity -- may follow the release of the stress-test results. In addition, the Treasury's Public-Private Investment Program (PPIP) plans to subsidize the purchase of banks' "toxic assets" by hedge funds and other investors. We estimate that the government will spend $2 for every $1 the private sector will put in. Still, PPIP has low chance of success due to large book and (any) market value discrepancy --> carrot approach cannot jump-starting lending. o cont.: It's time for government to use the stick, beginning with creditors. The first step should be an announcement that the FDIC guarantees of short-term debt, set to expire at the end of October, will not be renewed. Insolvent banks -- defined not by stress tests, but as those that cannot fund themselves in the private market -- will be taken over by the FDIC. o Rather than taking over and running banks, the FDIC should split each bank into two parts. One part ("the bad bank") will assume all the residential and commercial real- estate loans and securitized mortgages as assets, and all the long-term debt as liabilities. In addition, "the bad bank" will obtain a loan from the "good bank." This loan is necessary because the long-term debt of the old bank is not likely to be sufficient to fund the assets of the bad bank. The good bank will have all the remaining assets, including derivative contracts and its loan to the bad bank. It will have all the insured deposits and the FDIC-guaranteed short-term debt as liabilities. Once the split is accomplished, the good bank can be cut loose from FDIC receivership. o cont.: On the one hand, this split separates the toxic assets, whose value is very uncertain, in an institution that has no insured or guaranteed liabilities and poses no systemic risk. The bad bank will be like a closed-end mutual fund and can be run as such. The good bank will be well-capitalized, and the value of its assets will be clear.

264 o cont.: The losers in this reshuffling are the long-term debtholders who get stuck in the bad bank. For this reason, we propose that they be compensated by receiving all the equity of the good bank. The old shareholders will get the equity in the bad bank. (In any restructuring, bondholders should do better than equity.) And the FDIC minimizes its risk because it guarantees the deposits in the good bank. o One of the major objections to letting banks fail is the argument that they are not really insolvent; they are just facing a temporary dislocation in the marketplace. But if this observation were true, the bad bank would surge in value, and the old shareholders of the banks, who received the shares in the bad bank, would gain. If it is false, the bad bank would default and the old shareholders would receive nothing (as they should). o cont.: In order for this plan to work, legislation would need to take effect before the withdrawal of the FDIC guarantee in October, so that FDIC procedures for handling failed banks can be applied to bank-holding companies. FDIC Chairman Sheila Bair has called for such legislation. Most importantly, this plan won't impose any new cost on the taxpayer. http://www.rgemonitor.com/10006/Finance_and_Banking?cluster_id=13788

265 May 7, 2009 ECB Adopts Active Credit Easing and Extends Term Loan Maturity To 1 Year May 7 ECB monetary policy decision and QE strategy announcement: 1) ECB lowers main refi rate by 25bp to 1% and narrows rate corridor to 75bp in order to keep the deposit rate at 0.25% (marginal lending rate 1.75%) 2) ECB agrees on 60 billion-euro ($80 billion, 0.5% of eurozone GDP) plan to buy covered bonds (no commitment to stay within that asset class only) 3) ECB will extend the maturity of the unlimited loans it gives banks to 12 months and widen collateral eligibility 4) European Investment Bank (EIB), an SME lender, will now be an eligible counterparty for ECB liquidity Background: As the ECB's refi rate approached its lower bound as the deposit rate approaches zero, continued credit tightness drove the ECB to outright asset purchases. Private sector lending rates had yet to fall in line with lower ECB rates because 1) it seems banks were trying to widen their net interest margins to improve balance sheets and 2) the eurozone recession had raised corporate risk premia. Providing liquidity to the banks had not been enough to lower lending rates in the eurozone - and banks are a key source of finance for SMEs. However there are technical impediments to outright asset purchases by the ECB, such as the lack of a centralized government. What Will Drive the ECB to Outright Asset Purchases? o Goldman Sachs: The interest rate channel is not functioning as it should, and this is unlikely to change any time soon. This increases the pressure on the ECB to start buying debt and, in fact, ECB Trichet announced during the April press conference that the Governing Council will decide on more 'unconventional measures' in May. o Maccario: In the euro area you cannot lower the cost of funding for the real economy without lowering the cost of funding for banks, which still face significant difficulty in raising medium-term financing What Will the ECB Buy? o Government Debt? Purchases of government debt in the secondary market might interfere with the market's risk pricing mechanism, and might raise fears that the ECB is financing budget deficits; moreover, the impact on the real economy would be much more questionable than in the US, where many mortgage rates are linked to long-term Treasury yields. (Maccario) o Corporate Debt? The ECB could buy commercial paper, but some key economies would be left out of this support. In the same vein, they could buy corporate bonds but in that case the backbone of the euro area corporate sector - small and medium enterprises with very limited or no access to capital markets - would not benefit (Maccario). Besides, debt securities account for just 8.4% of corporate sector debt in the euro area as of 3Q08, far lower than in the US (Williams) o Bank Debt? The banking system plays by the far the dominant role in financing the eurozone's real economy and the banking system still faces significant difficulties in raising medium-term financing.

266 What Are the Stumbling Blocks and Ways to Overcome Them? o National allocation of purchases: ECB could provide capital to the Eurosystem central banks and let them decide which instruments to buy. The ECB would then announce the gross allotment, which could be divided among national central banks in proportion to their shares in the ECB's capital (Maccario) or in eurozone GDP (BNP). Another idea is for the ECB to create a fund to buy bank assets (BNP). o Shallowness and/or skew of market towards some sectors in certain countries: One option to overcome these problems would be for the ECB also to accept ABS structures, which would allow banks to come up with a more representative bundle of financial assets. (Goldman Sachs)

“ECB Adopts Active Credit Easing and Extends Term Loan Maturity To 1 Year. ECB monetary policy decision and QE strategy announcement”, RGE Monitor, 07/mayo/09. http://www.rgemonitor.com/10009/Europe?cluster_id=13684

267 May 7, 2009 April Junk Bond Return Highest In 22 Years: Are Investors Over-Optimistic?

Overview: May 1 Bloomberg: Junk bonds returned 11 percent in April, the best performance since at least 1987, according to Merrill Lynch & Co.’s U.S. High Yield Master II index. The debt outperformed the Standard & Poor’s 500, U.S. Treasuries and investment-grade bonds. The rally spurred more speculative-grade companies to issue debt, taking advantage of a drop in spreads. Sales of high-yield bonds in 2009 jumped to $21.8 billion from $4.4 billion in the previous four months. Issuance this year compares with $18.4 billion in the same period of 2008. Junk bond experts: junk bond rally is sustainable once default rates peak--> Moody's predicts 14.8% by the end of 2009 vs 8.3% in April. o May 7 : Bloomberg: Bonds rated CCC and lower -- those ranked most likely to default by Standard & Poor’s, Moody’s Investors Service and Fitch ratings --have gained 39 percent since March 9, compared with 14 percent for those rated BB. o cont.: Wall Street analysts: investors might be over-omptimistic given that default rate is set to spike from 8.3% to about 15% by the endo fo the year according to rating agencies o May 1: Economist: With short-term rates near zero, investors have been lured into bonds in search of income. According to Goldman, retail investors have put $8 billion into high-yield mutual funds since December 1st. But will such flows survive a high-profile default such as General Motors? o Fitch Q4 report: Both U.S. high yield and leveraged loan markets experienced worst quarter on record in Q4 and for all of 2008. Return indexes are down over 20% each and default rates have more than doubled between Q3 and Q4 to 8.5%. Altman and Fridson say until default rates peak, leveraged finance investors can lose a lot of money. When default rates peak, it is a bonanza. o cont.: Merrill Lynch High Yield Master II Index declined to -17.63% in Q4 and - 26.39% in 2008. o cont.: Leveraged loans fared even worse through Q4 and 2008: Credit Suisse Leverage Loan Index total return was -22.93% in Q4 and -28.75% in 2008. o cont.: In addition, default rates, as measured by the Fitch U.S. High Yield Default Index, nearly tripled during Q4, with the trailing 12-month rate increasing to 8.5% at December 31, 2008, up from just 3.3% at September 30, 2008. o Altman: Many high-yield bonds were refinanced shortly before the crisis hit, so the major refinancings are due after 2014. On the other hand, about $500bn in leveraged loans come due by 2008-2011 amid the credit crunch--> leveraged loan defaults might actually exceed high yield defaults in this cycle. o FT: The sharp fall in leveraged loan structures might actually be driven by a quickly deteriorating performance of the underlying rather than by unwinding of structured products--> a cash and derivatives index analysis shows indeed that cash spreads have been the main movers since mid-September

268 o Nov 19: HY Blog: Record spreads are not only due to firesales but find some justification in the deterioration of credit quality down the rating scale. Similarly, the spike in the projected default rate is in line with the deterioration of credit quality of outstanding debt down the rating scale. o Oct 3: Positive: LBO companies are able to buy back their outstanding leveraged debt at lower prices (e.g. Charter, Freescale) o Fitch: Between 2004 and 2007 approximately$450 billion of sponsored US LBO related leveraged loans came to market. http://www.rgemonitor.com/520/Corporate_Bonds_and_Leveraged_Loans?cluster_id=1 2588

269 diariojuridico.com - Derecho y Noticias Jurídicas Viernes, 08 de Mayo de 2009 La Reforma de la Ley Concursal “A pesar de los escasos años de vigencia de la actual Ley Concursal, la práctica diaria ha demostrado que el procedimiento judicial de insolvencia no constituye una herramienta útil de reestructuración.” 23/04/09 , Redacción Por: Antonio Fernández, Garrigues, Socio responsable de Reestructuraciones e Insolvencias Juan Verdugo, Garrigues, Asociado, Reestructuraciones e Insolvencias A pesar de los escasos años de vigencia de la actual Ley Concursal (en vigor desde 2004), la práctica diaria ha demostrado que el procedimiento judicial de insolvencia no constituye una herramienta útil de reestructuración, por ser un procedimiento caro, rígido y lento. Ante esta realidad, un número importante de compañías españolas han recurrido en los últimos meses a soluciones extrajudiciales, similares a otras comúnmente utilizadas en otros países de nuestro entorno, con las que han intentado enfocarse hacia la viabilidad, superando sus problemas financieros, de liquidez o estructurales y evitando el procedimiento concursal. Paradójicamente, estos procesos extrajudiciales de refinanciación de deuda no estaban regulados en nuestra legislación de insolvencias. De hecho, hasta ahora, la Ley Concursal suponía un freno a estos procesos, entre otras razones porque los acuerdos de refinanciación podían ser rescindidos en caso de que sobreviniera un procedimiento concursal. La saturación de los Juzgados de lo Mercantil, la generalización de los acuerdos de refinanciación y la demostración de que constituyen una interesante solución a las crisis empresariales -fundamentalmente en términos de conservación de valor- han llevado al Gobierno a promulgar, con carácter extraordinario, el Real Decreto-Ley 3/2009, de 27 de marzo, de medidas urgentes en materia tributaria, financiera y concursal ante la evolución de la situación económica. Según la Exposición de Motivos del Real Decreto, son cuatro los objetivos de la reforma concursal: (i) favorecer la refinanciación de las empresas, (ii) reducir los costes del concurso, (iii) precisar algunos extremos de la clasificación de créditos, y (iv) solucionar algunos problemas procedimentales y de gestión de los procedimientos concursales. A continuación se describen alguna de esas novedades: Acuerdos de refinanciación La mayor innovación de la reforma concursal es la inclusión (casi a modo de “nueva institución” jurídica) de los acuerdos de refinanciación. Estos acuerdos se definen como “los alcanzados por el deudor en virtud de los cuales se proceda, al menos, a la ampliación significativa del crédito disponible o la modificación de sus obligaciones, bien mediante la prórroga de su plazo de vencimiento, bien mediante el establecimiento de otras obligaciones contraídas en sustitución de aquéllas”. La nueva regulación favorece y estimula la adopción de tales acuerdos de refinanciación. De hecho, el Real Decreto los promueve siempre que respondan a un

270 “plan de viabilidad” que permita la continuidad de la actividad del deudor en el corto y medio plazo. En caso de que sobrevenga un procedimiento concursal, se establece la inatacabilidad de los negocios, actos, pagos y garantías constituidas en desarrollo de la refinanciación siempre que se cumplan los siguientes tres requisitos: a) suscripción por parte de acreedores que representen al menos el 60% del pasivo del deudor; b) informe de un experto independiente que avale la razonabilidad del “plan de viabilidad” así como la adecuación de las condiciones pactadas y la proporcionalidad de las garantías conforme a las condiciones de mercado en el momento de firmar el acuerdo; y c) formalización en instrumento público, estableciendo la reforma una reducción, muy sustancial, en los aranceles notariales asociados a la escritura. Además, a diferencia de lo que ocurría al amparo de la anterior regulación (en que cualquier acreedor podía impugnar dichos acuerdos subsidiariamente a la administración concursal), el nuevo Decreto indica que, una vez declarado el concurso, sólo la administración concursal está legitimada para impugnar dichos acuerdos. Reducción de los costes del concurso y simplificación de los convenios y liquidaciones Una de las finalidades más proclamadas de la reforma es la reducción de los costes del concurso. Dicha reducción se ha hecho patente en diversos ámbitos. Así, en sede de publicidad concursal, las comunicaciones a los interesados y a los registros públicos se realizarán preferentemente por medios telemáticos. De igual manera, se simplifica la publicidad del auto de declaración de concurso y de las principales resoluciones concursales (convocatoria de Junta de Acreedores, aprobación del convenio, conclusión del concurso, etc.), en la medida en dependerá de una publicación única, que se realizará en el Boletín Oficial del Estado, eliminándose las dos publicaciones en diarios o periódicos. Pero, sin duda, la medida que más influencia tendrá en la reducción de los costes del concurso es la revisión del sistema retributivo de los administradores concursales. El nuevo Decreto-Ley limita la retribución de estos profesionales y crea un mecanismo para asegurar, mediante la creación de un fondo común, unos honorarios mínimos para los administradores concursales de empresas que carezcan de activo suficiente para pagar los honorarios de estos profesionales. Por otra parte, la voluntad del legislador de reducir los costes temporales y económicos del concurso se manifiesta definitivamente en la nueva regulación del convenio de acreedores, que establece importantes incentivos a la propuesta anticipada de convenio (flexibilización en la posibilidad de presentación, facilitación de la obtención de adhesiones iniciales, facilitación del quórum necesario, etc.). Asimismo se simplifica la superación de los límites de quita y espera en el convenio ordinario pues la nueva regulación elimina el informe preceptivo de la administración competente sobre la trascendencia económica de la empresa. Finalmente, en aras a favorecer también la reducción de costes se permite al deudor presentar una propuesta de liquidación anticipada durante la fase común y se eliminar los recursos contrea las decisiones del Juez autorizando, por ejemplo, la venta anticipada de los bienes del deudor.

271 Nuevas normas para aclarar la clasificación de algunos créditos La tercera finalidad de la reforma concursal es aclarar la interpretación de determinados puntos oscuros de la Ley Concursal en materia de clasificación de créditos, referidos a acreedores muy concretos. Así, se establece que el crédito garantizado por persona especialmente relacionada con el concursado (i.e. crédito garantizado con fianzas personal de un socio, administrador, persona unida con lazos de consanguinidad o empresa del grupo) no puede ser considerado como subordinado salvo que el fiador haya pagado el crédito y se haya colocado en la posición de acreedor. Además, se aclara que el momento relevante para que los socios con una participación significativa sean considerados personas especialmente relacionadas con la sociedad es el del nacimiento del crédito, y no la declaración de concurso. Nuevas normas para agilizar los procedimientos concursales Por último, además de la ampliación del ámbito del “procedimiento abreviado” (a partir de la reforma todos los procedimientos concursales con pasivo inferior a 10 millones de euros serán de este tipo), el Decreto-Ley contiene modificaciones de algunas normas procesales, con la finalidad de agilizar los, ya de por sí, lentos procedimientos concursales. Sin ánimo de ser exhaustivos, podemos señalar que: i. Los incidentes concursales pueden resolverse por el Juez del concurso sin necesidad de celebrar vista oral; ii. El plazo de 10 días para impugnar la lista de acreedores y el inventario de bienes del deudor comienza desde la notificación a los acreedores personados, sin necesidad de esperar a la publicación en el BOE; iii. Las apelaciones frente a las sentencias que pongan fin a procedimientos concursales se acumularán a la resolución que pone fin a la fase común, lo que impide apelaciones intermedias o anteriores a ese momento; iv. Los convenios de acreedores podrán ser tramitados “por escrito”, prescindiendo de la Junta de Acreedores, si éstos superan el número de 300 Conclusión La reforma de la Ley Concursal ha venido a paliar, en parte, la insuficiencia de la anterior regulación para hacer frente satisfactoriamente a las necesidades de la actual situación empresarial. Sin embargo, lejos de plantearse como una reforma definitiva, la Exposición de Motivos del Real-Decreto plantea la necesidad de revisar en profundidad en el futuro la legislación concursal. De ello no cabe sino deducir que, si bien esta reforma pone su acento en aspectos cuya modificación había sido solicitada por distintos protagonistas (Jueces, empresarios, abogados y administradores concursales), en realidad parece más bien una reforma “quirúrgica” que adelanta los principios generales de una posterior, más profunda. Antonio Fernández y Juan Verdugo, “La Reforma de la Ley Concursal”, 08/05/2009, en: http://www.diariojuridico.com/opinion/la-reforma-de-la-ley-concursal.html

MANDEL ON ECONOMICS May 6, 2009, 12:01AM EST text size: TT

272 President Obama, Cut Corporate Taxes Instead Rather than risking jobs by tightening taxes on U.S.-based multinationals, the President should boldly slash corporate rates from 35% to 25% By Michael Mandel As the old saying goes, the road to hell is paved with good intentions. For decades various Washington politicians have tinkered with corporate income tax rules with the laudable goal of getting U.S.-based multinationals such as General Electric (GM) and IBM (IBM) to pay their "fair" share of taxes on growing overseas operations. The result has been a disaster—a system no one understands that requires vast resources to administer while raising very little revenue. The current rules even seem to encourage U.S.-based multinationals to move jobs overseas, although no one really knows for sure. Unfortunately, President Barack Obama's latest proposals to get U.S.-based multinationals to pay higher taxes on their foreign profits do nothing to fix these problems. The tax system will get another layer of complexity—effectively a "stimulus package" that benefits tax lawyers and accountants who find new loopholes. And to the degree that the new proposals bite, U.S.-based multinationals will find themselves at a bigger tax disadvantage compared with multinationals based outside the U.S. that operate under a different set of tax rules. In essence, the Obama proposal is a tax increase on companies headquartered in the U.S. The end result could well be fewer good jobs in the U.S. give U.S.-based companies a break Here's a radical idea: Obama should go the other direction, striking a blow for simplicity and jobs by reducing the corporate income tax rate from its current 35% to 25%. This is a move that has been advocated by many economists and politicians, notably Senator John McCain (R-Ariz.) last year in his Presidential campaign. But just as only a staunch Republican such as Richard M. Nixon could have opened up relations with China, a reduction in the corporate income tax may be a maneuver that can be accomplished only by a Democrat. What are the advantages of reducing the corporate income tax? First, such a drop would give U.S.-based multinationals a leg up against foreign-based multinationals—a good thing, if you believe companies based in the U.S. are more likely to locate high-end research, planning, and marketing jobs in this country. Such a drop would further reduce incentives for corporations to contort global investment decisions in an effort to avoid taxes. In particular, opening new operations in the U.S. would immediately become more attractive. At the same time, lowering the corporate income tax would help extricate the U.S. from a game it cannot win. In an increasingly global economy, chasing profits across national borders is a hopeless task. Indeed, when a product is designed in one country, manufactured in another, and sold in a third, it's almost impossible to figure out where profits are really being generated. U.S. Corporate Tax Share: About 10%

273 In exchange for lowering the corporate tax rate, Obama should extract a big quid pro quo: The President should require that companies make their income tax returns public, at least in summary form. The financial crisis has shown us that there's too much we don't know about how the global economy operates. Being able to see corporate income tax statements would facilitate transparency and openness. The downside of reducing the corporate income tax, of course, is that revenue would be lost in the short run. But the numbers involved would not be enormous. Over the past 10 years the corporate income tax has contributed only a bit more than 10% of federal tax receipts, on average. At worst, a cut in the corporate income tax rate from 35% to 25% would reduce total federal revenues by about 3%, and perhaps by less. Cutting the corporate income tax would be unpopular with Obama's political base. But at a time when jobs are disappearing by the millions, raising taxes on U.S.-based multinationals is not the right way to go. Mandel is chief economist for BusinessWeek. http://newsletters.businessweek.com/c.asp?766900&0be32f2fe5d5a10f&2

274 May 7, 2009, 5:00PM EST text size: TT How Private Equity Could Rev Up the U.S. Economy Two out of five private equity firms will disappear. The rest will feast off the financial wreckage By Peter Carbonara and Jessica Silver-Greenberg Donald B. Marron, founder of the $3 billion private equity firm Lightyear Capital, has been eyeing financial wreckage for more than a year. In early 2008 Marron, the former chairman and chief executive of brokerage PaineWebber, sent teams of analysts to scout out more than 200 struggling U.S. financial firms. So far Marron has made only one deal, buying a stake in student lender Higher One last summer. But the 74-year-old art aficionado, whose starkly modern New York office brims with abstract paintings, says dealmaking will soon pick up dramatically. "We expect this trend to continue," he says.

While some attention has been paid to the vultures now circling the troubled banking sector, private equity is beginning to venture out across the economy in search of deals big and small. Glen T. Matsumoto, a partner in Swedish buyout shop EQT Partners, is looking for more ways to spend the $1.5 billion his firm has amassed for infrastructure and energy plays, having picked up Michigan energy company Midland Cogeneration Venture in March. Brian A. Rich of Catalyst Partners, an upstart buyout shop with $300 million in assets, recently plowed $5.6 million into Mindbody, a California software company. He's hoping to invest in more cash-starved technology and media outfits. "We think it's a great time to put capital out," says 48-year-old Rich, who ran Toronto Dominion's (TD) U.S. merchant banking arm before starting Catalyst in 2000. It's been a rough two years for private equity firms, those freewheeling and much- vilified financiers who buy companies only to sell them later for a profit. The buyout boom that ended in 2007 wasn't pretty; many of the deals made at the height of the frenzy have been disasters. Bankruptcy courts are littered with private equity blunders, including household names Chrysler, Tribune (TXA), and Linens 'n Things. Such high- profile blowups heightened private equity's reputation as a group of fast-buck artists who are better at destroying companies than running them.

275 But a strange thing has happened. While the experts were proclaiming—and maybe even celebrating—their death, private equity firms were quietly bulking up their war chests and readying themselves for a new wave of deals. By some measures they're stronger than ever: Firms are sitting on a record $1 trillion with which to make new purchases, according to research firm Preqin. "They are showing up at the party with a wheelbarrow full of cash," says Donna Hitscherich, a professor at Columbia Business School. Slowly and deliberately, firms are mobilizing their forces to exploit huge opportunities being created by the recession. Some big buyout firms, filling the void created by the financial crisis, are acting like traditional investment banks, providing loans to troubled companies and even advising executives on mergers. Some firms are aggressively hiring and firing buyout specialists, turning the cold eye they usually train on companies onto themselves. Other firms are prowling bankruptcy courts in search of cheap assets or are capitalizing on government stimulus spending. "There is every reason to believe that private equity will have tremendous opportunity once we hit bottom," says Colin Blaydon, director of the Center for Private Equity & at Dartmouth's Tuck School of Business. When private equity starts cranking up its dealmaking machine—and it will, eventually—the $1 trillion it has amassed could help revive the economy by pumping crucial capital into the markets. "Private equity will be an integral part of this country's economic recovery," says Gregg Slager, a senior partner at accounting firm Ernst & Young. Noted Stephen A. Schwarzman, founder of Blackstone Group (BX), in the private equity firm's March annual report: "Getting the world economy moving again will take more than government intervention." STILL ATTRACTING INVESTORS Private equity's surprising resurgence is a study in managing through a downturn. With markets and businesses blowing up all around them, buyout firms calmly made their case to big investors that they were still worthy stewards of capital. In 2008 they attracted $554 billion from pension funds, university endowments, and other big investors, down only modestly from the record $625 billion the previous year. Even this year's seemingly small tally thus far of $49 billion still puts private equity on track to match 2004's total of $206 billion, the sixth-highest ever. Partly that's because returns haven't been as awful as feared. Private equity funds lost an estimated 20% in 2008. That was on a par with hedge funds and handily beat U.S. stocks (-37%), real estate (-38%), and commodities (-47%). Big investors think private equity will perform better in the future, too. U.S. corporate pensions are assuming their private equity holdings will return 10.1% a year over the next five years, compared with an estimated 7.8% for hedge funds, according to research firm Greenwich Associates. The nation's largest pension fund, California Public Employees' Retirement System, even boosted its target for private equity holdings in its portfolio by four percentage points last year. "We're strongly committed to private equity, which helps diversify the portfolios of long-term investors," says CalPERS' spokesman Clark McKinley. Robert Hunkeler, who manages the $13.1 billion in International Paper's (IP) pension funds, says he's keeping his stake in private equity at 5% despite recent losses. The next few years will be dismal for many firms, no question. Buyout shops may be sitting on piles of cash for new purchases, but their portfolios also are stuffed with

276 companies at risk of folding unless they can refinance their debt. Boston Consulting Group estimates that 20% to 40% of private equity firms will disappear altogether in the next few years. But the wiliest players have inoculated themselves from the worst of the pain. During the boom years, firms used a number of slick tricks to extract money from companies right away and ease potential losses. First they loaded the companies they bought with debt and kept the proceeds for themselves. Then they collected ongoing management fees from those same companies. Often they did both. Kohlberg Kravis Roberts, founded in 1976 by Henry R. Kravis and George R. Roberts, pulled off the biggest buyout ever in October 2007 when it joined with another big firm, TPG, to buy Texas utility TXU for $45 billion. (KKR also pulled off the largest transaction during the last buyout boom with its $31 billion bid for RJR Nabisco in 1989, the controversial deal immortalized in the book Barbarians at the Gate.) After picking up TXU, KKR and its private equity partners immediately collected $300 million from TXU for "certain services" associated with the deal, according to filings with the Securities & Exchange Commission. Plus, the firms are "entitled to receive an aggregate annual management fee of $35 million," which "will increase 2% annually." TPG and KKR declined to comment. Private equity firms also exploited the remarkably easy lending environment during the boom, negotiating financing terms with unprecedented flexibility. Firms often had to put up minimal capital to close a deal. The maneuvers are paying off now. Consider the tale of Chrysler. Cerberus Capital Management—named after the mythical three-headed dog that guards the gate of Hades—bought the troubled carmaker in May 2007 for $7.4 billion. Founder Stephen A. Feinberg, a secretive financier with blue- collar roots, has, with hard-nosed dealmaking, transformed Cerberus over the years from a scrappy vulture into a private equity stalwart. In the case of Chrysler, Cerberus contributed only $1.2 billion in cash. And even though Chrysler has filed for Chapter 11, Cerberus isn't likely to lose all of that money; it may be able to offset some of its losses with Chrysler Financial, the carmaker's lending arm, which isn't part of the bankruptcy. Cerberus could merge the lender with another Cerberus investment, GMAC Financial. "It is a big hit," says one Cerberus executive of the bankruptcy. "But it won't break the company." To be sure, the days of larger-than-life dealmaking are over. Banks are no longer providing the loans that fuel the biggest buyouts. Small purchases will replace megabuyouts, and firms will likely focus their energies on sprucing up operations rather than extracting fees and engineering financial gains. "It's back to the future," says William E. Ford, chief executive of General Atlantic, a private equity firm with $13 billion in assets. Some firms have even begun to deemphasize buyouts, quietly transforming themselves into diversified financial players that provide a wide array of money management, trading, and advisory services. Schwarzman, the 62-year-old head of Blackstone Group, is aggressively filling the void left by the Lehmans of the world. Schwarzman's ambitions are as grand as his New York City apartment, a 35-room triplex once owned by John D. Rockefeller. At the firm's start in 1985, Schwarzman and co-founder Peter G. Peterson shared a secretary and oversaw a grubstake of just $400,000. Today Schwarzman, infamous for a lavish birthday party he threw himself in 2007, sits atop more than $90 billion in assets and employs more than 1,340 people. Blackstone

277 collected $410 million last year—not from its bread-and-butter buyout business but from advising other companies on mergers, acquisitions, and restructurings. Said Schwarzman in the firm's annual report: "Our financial advisory group delivered record fees last year by meeting the demand for a trusted, independent adviser." PROFITING FROM THE PAIN Blackstone's advisory clients range from troubled insurer AIG (AIG) to the Ukrainian government. In December Tim Coleman, who co-heads Blackstone's reorganization and restructuring group, flew to Detroit to meet with Ford Motor's (F) CEO, Alan Mullaly, and other top executives. Coleman's recommendation: Rework the debt. After that initial meeting, Mullaly hired Blackstone and Goldman Sachs (GS) to dispense advice. The three companies spent the next few months brainstorming and hashing out strategies at Ford's headquarters. "We worked 'round the clock," says Coleman. "There wasn't room for anyone's ego to get involved." They brought their plan to bondholders in April, offering to exchange $1.8 billion in debt for $1.3 billion in equity. The investors agreed. Like all tough-minded investors, private equity firms are busy looking for ways to profit from rivals' pain—and even their own. College friends Rodger R. Krouse and Marc J. Leder are among the most aggressive. The two left Lehman Brothers (LEHMQ) in 1995 to forge their own firm, Sun Capital Partners, in Boca Raton, Fla. They had a tough time muscling into the clubby world of private equity, but since 2002 Sun Capital has bought more than 200 small and midsize companies and earned 20% a year. Among its holdings: restaurant chain Friendly Ice Cream and bagel chain Bruegger's Enterprises. More than 10 of Sun Capital's companies have filed for Chapter 11, including retailer Big 10 Tires, auto parts supplier Fluid Routing Solutions, and department store Mervyns. But Krouse and Leder, both 47, are capitalizing on the trouble by doling out high-interest, short-term loans to some of its bankruptcy victims. Sun Capital declined to comment. Few private equity portfolios are as troubled as that of New York's Apollo Management—but even its list of losers is presenting opportunities. The $45 billion Apollo owns bankrupt retailer Linens 'n Things, along with struggling casino chain Harrah's Entertainment and real estate firm Realogy. But Apollo recently raised $15 billion for new investments and plans to use a quarter of that stash to buy distressed debt, including the debt of some of its own holdings. Junk bonds are familiar territory for Apollo founder Leon Black. The 57-year-old started Apollo in 1990 after leaving Drexel Burnham Lambert, the notorious investment bank that collapsed that year. Black's interest in his own distressed debt is partly defensive and partly speculative. By buying back bonds aggressively, Black can try to prevent other vultures from picking up the debt and wresting control of his investments. He's also likely betting that the bond prices will rise in value and that he'll be able to sell them at a profit later. Apollo declined to comment. FRENCH CONNECTION Many private equity firms are taking a sharp pencil to their own books as well. Even as the giants are laying off staff and closing offices, they're recruiting specialists in fields where they see opportunities. Apollo, for example, added former Morgan Stanley (MS) banker Neil Shear to its new commodities group. In a burst of recent hiring, Blackstone picked up infrastructure specialists Trent Vichie and Michael Dorrell from the New York branch of Australia's Macquarie, among other recruits.

278 Carlyle Group, one of the largest and most secretive private equity firms, started preparing for a flood of bank deals last year. The 22-year-old firm, whose ranks have included such well-connected advisers as former President George H.W. Bush and former British Prime Minister John Major, has been expanding aggressively into real estate, , and other alternative assets—and has bagged some high-profile talent. Last year, Carlyle lured UBS (UBS) investment banker P. Olivier Sarkozy, half brother of the French President. Sarkozy has advised on a number of bank deals, including ABN Amro's sale of LaSalle Bank to Bank of America (BAC) for $21 billion, part of a breakup of the Dutch bank. At Carlyle, Sarkozy spends much of his day poring over balance sheets and scouring troubled mortgage portfolios. He has been traversing the U.S. for the past few months, visiting local banks in tiny towns and regional players in urban areas. Now Sarkozy, along with Blackstone, Centerbridge, and W.L. Ross, are in discussions with management at BankUnited (BKUNA), a struggling lender in South Florida. "Private equity will be a prime catalyst in the necessary recapitalization of banks, both here and globally," says Sarkozy, 39. "The time is ripe." BARGAINS IN THE `CANDY STORE' Perhaps the most combative arena for private equity these days is the bankruptcy courts. Buyout firms are swarming, making bids on busted businesses and in some cases entering into bidding wars. Lynn Tilton, the pugnacious founder of Patriarch Partners, spends much of her time in court fighting over cheap assets. The 49-year- old Tilton, known for her flamboyance in stiletto heels, recently lost a contentious 16-day auction for instant photography pioneer Polaroid to rivals Hilco Consumer Capital and Gordon Brothers Brands. She's appealing the decision. On Apr. 20 Tilton bought Stila Cosmetics, filling out a portfolio of troubled brand names that include mapmaker Rand McNally. Stila had fallen behind on its debt payments, and lenders took control of the makeup manufacturer. They called Tilton on a Friday night to make a deal. She talked with management on Sunday and by the following weekend owned the company. "I haven't seen anything like this in 35 years," Tilton says of the opportunities before her. "This is like a candy store for us." The value in Patriarch's distressed plays isn't always obvious. Last summer Tilton bought a paper mill in Maine, since renamed Old Town Fuel & Fiber. But she didn't buy it just to make pulp. A main attraction for Tilton is the mill's $30 million grant from the Energy Dept. for a research program studying how to make biofuels from wood chips. Tilton wants to produce a biofuel called butanol at the plant, which can be used as aircraft fuel. That would create another potential opportunity, because Patriarch also owns a helicopter maker and an aircraft parts manufacturer. Few investments look as appealing as those blessed by government dollars. As part of the $787 billion federal stimulus package signed into law in February, the government has earmarked $29 billion to patch crumbling roads, bridges, and schools. Thanks to Uncle Sam, the infrastructure investing trend is picking up. The states' cash crisis is also sparking interest. "With states facing real economic trouble, you will see further pressure on them to hand over infrastructure to private firms," says Ben Heap, co-head of infrastructure in UBS's (UBS) private equity group. There were 127 infrastructure funds in 2008, up from 91 in 2006, according to research firm Probitas Partners.

279 When Sadek Wahba, investment chief at Morgan Stanley's (MS) $4 billion infrastructure fund, goes shopping for deals, he follows two main principles. First, invest only in public necessities. Second, make sure the concerns of local citizens are heard— to minimize political problems later. In December, Morgan Stanley and a group of investors paid $1.15 billion for 36,000 parking meters in Chicago. Wahba is converting the old coin-operated devices to electronic pay machines. "These assets are a good hedge against inflation, because you are providing a basic service," says 43-year-old Wahba. But the best example of private equity's shrewdness in the downturn may be its ability to spiff up its sullied image. In Pittsburgh, Robert B. Fay and his brother Pat feared selling their 62-year-old construction business, Joseph B. Fay Co., to private equity, worried that a buyer would dismember the company and lay off staff. The family's lawyer called New York's FdG Associates after reading that the $300 million buyout firm had experience working with family-run businesses. In all, the Fay brothers met with six private equity firms. FdG's team wore casual khakis to its meeting to underscore its anti- Wall Street image, while rivals sent representatives in designer suits. The Fays identified with the FdG team instantly and agreed to sell to the firm in February. Says Bob Fay: "These guys came to us as partners, not vultures." with Tara Kalwarski in New York and David Welch in Detroit Business Exchange: Read, save, and add content on BW's new Web 2.0 topic network Old Stakes, New Value Amid the ongoing cash crunch, some university endowments, insurers, and other big investors are looking to sell their investments in private equity funds. An Apr. 13 piece on Deal.com reports that Goldman Sachs recently launched a $5.5 billion fund to buy up those stakes on what's known as the secondary market. "Things may be tougher than usual in the world of private equity but it just means more opportunities for Goldman," the author writes. To read the full article, go to http://bx.businessweek.com/private-equity/reference Carbonara is a senior writer for BusinessWeek. Silver-Greenberg is a reporter for BusinessWeek.com Peter Carbonara y Jessica Silver-Greenberg “How Private Equity Could Rev Up the U.S. Economy Two out of five private equity firms will disappear. The rest will feast off the financial wreckage” BusinessWeek, 07/05/09 http://www.businessweek.com/print/magazine/content/09_20/b4131028553342.htm

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May 6, 2009, 5:44PM EST text size: TT The Perils of Global Banking Selling through subsidiaries, banks have left investors across the globe holding potentially toxic bonds. Now governments may restrain foreign financial firms By David Henry and Matthew Goldstein JA Solar Holdings, a once-thriving Chinese manufacturer of solar-power cells, is getting a rude introduction to the dangers of global finance. So is Peter Howard, a retired British tax official. And so are Cedric Ruber, a Belgian school inspector, and his father, Rene, a retired employee of the U.S. Army. Each is trying to recoup money from Lehman Brothers, whose bankruptcy in September paralyzed the world economy. They're just a few of the tens of thousands of burned investors around the world complaining loudly that they were sold toxic bonds that were supposed to be safe. In street demonstrations from Hong Kong to Hamburg, protesters are demanding that their governments do something to get their money back. Now there's a growing fear among economists, policymakers, and business groups that in the name of protecting their citizens from global financial institutions, governments could slow the flow of capital between countries—at a time when the world economy is already contracting. "We're looking at a period of, at best, a pause of globalization, and more likely a period of 'de-globalization,' " Mohamed El-Erian, chief executive officer of bond giant PIMCO, said at a conference on Apr. 27. Governments are already moving to impose new hurdles on foreign firms. Regulators in Britain have started asking U.S. banks selling bonds there to provide hundreds of pages of proof that the mighty U.S. government, which is backing the bonds, could actually repay them. A revelation from Lehman's bankruptcy illustrates why public confidence has been so shaken. It turns out that during the credit boom, a little-known Amsterdam unit called Lehman Brothers Treasury churned out $35 billion worth of dubious bonds, fully a quarter of the parent company's total bond debt when it went bust. Many of those bonds, baroque in their complexity, were sold to small investors in Europe and Asia—high finance for the masses. In the U.K., at least 6,000 retirees bought in. Brokers in Asia plied small investors, a few of them mentally ill, with free digital cameras and flat- screen televisions. As Lehman fought for its life in its last six months, it pushed harder to sell the bonds, most of which were "guaranteed" by the parent company in New York. Or so the investors thought. When Lehman Brothers Holdings collapsed in September, the bonds lost virtually all their value. JA Solar (JASO) ate $100 million. Howard lost $74,000 of his retirement savings. Rene and Cedric Ruber are out some $200,000. The Amsterdam debacle offers a rare glimpse into Wall Street's relentless drive to exploit foreign markets. Overseas locales provide banks great opportunities for "regulatory arbitrage," the practice of searching high and low for the most beneficial legal environments for particular lines of business. Lehman chose Amsterdam because of the tax benefits there. In recent years Wall Street firms have set up thousands of overseas subsidiaries for various purposes. Among other things, the entities have sold trillions of dollars worth of risky "derivatives" like the ones bought by Howard and the

281 others. Lehman had 433 subsidiaries when it blew up—and it was relatively small. Citigroup (C) has more than 2,400 . That global tangle of bank subsidiaries is creating bigger problems than anyone realized. The Lehman case shows how hard it can be for burned investors to get their money back in the event of disaster. Its bankruptcy alone has spawned more than 75 insolvency proceedings in 15 countries, each with differing rules. Without coordinated efforts, countries could find themselves pitted against one another. Even Belgium and the Netherlands, two close friends, clashed after the multinational Fortis Bank began to collapse in September. The bankruptcy proceeding quickly devolved into each country looking out for its own citizens. Equally worrisome, Wall Street's embrace of foreign markets makes it nearly impossible for national regulators to keep watch over what's being sold abroad and to whom. Even now, in the thick of the credit crisis, the biggest firms on Wall Street, Goldman Sachs (GS) among them, are setting up deals to sell potentially risky investments through foreign subsidiaries. This is one reason why the current financial debacle is unlike any that policymakers have had to confront. "I wouldn't want to be a regulator today," says Fried Frank partner Thomas P. Vartanian, who served as general counsel to the Federal Home Loan Bank Board at the start of the savings and loan crisis of the 1980s. "Some of the buttons on the control panel simply don't work." Prominent regulators concede the point. "A lot of these institutions [that got into trouble] were already regulated," Sheila C. Bair, head of the Federal Deposit Insurance Corp., said at an Apr. 23 industry conference in Washington. It's no wonder that Lehman's Amsterdam operation is fueling outrage. The operation was created in 1995 to sell "structured notes," a type of derivative that's like a bond except that the payments are tied to the performance of other investments. The subsidiary had an Amsterdam address but was run out of London by Lehman Brothers International (Europe), itself a subsidiary of Lehman Brothers Holdings in New York. Bankers call such enterprises "special purpose entities," but a more direct term might be "shell company." The Amsterdam unit had no independent staff and was overseen, nominally, by a board of five directors. Two worked for Equity Trust, a Dutch company that provides administrative services for companies and investors—everything from setting up trusts to serving as directors on boards. Equity Trust counted Lehman as a client. What's more, the Amsterdam subsidiary used Equity Trust's mailing address as its own. In the past, the address was used by a unit of Enron. Equity Trust declined to comment. The Netherlands has emerged as a haven for companies that want to avoid certain taxes on profits. A 2006 report by SOMO, a research group that focuses on multinational companies, found that some 20,000 "mailbox companies" had set up shop in Amsterdam for this purpose alone. That's one reason the Obama Administration is proposing a crackdown on offshore corporate tax havens. Jeremy Isaacs, head of Lehman Brothers International (Europe), oversaw the Amsterdam unit. He had been something of a wunderkind, embarking on his career in finance at age 18, with a back-office job at a U.K. brokerage. In 1989 he got a job as a derivatives trader at Goldman in London. Isaacs joined Lehman in 1996, at age 31, and within four years had taken the helm of Lehman's entire European operation.

282 ULTRA-Customized Notes From 1995 through 2002 the Amsterdam subsidiary was a bit player in the Lehman empire. But as the global credit boom began, Isaacs turned the operation into a virtual factory, issuing $30 billion in structured notes from 2003 through August 2008. At industry conferences during those years, Lehman executives, including CEO Richard S. Fuld Jr., said the Amsterdam notes were an important source of revenue. Isaacs left Lehman two days before it collapsed. Lehman's Amsterdam notes were bafflingly complex. In all, the unit issued some 4,000 variations, and the documentation for each type often ran to 600 pages. Lehman tailored the notes in an amazing array of styles to cater to just about any investing need. Would someone like a bond that would pay on the "outperformance" of Japanese stocks vs. U.S. stocks? Lehman created them, along with a "rocket tracker" on the Dow Jones Euro Stoxx 50 index. How about a bond for a thrifty soul who wanted to guard against inflation in Italy? Lehman had notes tied to consumer price indexes there, and in Spain and Mexico, too. It shipped the proceeds from selling the bonds back to New York. JA Solar bought $100 million worth last summer, at the urging of its Lehman bankers. It says the bankers pitched the notes (which paid a little interest each quarter if a certain commodity index registered a gain) as no riskier than a money market fund. JA Solar says it was told that at worst the investment would come out flat. "We did not anticipate [the notes'] coming even close to risky," says Anthea Chung, JA Solar's chief financial officer.

Now the company is reeling. It has written off the entire $100 million on its books. Its stock, which is traded in New York, is down 66% since Lehman filed for bankruptcy. JA is becoming one of the pioneers of de-globalization, preferring to keep its financial deals closer to home. "For the near future, we are quite comfortable with Chinese banks," says Chung. "They are backed by the Chinese government."

283 Lehman also tapped retail banks, including Citigroup and UBS (UBS), to hawk the Amsterdam notes, which were part of an enormous market. All told, Wall Street has sold more than $640 billion of structured notes to small investors around the world, according to StructuredRetailProducts.com—most of them from overseas units. That's about the size of the market for subprime collateralized debt obligations (CDOs), which brought on the global crisis. "[Lehman's notes] were sold directly by the banks to their retail customers," says Erik Bomans, a partner at Deminor, an advisory firm specializing in investor protection. Deminor, based in Brussels, is working with attorneys representing buyers of Lehman notes sold in Belgium, Italy, and the Netherlands. To date, the firm says, it has been contacted by 1,600 investors. "You can't even call them investors—they were savings bank customers," says Bomans. The Rubers are among those who claim they were misled. Rene Ruber says a banker at a Citigroup office in Belgium sold him and his son about $200,000 of Lehman notes, promising an annual return of up to 6%. He says the notes were presented as a risk-free savings tool. "In plain English, we were screwed," says Rene. "I was lied to. They are not honest bankers." His son Cedric says some of his lost money had been earmarked for a new home, and some for college savings for his two children. UBS says it "properly sold these investments to its clients. The offering materials clearly identified Lehman as the issuer and discussed all the relevant risks." A Citi spokesman in Belgium says the bank "is committed to helping affected customers retrieve as much of their original investment as possible through Lehman's bankruptcy proceedings in the U.S. and the Netherlands." In Britain it's a somewhat different story. Most of the notes sold there were marketed under the names of various London-based brokerages. Investors say they never knew that Lehman originated the bonds or guaranteed them. "If people knew it was Lehman, many wouldn't have bought them," says Howard, the retired British schoolteacher, who purchased notes in February 2008. "Many [American banks] were having a sticky time back then." Howard, 58, is trying to organize U.K. investors to recoup their money. Working from his home in Wantage, in Oxfordshire, he has spoken with about 100 people so far, he says. "The average age is 65," says Howard. "Most of them took some of their pension money and invested in these notes." He says he has been talking to members of Parliament to get them to pressure brokerages to reimburse investors. In the next few weeks, his grassroots group, SPIRIT—short for Structured Products Investors Recovery & Information Team—plans to launch a Web site to draw more attention. Similar stories abound in Asia, where investors have taken to the streets in Hong Kong several times since Lehman collapsed. The government says the Hong Kong Monetary Authority received more than 20,800 complaints about the notes, called there. Government officials on Apr. 28 alleged that some banks sold minibonds to mentally ill investors, although more details couldn't be obtained. The minibonds were similar to the Amsterdam notes except that they weren't "principal protected." Instead, a marketing leaflet said the minibonds were "credit-linked to a basket of well-known international financial institutions," such as JPMorgan Chase (JPM). In fact, they were tied to a CDO. The leaflet said the minibonds were safe and that returns "may reach 48.4%." But they were no more secure than Lehman's ability to pay back the cash. That risk was buried in the , below icons for gifts—digital cameras, LCD TVs, even grocery coupons.

284 Gordian Knot Now investors are trying to get their money back. —We feel totally cheated,— says Alex Chow, 51, who lost about $130,000 and is organizing more protests. "The bank stole our money," he says. Two firms that distributed Lehman minibonds have agreed with regulators to repay investors. About 6,000 investor claims are being settled, says the Hong Kong government. Meanwhile, in Amsterdam, the untangling of Lehman Brothers Treasury is just beginning. Rutger Schimmelpenninck, a partner with law firm Houthoff Buruma who is serving as the bankruptcy trustee, is daunted by the task. His exasperation came through in an Apr. 16 report in which he complained that "almost all the notes are governed by English law, while the validation of debt…is under Dutch bankruptcy law. … Obligations under the notes are governed by New York State law [and claims] have to be calculated and filed in accordance with the bankruptcy law of the United States." There's no clean way to slice through the Gordian knot of contracts, he tells BusinessWeek: "The legal practices for resolving disputes in bankruptcy situations around notes with embedded derivative elements have not yet developed."

Regulators have worried about that sort of problem for years. "Insolvency proceedings from one country to another are completely different," says Michael H. Krimminger, special adviser for policy to FDIC Chairman Bair. Despite the mess in Amsterdam, new deals are hatching in Europe. On Feb. 11 Goldman registered a plan in Ireland to sell notes that seem similar in structure to the ones sold by Lehman in Amsterdam. The notes will be issued by an Irish unit called Goldman Sachs Financial Products Europe, according to the prospectus. Like Lehman's notes, some of Goldman's will be backed by the parent company in New York. Goldman declined to comment.

Ireland, like Amsterdam, has become a favorite place for global banks to set up subsidiaries to sell financial instruments. A recent Government Accountability Office report listed Ireland among more than 30 nations where U.S. companies have established units to take advantage of easier regulation. Goldman's operation is similar to Lehman's in another way. Two of the subsidiary's directors are executives with Deutsche International Corporate Services, a unit of Germany's (DB) that provides trustee and securities services to scores of investment vehicles set up by Goldman and others. The mailing address for Goldman's Ireland subsidiary? It's the one used by the Deutsche operation. If more structured notes go sour or if bank bailout burdens grow, the biggest loser could be globalization itself. Josef Ackermann, chairman of Deutsche Bank, warned of the consequences of financial protectionism in a recent speech at the London School of Economics. "Market integration, for goods and services and for capital, is the bedrock of our prosperity," he said. But by selling risky instruments to unwitting investors around the world, Wall Street is placing that prosperity in jeopardy.

285 Business Exchange: Read, save, and add content on BW's new Web 2.0 topic network End Life Support for Troubled Banks Propping up failed banks isn't working, says Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City. Despite billions spent, markets haven't recovered, he wrote on May 4 in the Financial Times. Hoenig has argued for the forced liquidation of assets of failing banks. To read Hoenig's column, go to http://bx.businessweek.com/banking- industry/reference/. Henry is a senior writer at BusinessWeek. Goldstein is a senior writer at BusinessWeek. With Theo Francis in Washington and Bruce Einhorn in Hong Kong http://www.businessweek.com/magazine/content/09_20/b4131038438462.htm?campaig n_id=mag_May7&link_position=link41

286 May 6, 2009, 12:01AM EST text size: TT Virtual Currencies Gain in Popularity Gaming companies, startups, even social networks like Facebook and MySpace are developing "cash" technologies for online transactions By Olga Kharif Make way, Zambian kwacha. There's a hot new exotic currency on the market, only it's not from any country on earth—at least not one in the material world. This currency is called the Project Entropia Dollar (PED) and it's used to buy and sell goods on the planet Calypso, in an online gaming world called Entropia Universe. The PED is among a growing number of alternative currencies changing hands in virtual worlds, social networks, and other Web sites eager to make it easier for users to spend money and carry out other transactions while online. "We'll try to make the link between real and virtual world as close as possible," says Hans Andersson, who in March was granted a license from the Swedish government to open Mind Bank, which will exchange Swedish kronor for PEDs. The game's 1 million users now buy and sell land, minerals, and tools by depositing U.S. dollars or Swedish kronor directly into the game. Once Mind Bank opens in January, users will be able to link real-world checking and savings accounts to the virtual world. Eventually they'll be able to take out PED loans. Andersson hopes that as it becomes simpler to transfer funds from real-world financial institutions to those that exist on the Internet, site users will spend more time and money online. The difficulty of paying for goods in virtual worlds, online games, social networks, and even dating sites has long stymied growth in what analysts see as a burgeoning market. China's virtual goods economy, the largest in the world, is worth $800 million and growing 30% a year, estimates Shaun Rein, managing director at China Market Research Group. In Second Life, one of the biggest U.S.-based virtual economies, transaction volume is expected to rise 39%, to $500 million this year, according to the world's creator, Linden Research. "Our virtual economy has been on a tear," says Tom Hale, Linden's chief product officer. "It's grown much better than the real economy. It's a wonderful, wonderful business." Facebook: Testing Virtual "Credits" Services such as eBay's (EBAY) PayPal and credit and debit cards provide a way for people to pay for virtual goods or site-specific virtual currencies. But many users, including teens and people in emerging economies, don't have bank accounts or credit cards. In the U.S., 95% of teens make purchases with cash, according to the Charles Schwab (SCHW) Teens & Money 2007 survey. Of China's 1.3 billion people, only 115 million own credit cards. And many players balk at the high fees levied by financial services on the sub-$1 transactions commonplace in the virtual-goods world. "There's a new category of transactions—micropayments—that traditional players have had trouble catering to," says Michael Ting, senior director at mobile-payments provider Obopay. Visa (V) and PayPal declined to comment for this story. Web sites view alternative payment methods as a way to accelerate the sale of the virtual goods that are an important source of revenue, especially as demand for online ads slumps. On Apr. 3, social network Facebook announced that it is testing its own

287 "credits," which would let users carry out transactions in certain subnetworks. News Corp.'s (NWS) MySpace is developing its own virtual currency and payment system. Some Web sites are letting users buy virtual credits from brick-and-mortar establishments. On Apr. 30, KingsIsle Entertainment, creator of the Wizard101 game played by some 2 million mostly young people, announced it will make $10 gift cards available through 7-Eleven stores. Several startups also hope to make money from virtual goods transactions. These include Sim Ops Studios, Fragegg, Twofish, and PlaySpan. Some have backing by such venture capital heavyweights as Menlo Ventures and SK Telecom Ventures. Rixty: Outlets Targeting Teens Acquisitions in online micropayments are heating up as well: On Apr. 21, PlaySpan, whose technology verifies and analyzes virtual currency transactions, acquired Spare Change, which powers virtual-goods payments on sites such as Facebook. In January, Linden Lab acquired two virtual goods marketplaces, Xstreet SL and OnRez. Linden is also considering letting its currency, the Linden Dollar, be used in other virtual universes. New payment options could further accelerate virtual-goods market growth by reaching out to users who can't now pay for virtual goods. A service called Rixty will let teenagers set up accounts in gaming portals such as Perfect World. Starting in June, users will be able to purchase in-game currency by depositing change in Coinstar (CSTR) kiosks or through convenience store purchases. "We give users an ability to capture the value of loose change," says Rixty CEO Ted Sorom. Other companies want to let users buy game currencies by charging purchases to cell- phone bills, a move already popular in Asia. "The big push for us in the next 12 months will be to support these [new] payment methods," says Hale of Linden Lab. Obopay is considering supporting such transactions, too. Some companies are looking to act as virtual currency exchanges. The social gaming network Fragegg was launched in test mode in early April, offering access to 20 multiplayer online games. The company wants to let players exchange currency they earn playing games on its site with the currencies of its game partners. Revenues for Game Developers Twollars wants to harness virtual payments for a cause. Launching in May, the service will let users of social network Twitter send Twollar reward points to a favorite charity for free. Twollar sponsors will then make a corresponding cash donation to the charity and may in turn reward users with virtual goods. Another outfit, Twofish, offers software that will allow client Web sites to release branded currencies—say, bills bearing a coffee or soft drink brand name—for redeeming virtual goods in games. The new payment services might even encourage developers to create more virtual goods and features for purchase on Web sites. Released in March, Sim Ops' software tools, for instance, let developers create games for free, and to make money from sales of virtual goods, such as weapons for avatars. But as virtual trading's use spreads, so could accompanying problems, such as fraud. Sites have to ensure that users can't "manufacture" virtual currency without paying for it with real money or earning it in game play. Further complexities may arise as the sites try to rope in teenagers: In China, where youngsters can buy virtual goods and

288 currencies by charging them to a phone, some teens have managed to charge their parents' office phones, says Yang Wang, a PhD student at the University of California- Irvine, who conducted research into Chinese virtual currency practices for the research arm of chipmaker Intel (INTC). The sites themselves may need to be regulated by the government to prevent fraud. "We need transparency, as with other investments, [including restrictions on insider trading]," says Mark Methentis, a lawyer and author of gaming-law blog, Law of the Game. But for now, Web sites and companies trying to help them are concerned mainly with using the currencies and payment systems to get users more engaged. Says Twofish President Lisa Rutherford: "The question is, how can we make game play more exciting?" Kharif is a senior writer for BusinessWeek.com in Portland, Ore. http://www.businessweek.com/print/technology/content/may2009/tc2009055_070595.ht m

289 The Wall Street Journal BUSINESS MAY 8, 2009 Fed Sees Up to $599 Billion in Bank Losses Worst-Case Capital Shortfall of $75 Billion at 10 Banks Is Less Than Many Feared; Some Shares Rise on Hopes Crisis Is Easing By DAVID ENRICH, ROBIN SIDEL and DEBORAH SOLOMON The federal government projected that 19 of the nation's biggest banks could suffer losses of up to $599 billion through the end of next year if the economy performs worse than expected and ordered 10 of them to raise a combined $74.6 billion in capital to cushion themselves. The much-anticipated stress-test results unleashed a scramble by the weakest banks to find money and a push by the strongest ones to escape the government shadow of taxpayer-funded rescues. Interactives: Compare Banks Tested View Interactive http://online.wsj.com/article/SB124172137962697121.html#project%3DSTRESS0409% 26articleTabs%3Dinteractive

Bank by Bank Findings View Interactiv e http://online.wsj.com/article/SB124172137962697121.html#project%3DSTRESSTEST DOCS0905%26articleTabs%3Dinteractive The Federal Reserve's worst-case estimates of banks' total losses and capital shortfalls were smaller than some had feared. Optimists interpreted the Fed's findings as evidence that the worst is over for the industry. But questions remain about the stress tests' rigor, in part since the Fed scaled back some projected losses in the face of pressure from banks.

290 The government's tests measured potential losses on mortgages, commercial loans, securities and other assets held by the stress-tested banks, ranging from giants Bank of America Corp. and Citigroup Inc. to regional institutions such as SunTrust Banks Inc. and Fifth Third Bancorp. The government's "more adverse" scenario includes two-year cumulative losses of 9.1% on total loans, worse than the peak losses of the 1930s. Treasury Secretary Timothy Geithner said Thursday that he is "reasonably confident" that banks will be able to plug the capital holes through private infusions, alleviating the need for Washington to further enmesh itself in the banking system. Banks also said they will consider selling businesses or issuing new stock to meet the toughened capital standards. The information provided by the stress tests will "make it easier for banks to raise new equity from private sources," Mr. Geithner said. Still, he added, "We have a lot of work to do...in repairing the financial system." Some of the banks told to add capital raced to accomplish that by tapping public markets. On Thursday, Wells Fargo & Co., which the Fed said needed to raise $13.7 billion, laid plans for a $6 billion common-stock offering. Morgan Stanley, facing a $1.8 billion deficit, said it will sell $2 billion of stock and $3 billion of debt that isn't guaranteed by the U.S. government. If successful, the offerings "should be a meaningful step in restoring a modicum of confidence to the banks," said David A. Havens, a managing director at Hexagon Securities. "It indicates that even the big messy banks are able to attract private capital." Shares of more than a dozen stress-tested banks rose in after-hours trading as the government's announcement soothed jitters about the industry's immediate capital needs. Bank of America shares climbed 3.6% to $13.99, while Citigroup was up 6.3% to $4.05. Fifth Third jumped 19% to $6.35. SunTrust fell 2.5% to $18.05, and Wells Fargo slipped 0.9% to $24.54.

No Need to Stress Over Bank Stress Tests Nine of the stress-tested banks -- including titans like J.P. Morgan Chase & Co. and Wall Street's Goldman Sachs Group Inc. as well as several regional institutions -- have adequate capital. That finding essentially represents a seal of approval from the Fed. The others need to raise anywhere from about $600 million for PNC Financial Services Group Inc. to $33.9 billion for Bank of America. In between are several other regional lenders: Fifth Third, which needs to raise $1.1 billion; KeyCorp, $1.8 billion; Regions Financial Corp., $2.5 billion; and SunTrust, $2.2 billion. Experts warn that the tests could have a serious unintended consequence: Loans could be harder to come by for consumers and businesses. That's because the government's intense focus on thicker capital cushions might prompt banks to hoard cash and further curtail lending, said Jim Eckenrode, banking research executive at TowerGroup, a financial consulting firm. He said banks will have less room to offer consumers low interest rates, while corporate customers may have a tougher time getting financing for commercial real-estate and property development.

291 That would undercut a key goal of the Obama administration, which has been pushing banks to lend more in order to jump-start the economy. The test results were vigorously contested by some banks, which argued they were superficial and didn't reflect significant differences in the health of various banks' loan portfolios. In a news release Thursday, Regions publicly criticized the testing process. The Birmingham, Ala., bank said the Fed's loss assumptions were "unrealistically high." Regions said it "questions whether it should be required to raise additional capital now to provide for a two-year adverse economic scenario," given recent hints that the economy may have hit bottom. With the tests complete, Washington's effort to clean up the banking system now shifts into a new, potentially messy phase. While most of the banks that need capital are likely to be able to find it, analysts and bankers say a few others are likely to end up being largely owned by the U.S. government due to their inability to raise capital from private investors. Meanwhile, the tests don't address a sea of problems confronting many midsize and smaller banks. Federal officials have repeatedly vowed to support the 19 banks, which essentially have been labeled too big to fail. Those reassurances have propelled the companies' shares to their highest levels in months. The White House, Treasury Department and Fed hope that by restoring confidence in the industry, private investors will help troubled banks shore up their finances, eliminating the need for taxpayer-financed rescues. There are some encouraging signs. In recent weeks, a handful of healthy banks -- ranging from giants like Goldman Sachs to Denver's 34-branch Guaranty Bancorp -- have raised money by selling stock in public offerings. That represents a seismic shift from earlier this year, when many investors refused to touch any bank stocks. "What we're starting to hear from investors is a view that these companies were oversold and, although things are bad, they're not as bad as was baked into the assumptions," said Brian Sterling, co-head of at Sandler O'Neill & Partners in New York. Some Fed-blessed banks are likely to pursue public equity or debt offerings to flex their financial muscles and help pay back the funds that the government invested in them. View Full Image

Associated Press Comptroller of the Currency John Dugan, left, Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke gathered in Geithner's office at Treasury on Thursday.

292 State Street Corp. Chairman and Chief Executive Ronald E. Logue said the government's conclusion that the Boston company needs no additional capital puts it "in a position to consider repayment of the TARP preferred stock and warrants under the appropriate circumstances." State Street, one of the largest managers of index funds, got a $2 billion taxpayer-funded infusion under the Troubled Asset Relief Program, or TARP. On Wednesday, The Wall Street Journal incorrectly reported that State Street had been told to come up with more capital. Bankers acknowledge that investors' appetites are limited. Investors say not enough private funds are available to fill the big banks' financial holes. "I think there is some demand in the market to raise a certain amount, but whether you could find $60 billion of capital in the next couple of months is highly unlikely," said Joshua Siegel, managing principal at StoneCastle Partners LLC, a New York firm that invests in banks. Banks that can't coax private investors have some other options. They can sell assets or business lines, a strategy already under way at Bank of America and Citigroup. They can push investors to swap so-called preferred shares for common stock, padding a measure of capital known as tangible common equity. During a Thursday conference with investors, Bank of America Chairman and Chief Executive Kenneth Lewis said, "Our game plan is designed to help get the government out of our bank as quickly as possible," and vowed to abandon a loss-sharing agreement with the U.S. on $118 billion in assets. But bankers and analysts say at least a few lenders are in a vise. Too weak to lure investors, and lacking a large pool of privately held preferred stock, these banks likely will have to turn to Washington for help. Fifth Third and Regions both said in statements Thursday that they hope to raise private funds. The 19 tested banks, which all have at least $100 billion in assets, accounted for most of the industry's total loans. But the companies represent a sliver of the roughly 8,000 banks nationwide. Among that vast field, many banks -- from regional institutions to tiny community lenders -- are holding huge portfolios of rapidly souring loans. Unlike their larger rivals, these banks lack the diverse income streams to overcome the brutal operating environment. Analysts at RBC Capital Markets estimate that 60% of the top 100 U.S. banks that weren't included in the stress tests would need to raise new capital based on the Fed's loss assumptions. —Jane J. Kim contributed to this article. Write to David Enrich at [email protected], Robin Sidel at [email protected] and Deborah Solomon at [email protected]

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Barack Obama and the carmakers An offer you can't refuse May 7th 2009 From The Economist print edition In its rush to save Detroit, the American government is trashing creditors’ rights

Illustration by Claudio Munoz NO ONE who lent money to General Motors (GM) or Chrysler can have been unaware of their dire finances. Nor can workers have failed to notice their employers’ precarious futures. These were firms that barely stayed afloat in the boom and both creditors and employees were taking a punt on their promise to pay debts and generous health-care benefits. The bet has failed. The recession has tipped both firms into the abyss—together they lost $48 billion last year. Chrysler has entered bankruptcy, from which it may emerge under Fiat’s control (see article). GM could soon follow if efforts to hammer out a voluntary restructuring fail. America’s government, keen to protect workers, is providing taxpayers’ cash to keep the lights on at both firms. But in its haste it has vilified creditors and ridden roughshod over their legitimate claims over the carmakers’ assets. At a time when many businesses must raise new borrowing to survive, that is a big mistake. Bankruptcies involve dividing a shrunken pie. But not all claims are equal: some lenders provide cheaper funds to firms in return for a more secure claim over the assets should things go wrong. They rank above other stakeholders, including shareholders and employees. This principle is now being trashed. On April 30th, after the failure of negotiations, Chrysler entered Chapter 11. Under the proposed scheme, secured creditors owed some $7 billion will recover 28 cents per dollar. Yet an employee health- care trust, operated at arm’s length by the United Auto Workers union, which ranks lower down the capital structure, will receive 43 cents on its $11 billion-odd of claims, as well as a majority stake in the restructured firm. The many creditors who have acquiesced include banks that themselves rely on the government’s purse. The objectors have been denounced as “speculators” by Barack Obama. The judge overseeing the case has consented to a quick, “prepackaged”

294 bankruptcy, which seems to give little scope for creditors to argue their case or pursue the alternative of liquidating the company’s assets. In effect Chrysler and the government have overridden the legal pecking order to put workers’ health-care benefits above more senior creditors’ claims, and then successfully argued in court that the alternative would be so much worse for creditors that it cannot be seriously considered. The Treasury has also put a gun to the heads of GM’s lenders. Unsecured creditors owed about $27 billion are being asked to accept a recovery rate of 5 cents, says Barclays Capital, whereas the health-care trust, which ranks equal to them, gets 50 cents as well as a big stake in the restructured firm. If creditors refuse to co-operate, the government will probably seek to squash them using the same fast-track legal process. Chapter and verse The collapse of Detroit’s giants is a tragedy, affecting tens of thousands of current and former workers. But the best way to offer them support is directly, not by gerrymandering the rules. The investors in these firms are easily portrayed as vultures, but many are entrusted with the savings of ordinary people, and in any case all have a legal claim that entitles them to due process. In a crisis it is easy to put politics first, but if lenders fear their rights will be abused, other firms will find it more expensive to borrow, especially if they have unionised workforces that are seen to be friendly with the government. It may be too late for Chrysler’s secured creditors and if GM’s lenders cannot reach a voluntary agreement, they may face a similar fate. That would establish a terrible precedent. Bankruptcy exists to sort legal claims on assets. If it becomes a tool of social policy, who will then lend to struggling firms in which the government has a political interest? “In its rush to save Detroit, the American government is trashing creditors’ rights”, The Economist, 07/05/09, http://www.economist.com/opinion/displaystory.cfm?story_id=13610871

295 The Wall Street Journal OPINION MAY 7, 2009 Capitalism in Crisis. It's hard to run a safe banking system when the central bank is recklessly easy. By RICHARD A. POSNER

The current economic crisis so far eclipses anything the American economy has undergone since the Great Depression that "recession" is too tepid a term to describe it. Its gravity is measured not by the unemployment rate but by the dizzying array of programs that the government is deploying and the staggering amounts of money that it is spending or pledging -- almost $13 trillion in loans, other investments and guarantees -- in an effort to avoid a repetition of the 1930s.

David Klein Much of this sum will not be spent (the guarantees), and probably most will eventually be recovered. But a commitment of such magnitude -- stacked on top of enormous budget deficits enlarged by sharply falling federal-tax revenues -- could lead to high inflation, greatly increased interest costs on a greatly increased national debt, much heavier taxes, the restructuring of major industries, and the redrawing of the line that separates business from government. How did this happen? And what is to be done? The key to understanding is that a capitalist economy, while immensely dynamic and productive, is not inherently stable. At its heart is a banking system that enables large-scale borrowing and lending, without which most businesses cannot bridge the gap between incurring costs and receiving revenues and most consumers cannot achieve their desired level of consumption. When the banking system breaks down and credit consequently seizes up, economic activity plummets. Lending borrowed capital -- the essence of banking -- is risky. That risk is amplified when interest rates are very low, as they were in the early 2000s because of a mistaken decision made by the Federal Reserve under Alan Greenspan to force interest rates down and keep them down. Because houses are bought with debt (for example, an 80% first mortgage on a house), low interest rates spur demand for houses. And because the housing stock is so

296 durable a surge in demand increases not only housing starts but also the prices of existing houses. When people saw house prices rising -- and were assured by officials and other experts that they were rising because of favorable "fundamentals" -- Americans decided that houses were a great investment, and so demand and prices kept on rising. In fact, prices were rising because interest rates were low. So when the Federal Reserve (fearing inflation) began pushing interest rates up in 2005, the bubble began leaking air and eventually burst. It carried the banking industry down with it because banks were so heavily invested in financing houses. The banking crash might not have occurred had banking not been progressively deregulated beginning in the 1970s. Before banks were forbidden to pay interest on demand deposits. This gave them a cheap source of capital, which enabled them to make money even on low-risk short-term loans. Competition between banks was discouraged by limits on the issuance of bank charters and by (in some states) not permitting banks to establish branch offices. And nonbank finance companies (such as broker-dealers, money-market funds and hedge funds) did not offer close substitutes for regulated banking services. Those days are gone. Had Americans' savings not become concentrated in houses and common stocks, the banking meltdown would have had less effect on the general economy. When these assets -- their prices artificially inflated by low interest rates -- fell in value, credit tightened and people felt (and were!) poorer. So people reduced their spending and allocated more of their income to precautionary savings, including cash, government securities and money-market accounts. The Fed tried to encourage lending by once again pushing interest rates way down. But the banks -- their capital depleted by the fall in value of their mortgage-related assets -- have hoarded most of the cash they've received as a result of being able to borrow cheaply, rather than risk lending into a depression. Their hoarding, like that of consumers, is entirely rational, but it inhibits investment as well as consumption. With easy money failing to do the trick, the government began lending large sums of money directly to banks. It also tried to bypass the banks in its efforts to stimulate consumption and employment by implementing tax cuts, benefits increases and public-works projects hard hit by unemployment. Though the banks are continuing to hoard bailout money and the stimulus program is just beginning to be implemented, these and other recovery programs have probably slowed the downward spiral. It's not too soon, therefore, to derive some important lessons from the economic crisis: First, businessmen seek to maximize profits within a framework established by government. We want businessmen to discover what people want to buy and to supply that demand as cheaply as possible. This generates profits that signal competitors to enter the market until excess profit is eliminated and resources are allocated most efficiently. Financial products are an important class of products that we want provided competitively. But because risk and return are positively correlated in finance, competition in an unregulated financial market drives up risk, which, given the centrality of banking to a capitalist economy, can produce an economic calamity. Rational businessmen will accept a risk of bankruptcy if profits are high because then the expected cost of reducing that risk also is high. Given limited liability, bankruptcy is not the end of the world for shareholders or managers. But a wave of bank bankruptcies can bring down the economy. The risk of that happening is external to banks' decision-making and to control it we need government. Specifically we need our central bank, the Federal Reserve, to be on the lookout for bubbles, especially housing bubbles because of the deep entanglement of the banking industry with the housing industry. Our central bank failed us. The second lesson is that we may need more regulation of banking to reduce its inherent riskiness. But now is not the time for that: There is no danger of a renewed housing or credit bubble in the immediate future. The essential task now is to recover from the depression. That

297 requires, as John Maynard Keynes taught, a restoration of business confidence. Investment is inherently uncertain, and it is even more uncertain in a depression. Anything that amplifies this uncertainty slows recovery by making businessmen more likely to freeze and hoard rather than venture and spend. Reregulating banking, hauling bankers before congressional committees, passing laws tightening credit-card lending, and capping bonuses all impede recovery. All that is for later, once the economy is back on track. For now such measures are just distractions. Moreover, it is unclear how banking should be regulated. Banking in the broad sense of financial intermediation (borrowing capital in order to lend or otherwise invest it) is immensely diverse. It is also international. If one nation reduces the riskiness of its banking industry, business will flow to other nations, just as a bank that decides to be cautious will lose investors to its competitors because of the positive correlation of risk and return. So international regulation of banking is needed in principle, but international regulation tends to be lowest-common- denominator regulation and so may be ineffectual. Finally, let's place the blame where it belongs. Not on the bankers, who are not responsible for assuring economic stability, but on the government officials who had that responsibility and failed to discharge it. They failed even to develop contingency plans to deal with what everyone knew could happen in a context of escalating housing prices (it had happened in Japan in the late 1980s and the 1990s). Lacking such plans, the government responded to the crisis with spasmodic improvisations, amplifying uncertainty and mistrust and thus retarding recovery. And let's not forget to apportion some of the blame to the influential economists who assured us that there could never be another depression. They argued that in the face of a recession the Federal Reserve had only to reduce interest rates and flood the banks with money and all would be well. If only. Mr. Posner is a federal circuit judge and a senior lecturer at the University of Chicago Law School. He is the author of the just-published "A Failure of Capitalism: The Crisis of '08 and the Descent into Depression" (Harvard University Press). Richard A. Posner, “Capitalism in Crisis. It's hard to run a safe banking system when the central bank is recklessly easy”, TWSJ, 07/05/09, disponible en: http://online.wsj.com/article/SB124165301306893763.html

May 19, 2009, 7:49 am Prodigal intellectuals So I see Richard Posner has decided that modern conservatism is intellectually bankrupt. And Bruce Bartlett has a new book saying it’s time to let go of Reagan. At one level it’s good to see decent people showing some intellectual flexibility (Bartlett, in particular, has always come across as someone with whom one can have honest disagreements.) And yet — why, exactly, should we listen to people who by their own admission completely missed the story? I mean, anyone who actually listened to what Newt Gingrich and Dick Armey were saying in 1994, let alone what passed for thought in the Bush administration, should have realized long ago that if there ever was an intellectual basis for modern conservatism, it was long gone. And the truth is that the Reaganauts were a pretty grotesque bunch too. Look for the golden age of conservative intellectualism in America, and you keep going back, and back, and back — and eventually you run up against William Buckley in the 1950s declaring that blacks weren’t advanced enough to vote, and that Franco was the savior of Spanish civilization. So the idea that we should pay any attention to people who somehow failed to see all this until very late in the game — and, in the case of Posner (not Bartlett), waited to express their doubts until conservatism had lost power ….

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Stress Test Finds Strength in Banks Uncertainty Remains, but Officials Say Most Have Capital to Outlast Recession By Binyamin Appelbaum Washington Post Staff Writer Thursday, May 7, 2009 Long-awaited results of the government's stress test of 19 major banks show that nearly all, including several that verged on collapse during the financial crisis, now have enough money to weather the recession, the Obama administration plans to announce this afternoon. In an outcome more positive than many investors had expected, the tests concluded that the banks have enough capital in reserve but may need to strengthen the ability of those holdings to absorb losses. The report is expected to show clear distinctions among the nation's largest banks, according to sources familiar with the findings. J.P. Morgan Chase will not require additional capital, clearing the way for the bank to repay the government's investment. Bank of America and Wells Fargo also do not need more money, but will be required to strengthen their reserves, potentially by converting tens of billions of dollars of other forms of capital to common equity, the most dependable form of capital. Bank of America will need to increase these holdings by about $34 billion and Wells Fargo by $15 billion, sources said. Citigroup, the weakest of the giants, will be required to raise about $5 billion in new capital and take additional steps to strengthen its reserves. The formal unveiling of the results scheduled for this afternoon marks the end of a months-long process designed by the Obama administration to restore confidence in the banking industry, in part by forcing some banks to accept additional capital. The markets responded to early reports of the results yesterday with a euphoric burst, bumping up shares of Bank of America by 17 percent, Citigroup by 16 percent and Wells Fargo by 15 percent. But it might not be clear for some time whether the government has succeeded in restoring confidence, a prerequisite for economic revival. Auto-financing giant GMAC may be the company most likely to require a new federal investment, according to sources familiar with the situation. Sources said the government would require GMAC to increase by $11.5 billion its holdings of common equity -- money raised from the sale of common stock and retained from profit. The company, with only $5 billion in government money that can be converted to common equity, has struggled to attract private investors and may be forced to accept additional federal aid. The government already is planning to pump billions of dollars more into the company to help it replace Chrysler Financial as the primary source of loans for Chrysler dealers and car buyers. The 19 banks, which together hold two-thirds of the nation's deposits, were required to provide regulators with reams of data detailing loans and other commitments. The banks also estimated loan defaults and losses through the end of 2010, based on a moderately bleak economic forecast provided by the government. Finally, regulators adjusted the findings to ensure comparability among firms.

299 Some economists have warned that the recession may prove even more severe, raising the prospect that banks still won't have enough capital. Prevailing regulations require all banks to maintain a capital reserve equal to 6 percent of their outstanding loans and other commitments, so the bank can absorb unexpected losses. For the purpose of the stress test, regulators also required that banks keep most of that reserve in the form of common equity. The change is a concession to investors who are concerned that banks increasingly hold capital from less dependable sources, such as the sale of preferred shares, which are structured like loans that must be repaid. This problem was exacerbated by the government's investment in banks, which came in the form of preferred shares. Nearly all of the banks have enough capital to meet the first requirement, but many were unprepared to meet the narrower requirement. The results, which will be released by Treasury Secretary Timothy F. Geithner and the heads of the major regulatory agencies, divide banks into three categories. A small number of institutions need more money to buttress their reserves. A larger group of banks do not need more money, but will be required to raise additional common equity to strengthen their reserves. Some banks will receive a clean bill of health. Regulators have been careful to note that all of the tested banks have enough capital at present; the question is whether they will maintain enough capital through 2010. Banks that must take remedial action have until June 8 to develop detailed plans, officials said yesterday. The firms then have until Nov. 9 to meet the government's requirements before they are required to accept federal aid, or else they will be required to accept federal aid. Officials say they are confident that most companies will not need additional money from the government, although companies that convert existing federal investments will be able to suspend dividend payments, potentially erasing billions of dollars in expected returns for the government. Citigroup will be required to raise about $5 billion in additional capital, and to increase its holdings of common equity by about $50 billion, or more than 60 percent. That's the largest hole for any bank. The company has announced plans to exchange common shares for $52.5 billion in preferred shares, including $25 billion held by the government, which would give taxpayers a roughly 36 percent stake. The firm is also selling a number of business units, including much of its operation in Japan. Executives have expressed confidence that the company will not require additional federal aid. Regions Financial of Alabama also will be required to raise additional capital. The longer list of banks that need to raise common equity is headlined by Bank of America, which will be required to raise $33.9 billion, an increase of roughly 50 percent in the bank's common equity, according to a person familiar with the matter. The bank could meet that requirement by converting a portion of the government's existing $45 billion investment, a step that would not involve raising any new money. But the bank is likely to consider other options, such as the sale of business units,

300 because exchanging common shares for the preferred shares now held by the Treasury would give the government a significant ownership stake in the company. Bank of America is shopping its mutual fund unit, Columbia Management, and also exploring the sale of its stake in China Construction Bank. The company also has about $33 billion in preferred shares held by private investors, which it could try to convert to common shares. Regulators plan to require Wells Fargo to increase its common equity by $15 billion. The company has issued $25 billion in preferred shares to the government. The list of banks judged by the government to have sufficient capital and sufficient common equity also includes Goldman Sachs, Bank of New York Mellon and American Express. Tests determined that Capital One Financial of McLean needs little, if any, additional common equity, sources said. Several of these companies are expected to push for permission to repay the government's existing investments. The administration has said that it would only allow banks to repay that money if they also demonstrate that they no longer need to rely on another government aid program, administered by the Federal Deposit Insurance Corp., which allows banks to issue debt at lower interest rates by guaranteeing investors against loss. All of the banks declined to comment yesterday, citing orders from the government not to speak about the test results. Staff writers Neil Irwin and David Cho contributed to this report.

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Business

May 7, 2009 As Stress Tests Are Revealed, Markets Sense a Turning Point By ERIC DASH and LOUISE STORY

The results of the bank stress tests have been trickling out for days, from Washington and from Wall Street, and the leaks seem to confirm what many bankers feel in their bones: despite all those bailouts, some of the nation’s largest banks still need more money.

But that does not necessarily mean the banks will get that money from the government.

The findings, to be released Thursday by the Obama administration, suggest that the rescue money that Congress has already approved will be enough to fill the gaps. If so, the big bailouts for the banks may be over.

302 All of this assumes that the economy does not take another turn for the worse, which would result in even more losses at the banks — and the need for even more money to prop them up. But hopes that the tests will be a turning point in this financial crisis electrified Wall Street on Wednesday and some overseas markets the next day. Financial shares soared, lifting the broader American stock market to its highest level in four months. The Dow Jones industrial average rose 101.63, or 1.2 percent, to close at 8,512.28 Wednesday, while Japan's Nikkei index rose more than 4 percent by midday Thursday. How well many of the banks fared in the tests seems to have become something of a open secret on Wall Street, where the results, and mere whispers of them, have been the subject of intense speculation. After news this week that Bank of America and Citigroup would be required to bolster their finances again, word came Wednesday that regulators had determined that Wells Fargo and GMAC, the deeply troubled financial arm of General Motors, would need to do so as well. But regulators decided that American Express, Capital One, Bank of New York Mellon, Goldman Sachs, JPMorgan Chase and MetLife would not need to take action. The official word is due at 5 p.m. Thursday. The results so far seem to suggest that the 19 institutions that underwent these exams will need less than $100 billion in additional equity to cope with a deep recession, far less than some investors had feared. The question now is, where will banks get that capital? Most of them would prefer to raise money privately, either by selling shares to the public or a big investor, or by selling some of their businesses. But if that is not enough, the odds are the government will step in. The thinking is that some banks will ask the government to convert preferred shares that it bought last year, at the height of the financial crisis, to common stock. As a result, the government would become a significant shareholder in a number of banks besides Citigroup. But under that assumption, no new taxpayer money would go to the banks. The government would merely exchange one investment, its preferred stock, which is much like a loan, for ordinary common shares. The move amounts to shifting public money from one pot to another to ensure that these big lenders — those deemed too big to fail — have enough common stock to cushion their potential losses. This would represent a riskier deal for taxpayers. Whether they get out whole would depend on the stock market. And by exchanging its preferred shares for common stock, the government would also forgo dividend payments on its preferred shares. “What is positive is that there’s a line being drawn,” said Jim Reichbach, a vice chairman of United States financial services at Deloitte. “There’s a number being put on the table.” To help cover a huge shortfall, Citigroup has announced plans to convert a portion of the government’s $45 billion investment to common stock, which would give the government a stake of as much as 36 percent. Regional lenders like Fifth Third Bank of Ohio or Regions Financial of Alabama could find themselves in a similar boat. The banks are eager to avoid having the government increase its stake drastically because that would dilute the holdings of the banks’ existing shareholders. Bank of

303 America, for instance, is looking to sell businesses and to cash in investments to help cover a shortfall of nearly $34 billion. Morgan Stanley plans to meet an expected shortfall of $1 billion to $2 billion by selling assets or stock to private investors, a person briefed on the plan said. Citigroup has also sold several big businesses, reducing its large capital deficit to around $6 billion. In fact, after so much talk of nationalizing banks, the administration’s stress tests and capital programs seem to be intended to encourage lenders to take steps to minimize government ownership. The Treasury Department plans to offer a special type of preferred stock that banks can convert to full-voting common shares only as needed. To use it, they will first have to try to raise private capital or do similar exchanges with private investors. What is more, any gains from asset sales, stock sales or larger-than-expected profits over the next two quarters can be used to offset the shortfalls. That might encourage banks to take bolder action, although some have struggled to find buyers for their businesses, or at least ones willing to pay the prices they seek. Timothy F. Geithner, the Treasury secretary, said Wednesday that the results of the stress tests might be comforting news. “It will help lift this fog of uncertainty over the financial system, and I think the results will be, on balance, reassuring,” Mr. Geithner said Wednesday on “The Charlie Rose Show.” Critics say the tests have eroded confidence rather than bolstered it. The tests have occupied banking executives for months and fed the Wall Street rumor mill, adding to the volatility in the markets. Some also ask why the banks were able to negotiate with regulators behind closed doors over the tests and the results. “The banks are healing themselves, and it could have been done a lot faster if government had gotten out of the way instead of parking the emergency equipment in the middle of the road,” said Gary B. Townsend, a former banking regulator who now runs his own investment firm. It may come as a surprise to many people that by most standards, all of the banks that underwent these tests are already adequately capitalized. But regulators are focusing on the amount of capital made up of common stock, the first layer to absorb losses on bad loans. The government is betting that if banks have a bigger buffer of equity, private investors will be confident enough in the banks’ health to pour money in. That should encourage the banks to start lending again. “This is sending a message that the banks need more capital, but their losses are manageable and the system itself is solvent,” said Kevin Fitzsimmons, an analyst at Sandler O’Neill. “Whether it sticks is something else.” http://www.nytimes.com/2009/05/07/business/07bank.html?_r=1&th&emc=th

304 May 6, 2009, 6:58 pm

Grading the Banks’ Stress Test, By The Editors

(Left to right: Scott Olson/Getty Images, Mario Tama/Getty Images, Justin Sullivan/Getty Images) On Thursday, the government is set to announce the results of the financial stress tests for 19 large banks. Sources have already disclosed what most experts already knew: some of the biggest banks are still short of of money, though they may not be receiving more federal funds. The stress test was put in place to determine whether the banks can get through the recession and shore up confidence in the federal oversight of the nation’s banks. Has this process achieved these goals? Or, as critics claim, has the process failed to measure the depth of the banks’ problems? • Yves Smith, financial analyst • William K. Black, former banking regulator • Douglas Elliott, Brookings Institution • Simon Johnson, M.I.T. economist • Bert Ely, banking consultant • Alex J. Pollock, former chief, Federal Home Loan Bank of Chicago

An Insufficient Effort Yves Smith has written the blog Naked Capitalism since 2006. She has spent more than 25 years in the financial services industry and currently head of Aurora Advisors, a management consulting firm. The fact that the stress tests took place at all was an admission of regulatory failure. Financial firms are subject to oversight, most important, of safety and soundness, on an ongoing basis. The notion that a one-shot effort is a substitute for insufficient supervision is spurious. A crash effort to catch up was not a bad idea. But these stress tests fell far short of the needed level of review. Given that the minders were badly behind the curve thanks to years of believing that the industry could manage itself prudently, a crash effort to catch up was not a bad idea. But this should have taken place a year ago, when Bear Stearns exposed that no one really knew what was up at these firms. The fact that a bailout package was crafted based on a cursory emergency weekend review of complex trading exposures clearly demonstrated the dangers of ignorance.

305 But the stress tests fell far short of the needed level of review. First, they were administered by the industry based on scenarios provided by the industry. Most observers found the “adverse” case to be too optimistic. Even worse, banks got to use their own risk models, the same ones that got them into trouble. And there was no independent verification of the quality of the accounting. The number of examiners per bank was well short of what you’d need to probe a single business, much less an entire firm. Second, the industry got to negotiate the results. This is simply unheard of. That suggests both a lack of confidence in the process and a lack of belief on the part of the key actors (Treasury Secretary Timothy Geithner, in particular) that the government needs to set the parameters and demand compliance.

Not a Real Test at All

William K. Black, an associate professor of economics and law at the University of Missouri- Kansas City, is author of “The Best Way to Rob a Bank Is to Own One.” He served as a senior official for, among other government agencies, the Federal Home Loan Bank Board and the Office of Thrift Supervision. Leaks claim that the test found that Bank of America needs $33.9 billion in additional capital. The bank reportedly has the highest requirement of any of the banks that were tested. Treasury officials are leaking furiously that the results of the stress tests prove that no large bank is insolvent or even seriously undercapitalized. The stress tests, as predicted (and designed) have found that there is no banking crisis — all is well. Even Bank of America can “raise” the “additional” capital with the stroke of a pen by designating prior aid from the Treasury as “capital.” Treasury used a ‘one size fits all’ stress test that grossly understated derivatives risk — the primary risk that the largest banks face. The case of Bank of America illustrates the mysterious nature of the stress tests. Here’s what we’ve been told: the Federal Reserve sent roughly 180 examiners for about eight weeks into the 19 biggest banks. In that time period a team of that size would be able to examine the asset quality of two or three massive banks with plain vanilla assets. You cannot do a meaningful stress test without examining thoroughly each bank’s asset quality. Doing a meaningful stress test takes weeks after completing the asset examination. It is a particularly complex, individualized process when the assets are financial derivatives because evaluating counter-party risk is exceptionally difficult. We know that Treasury used a “one size fits all” stress test that grossly understated derivatives risk — the primary risk that the largest banks face. Bottom line: there were no real examinations. Banks continue to overstate asset quality. The bankers pressured Congress, which extorted the Financial Accounting Standards Board, which gutted the accounting rules on loss recognition. Because there were no real examinations, there were no real stress tests. So only one question is key: why does Treasury believe that anyone will believe its compound fiction?

How to Read the Results

306 Douglas Elliott, a former investment banker, is a fellow in the Initiative on Business and Public Policy at the Brookings Institution. Regulators have just put the country’s 19 largest banks through a comprehensive “stress test” to estimate their ability to withstand an economy worse than what has been predicted. We will learn two key things when the results are released on Thursday afternoon. First, how much more capital will the regulators require the banks to raise? Second, what does this tell us about how deep the banking crisis will be? If the need for capital exceeds $200 billion, the system is in trouble. There have been a number of leaks confirming my previous estimate that the total capital raised will be between $100 and $200 billion (see “Interpreting the Bank Stress Tests”). The banks are being given two numbers, the total capital they need and how much has to be in the form of common stock, the strongest form of capital. The big need will be coming up with more common stock –- most of this can be achieved by converting the government’s preferred shares into common shares. Taxpayers will effectively be going from lenders to partners. We’ll have more risk, but more potential return as well. A capital need in this expected range will not tell us much about how the regulators really feel. A larger number would require the government to commit taxpayers’ funds that might force an early return to Congress for more money, which both the administration and Congress desperately want to avoid. So if the number exceeds $200 billion, it will mean the regulators truly are worried about the system. If we get a number smaller than $100 billion, it will be a positive sign that things are better than they have looked, since there is political room to go above $100 billion.

Lessons Learned

Simon Johnson is a professor at the M.I.T. Sloan School of Management and co-founder of the global crisis Web site BaselineScenario. He is a senior fellow the Peterson Institute for International Economics and a regular contributor to the Times’s Economix blog. We’ve learned a great deal from the stress tests, but not perhaps what we hoped to learn. The tests, of course, were billed as assessing the capital adequacy of major banks, i.e., would banks have enough capital if the recession proves deeper and loan losses larger than the current consensus expectation? But the “stress” scenario used by the government turns out to be a mild and short-lived downturn, so the tests were effectively designed to allow everyone to pass. Actual official outcomes for each bank are the result of complicated closed door negotiations, and at the bank level all we have learned is who has more or less political power. The handling of the stress tests shows the administration prefers to adopt a “wait and see” policy toward banks. The big lesson is how the government will treat the financial system. Larry Summers has made it plain that the Obama administration will do what it takes to “support financial intermediation,” and sees this as a “critical node” to ensure an economic recovery. A Goldman Sachs report out this week (and the documents of this firm read increasingly like official policy statements) makes the point clearly — big banks will earn their way back to solvency through exercising their greater market power (Lehman and Bear Stearns are gone), government-subsidized debt (courtesy of the Federal Deposit Insurance Corporation), and various forms of implicit subsidy (through “legacy” loan removal programs).

307 The handling of the stress tests shows the administration prefers to adopt a “wait and see” policy toward banks. If the economy recovers, this will help the banks get back on their feet. If the economy doesn’t recover, more subsidies for banks will soon be in the mail.

A Far-Too-Public Test

Bert Ely is a banking consultant. The bank stress tests should never have been launched in such a public manner — they represent a serious public-policy blunder that hopefully will not be repeated. Government banking supervision has always had, or is supposed to have, a forward-looking element to it. Accordingly, banking supervisors are supposed to communicate to a bank the actions it must take to remain well capitalized in the face of current and anticipated economic conditions. Banks are then supposed to take those actions. All of this is done quietly so that market and public confidence in a bank is not rattled as a bank and its government overseers debate what actions a bank must take to remain in good financial condition. Within a month or two, we may hear cries for another stress test, which will continue to muddy the waters about the banks’ conditions. The stress tests have been harmful in two regards. First, the Treasury white paper describing the tests was so vague as to undermine the credibility of the tests. Consequently, the stress test results may lack credibility, too, especially if enough investors believe that they paint too rosy a picture of the financial condition of those banks seen as the most troubled. Second, many view the stress tests as a one-off review of the banks where as banking supervision, of necessity, is a continuous process for the simple reason that conditions within a bank and within the economy are constantly changing. Within a month or two, we may hear fresh cries for another stress test, which will continue to muddy the waters about the conditions of the nation’s largest banks. Investors and regulators instead should view bank stock prices — specifically the ratio of the market value of a bank’s common equity to the book value of that equity — as a far better and more timely measure of a bank’s financial condition and prospects.

A Nice Melodrama

Alex J. Pollock, a fellow at the American Enterprise Institute, spent 35 years in banking, including 12 years as chief executive of the Federal Home Loan Bank of Chicago. The stress tests have definitely achieved their principal purpose, which was, as I see it, to show that the Administration had a plan and was doing something: “Our plan is to have stress tests, and we are carrying them out.” A nice drama, or melodrama, ensued, with a problem, the build up of suspense, and a happy ending, as shown by the big rally in relevant bank stock prices as the results were leaked. Stress tests in general are a perfectly sensible, traditional financial idea: see how some entity fares in a given set of scenarios. Of course, much depends on all the estimates that go into such a test. It is ironic that the tranched subprime mortgage-backed securities that have caused so much trouble for everybody were all given credit ratings by stress tests. Booms are full of overoptimism, busts of overpessimism. It may be that the stress tests are part of a transition to a helpful, less pessimistic stage. http://roomfordebate.blogs.nytimes.com/2009/05/06/grading-the-banks-stress-test/

308 More Stress Test Leaks: Morgan Stanley, JPMorgan, AmEx all Pass by CalculatedRisk on 5/06/2009 02:32:00 PM From MarketWatch: Morgan Stanley doesn't need more capital: report

From WSJ: J.P. Morgan, American Express Won't Need New Capital [F]ederal banking regulators have informed Regions Financial Corp., a regional bank based in Birmingham, Ala., that it needs to raise new capital, according to a person familiar with the matter. A spokesman at Regions declined to comment Wednesday. The size of the cushion that regulators told bank executives they need to protect Regions from potential losses wasn't immediately clear. From Bloomberg: Bank of America, Citigroup, Wells Fargo, GMAC Need More Capital Here is a scorecard by asset size (let me know if you hear of any other leaks - we will know it all tomorrow!): Name Total Assets (Billions) Stress Test Results 1. Bank of America 2,500 Needs $34 billion 2. JPMorgan Chase 2,175 Pass 3. Citigroup 1,947 Needs $5 billion 4. Wells Fargo 1,310 Needs $15 billion 5. Goldman Sachs 885 Pass 6. Morgan Stanley 659 Pass 7. MetLife 502 Pass 8. PNC Financial Services 291 ??? 9. U.S. Bancorp 267 ??? 10. Bank of New York Mellon 238 Pass 11. GMAC 189 Needs $11.5 billion 12. SunTrust 189 ??? 13. State Street 177 ??? 14. Capital One Financial Corp. 166 ??? 15. BB&T 152 ??? 16. Regions Financial Corp. 146 Needs $$$ 17. American Express 126 Pass 18. Fifth Third Bancorp 120 Needs $3.3 billion (1) 19. KeyCorp 105 Needs $3.3 billion (1) (1) Citi estimate. (ht Turbo) http://www.calculatedriskblog.com/

309 Senate Passes Expanded FDIC Credit Line by CalculatedRisk on 5/06/2009 06:05:00 PM From Reuters: US Senate expands credit lines to FDIC reserves The U.S. Senate on Wednesday approved a measure to expand a government credit line for the Federal Deposit Insurance Corp ... The FDIC ... has been able to tap the Treasury Department for up to $30 billion since 1991. That credit line would be increased to $100 billion under the new bill.

The House of Representatives has already passed its version of the legislation ...

Besides raising the cap on FDIC borrowing, the bill gives the federal insurer a $500 billion credit limit that will sunset at the end of next year. Part of this is for the PPIP, see: Sorkin's ‘No-Risk’ Insurance at F.D.I.C. [The F.D.I.C. is] going to be insuring 85 percent of the debt, provided by the Treasury, that private investors will use to subsidize their acquisitions of toxic assets. The program ... is the equivalent of TARP 2.0. Only this time, Congress didn’t get a chance to vote. ... The F.D.I.C. is insuring the program, called the Public-Private Investment Program, by using a special provision in its charter that allows it to take extraordinary steps when an “emergency determination by secretary of the Treasury” is made to mitigate “systemic risk.” http://www.calculatedriskblog.com/

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07.05.2009 Czech Senate approves Lisbon Treaty

The Czech Senate yesterday voted decisively to adopt the Lisbon Treaty, with 54 Yes votes and 20 No Votes (out of 79 senators present), a comfortable majority. Frankfurter Allgemeine reports from Prague that the vote was preceded by an emotional speech from outgoing PM Mirek Topolanek, who called ratification the price the Czech Republic would have to pay for EU membership. A No Vote would leave the country in total isolation, and without any influence on future Treaties and policies. Furthermore it would split the EU and strengthen Russia’s influence on the CEE countries. President Vaclav Klaus said that he is no hurry to sign the Treaty, and he will want to wait until the Czech constitutional court gives its verdict on the Treaty. The FT writes that the vote leaves Vaclav Mr Klaus and Polish President Lech Kaczynski with effectively no chance to reject the Treaty. The last obstacle would therefore be the second Irish referendum to be held around October. An Irish Yes vote would clear the way for the treaty to come into force in January 2010. The FT article also made that the point that some Senators hope the Yes vote would “redeem” the country in the eyes of other member states. IMF to correct errors Ooops. The IMF double counted some data, which led to mistaken statistics in its most recent Global Financial Stability Report. The mistake concerns the 2009 external debt refinancing needs for several eastern European countries, expressed as a ratio to GDP, the FT reports. In the case of the Czech Republic that number was revised downwards from 236% to 89%, in the case of Estonia from 210% to 132%, and several others are likely to follow. The IMF apologised for the error, and promised to review its internal procedures. The article quotes analysts as saying that the situation for the CEE countries is not quite as glum as the report initially suggested. Too much stress – the news is all but leaked Calcuated Risk has a nice overview of today’s stress test result, or rather a table contained the leaked results. Bank of America needs $34bn, Citigroup $5bn, Wells Fargo $15bn, GMAC $11.5bn, and there are still some question marks left. East European currencies are sliding

311 The FT has a story that a return of risk aversion in financial markets - in anticipation of the release of the stress tests, and the ECB meeting – and that market sentiment is turning bearish once again on CEE currencies, including the Polish zloty, which yesterday dropped 1.4% against the dollar and 0.8% against the euro. Germany plans innovation package Instead of a third stimulus package Germany is now planning an innovation package in autumn, reports the FT Deutschland. The package shall include tax allowances for research in companies, better access of highly qualified foreigners and more public research expenditures. The federal state together with the Lander is to increase their research budget by €18bn for 2011 to 2018. Education minister Annette Schavan said that the EU target for research expenditures of 3% of GDP is a target for good times, but that Germany is now heading for more. Schavan is optimistic that the package could be adopted by June. Back in 2003, Bernanke wanted to cut rates to zero The Wall Street Journal looked at the 2003 transcripts of the FOMC meetings, and found a gem. Then-governor Ben Bernanke is quoted as saying that the board should make it known that it would be prepared, if necessary, to lower interest rates to zero, as this would have a beneficial effect on expectations. “It’s extremely important that we do what we can to maintain the supportive configuration in financial markets. That means continuing our easy monetary policy and, even more important, using our statement to signal our willingness to keep policy easy so long as there is a risk of further disinflation and continuing economic weakness.” It turns out that Greenspan was the conservative on the Fed’s open market committee after all. Tito Boeri and Pietro Garibaldi on Italy’s economic policy Writing in Lavoce, Tito Boeri and Pietro Garibaldi say that the government’s 2009 forecasts are out, showing generally more optimistic estimates for the economy than the recent IMF forecasts. They say the document is proof how the government’s inaction has aggravated the crisis. Public expenses are tilting once more in favour of expenditures for pensioners and public employees, while deficits and debts are deteriorating steadily. And the forecast is probably still too optimistic about revenue. Brad Setser on green shoots on trade Brad Setser is trying to make sense of the latest trade data for Korea, which show an increase in trade volumes in April from March, and wonders whether this might indicate a turnaround after the dramatic falls in Q4 and Q1. But he cautioned not to get ahead of oneself yet. Korea’s won has depreciated, so that Korea is increasing market share. US imports of Korean cars held up well, and Korea’s imports are still doing badly. As a result, global trade is probably not doing as well as Korea’s. He is also sceptical about the effects of China’s stimulus. It has yet to regist in either import or export data. FTD Indicator predicts turning point for the euro zone

312 The leading FTD Euroindicator from Euroframe is predicting a turning point for the eurozone in the second quarter, 2009, much earlier than other experts predict. For the second quarter the economy is still shrinking but with -2% compared to last year it is less than the dramatic contraction of -2.4% in the first quarter. The Purchasing Manager Index shows improving prospects for France and Italy, while Germany is lagging behind and Spain is to recover from very low levels. Another, not so good indicator Naked Capitalism has dug up a story from ChinaStakes, according to which power generation – seen as a good indicator of industrial activity in China – dropped again in April, down by 3% over the month. The report is generally sceptical about demand from China’s industry and agriculture as the recession spreads. Not many green shoots here. http://www.eurointelligence.com/article.581+M50914a380c4.0.html#

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'Ecomafia', 20.500 millones de beneficio Un informe ecologista presentado con el apoyo del presidente de Italia destapa el boyante negocio de las organizaciones criminales con el tráfico de residuos MIGUEL MORA | Roma 06/05/2009 En Nápoles se dice la monnezza è ricchezza (la inmundicia es riqueza). No importa que ahí fuera el mundo se hunda, la frase en el libro Gomorra sigue siendo cierta. En 2008, la ecomafia facturó con el tráfico ilegal de residuos 20.500 millones de euros. En Nápoles se dice la monnezza è ricchezza (la inmundicia es riqueza). No importa que ahí fuera el mundo se hunda, la frase en el libro Gomorra sigue siendo cierta. En 2008, la ecomafia facturó con el tráfico ilegal de residuos 20.500 millones de euros. Lo afirma el informe anual de Legambiente, asociación ecologista italiana, presentado ayer en Roma con el apoyo del presidente de la República. Se trata de la facturación más alta. Con toda esa escoria se podría levantar una montaña similar al Etna: una base de tres hectáreas y una altura de 3.100 metros. En 2008, se produjeron en Italia 25.776 delitos ecológicos, es decir, 71 diarios, tres cada hora. La buena noticia es que en 2007 se habían registrado más, 30.124. Así y todo, Legambiente calcula que se enterraron en suelo italiano 31 millones de toneladas de residuos, el equivalente a medio millón de camiones. "Se sabe dónde se producen, no siempre dónde se entierran", afirma el estudio. Casi la mitad de los delitos se localiza en las cuatro regiones de tradicional presencia mafiosa (Campania, Calabria, Sicilia y Puglia); el resto se reparte por el territorio. Y asoma con fuerza el rico norte del país, Piamonte sobre todo. "Las mafias han extendido sus tentáculos por vastas áreas del norte", señala el presidente de Legambiente, Vittorio Cogliati. Como síntoma, el arresto de Mario Chiesa, otrora protagonista de casos de corrupción, "que ahora se dedicaba al tráfico de residuos con toda una red de cuellos blancos: empresarios, intermediarios y funcionarios corruptos". El presidente Giorgio Napolitano se felicitó en una nota porque el informe demuestra que ha mejorado la lucha institucional. Desde 2002, cuando se instituyó el delito de tráfico ilícito de residuos, los jueces han abierto 123 procesos a los capos del veneno. El año pasado hubo 25 pesquisas, 2.328 personas denunciadas, y 564 empresas: movían 7.000 millones. Un récord histórico. Los ecologistas consideran que hay cientos de clanes mafiosos viviendo de la inmundicia. Según el fiscal nacional antimafia, Pietro Grasso, "faltan recursos y un observatorio nacional. Detrás de la ecomafia hay un sistema criminal complejo, con técnicos de laboratorio, transportistas y otros, y necesitamos más armas jurídicas". Grasso reclamó al Gobierno que garantice las escuchas telefónicas. La basura industrial que envenena el suelo mata animales, bosques y ciudadanos. El reciclaje acaba en la construcción de viviendas ilegales, actividad que la crisis tampoco ha logrado frenar. El año pasado brotaron en Italia 28.000 nuevas casas abusivas. Primer puesto, Campania; segundo, Calabria. Dos regiones en recesión. En la primera, los

314 clanes edificaron 300.000 metros cuadrados en un área (feraz y ex agrícola) de 158 kilómetros cuadrados. La Dirección Antimafia recuerda que, en Calabria, la N'Drangheta "sigue expandiéndose en el hábitat de las obras públicas", como las autopistas Salerno-Reggio Calabria y Jónica. Su sueño es el puente del estrecho de Messina. Más allá, la fiscalía de Palermo acaba de abrir otra investigación. Cosa Nostra se ha infiltrado en los contratos públicos para construir parques de energía eólica. Miguel Mora, “'Ecomafia', 20.500 millones de beneficio”, El País, 06/05/2009, disponible en: http://www.elpais.com/articulo/internacional/Ecomafia/20500/millones/beneficio/elpepiint/2009 0506elpepiint_5/Tes?print=1

315 May 6, 2009, 11:34 AM ET FOMC 2003 Transcripts: Bernanke Willing to Lower Rate to Zero –Brian Blackstone The 2003 FOMC transcripts showed then-Governor Ben Bernanke very tuned into financial markets as he pressed for earlier release of Fed forecasts and a willingness to lower interest rates to zero. From the June 2003 FOMC meeting, when the Fed lowered the target fed funds rate to 1%: “I wonder if you might give some thought to whether or not it would make sense tactically to say publicly that we are willing to lower the federal funds rate to zero if necessary…I think it would have a beneficial effect on expectations in that there would no longer be a feeling in the market that we had reached the end of our rope.” “It’s extremely important that we do what we can to maintain the supportive configuration in financial markets. That means continuing our easy monetary policy and, even more important, using our statement to signal our willingness to keep policy easy so long as there is a risk of further disinflation and continuing economic weakness.” Pressing for earlier release of FOMC economic forecasts in June 2003: “It occurs to me that the numbers that we see here would be quite useful to release to the public in two senses. One, this combination of unusually high growth and low inflation would make very clear on what we base our balanced risks for growth going forward combined with our downward risks to inflation. Second, I think it would support the financial market configuration that we’re looking for, which is a strong stock market and a strong bond market.” During the August 2003 meeting, Bernanke supported addition of a sentence to the policy statement that policy accommodation can be maintained for a “considerable period,” despite opposition from some other officials: “I would appeal to the Committee to retain the sentence because in my view it makes a very big difference. I think the addition of the sentence will go some way to bringing policy expectations in the market toward what I heard around the table during the entire meeting today. It will have a beneficial effect on the United States economy, which is the ultimate goal of this Committee.” Greenspan ended up putting it to a vote, and only seven of the 18 FOMC members present (voting and nonvoting) supported removing the sentence, so it stayed. After the vote Greenspan added: “And we will revisit this issue because this whole question is going to be a very important one.” At the August 2003 FOMC meeting, Bernanke appeared willing to lower the fed funds rate below 1%: “Despite the good news, I think it’s premature to conclude that we should not consider further rate cuts, if not at this meeting then at some time in the near future depending on how the data play out. My concern is focused on the behavior of inflation both in the short term and in the long term.” http://blogs.wsj.com/economics/2009/05/06/fomc-2003-transcripts-bernanke-willing-to- lower-rate-to-zero/

316 May 6, 2009 Assessing Stress Test Methodology And Results: Bank Of America Faces $35bn Capital Shortfall? Overview: Fed releases white paper on stress test methodology. "Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized" although the crisis has substantially reduced the capital buffer of some banks. All U.S. bank holding companies with year-end 2008 assets exceeding $100 billion were required to participate in the assessment, which began February 25. These institutions collectively hold two-thirds of the assets and more than half the loans in the U.S. banking system. Torres: Official says that supervisors concluded that banks’ lending practices need to be given as much weight as macroeconomic scenarios in determining the health of each bank and that the goal of the reviews is to keep the major financial institutions lending over the next two years.--> see Bank Lending Continues To Fall: Is There A Lack Of Credit Demand Or Supply? o WSJ May 6: Stress test results may show that BofA need to raise $35bn in new capital according to sources. o April 22 WSJ: In particular, under a more adverse scenario, which assumes a 10.3% unemployment rate at the end of 2010, banks would have to calculate two-year losses of up to 8.5% on their first-lien mortgage portfolios, 11% on home-equity lines of credit, 8% on commercial and industrial loans, 12% on commercial real- estate loans and 20% on credit-card portfolios, according to a confidential document the Federal Reserve gave banks in February that was viewed by The Wall Street Journal. Regulators are expected to have used other assumptions as well when measuring a bank's strength. o May 5 WSJ: The U.S. is expected to direct about 10 of the 19 banks undergoing government stress tests to boost their capital. The exact number of banks affected remains under discussion. It could include Wells Fargo & Co., Bank of America, Citigroup Inc. and several regional banks. o Elliott (Brookings): The likely result is that a handful of the 19 banks will need to issue common or preferred stock totaling $100-200 billion in the aggregate. o May 5 DealBook: S&P credit rating agency put 22 banks and one thrift on its CreditWatch list with negative implications, citing a “one-in-two likelihood” of a rating downgrade in the next 90 days. o Methodology: Regulators accounted for off-balance sheet units that banks will be re- intermediate in 2010 as a result of proposed accounting rules changes. Banks may bring on about $900 billion to their balance sheets (i.e. involuntary leverage) as a result of the change, and supervisors boosted the risk-weighted assets in their assessments by $700 billion, the Fed said. --> see FAS 140 Consolidation of $5 Trillion Variable Interest Entities (VIE) and QSPEs: Investment Banks' Stumbling Blocks?

317 o Ross Sorkin NYT: But what private investor is going to invest in any of the failing banks, knowing full well that the government may end up coming in later on and diluting the investor’s stake? o Guha (FT): US banks could be forced to hold more equity than initially expected after it emerged that "stress tests" organized by regulators take into account not only macro risks but also 'counterparty risk' on derivatives contracts, i.e.the risk that the party on the other end of the deal might default, depriving the bank of the payment that is due. o April 23 Weiss (M&M): OCC data show that as of Q4, the total credit exposure with derivatives as % of risk-based capital was: 179% for Bank of America, 278% for Citibank, 382% for JPMorganChase; 550% for HSBC (U.S.); 1056% for Goldman Sachs. "Moreover, since JPM holds half of all the derivatives in the U.S. banking industry, JPMorgan is ground zero in the debt crisis." o Industry analysts like Mike Mayo and GoldmanSachs report that unsecuritized legacy loans are currently marked at 92-98 cents on the dollar on banks' books. -->White paper p3: Importantly, stress test relies on recent FASB changes as the majority of assets at most of the participating bank holding companies are loans booked on accrual basis. "The results of this exercise are not comparable with those that would evaluate such assets on a mark-to-market basis." o April 23 Economist: The IMF has just had a stab at estimating the size of the new equity that is needed. This is based on writedowns of $550 billion over the next two years (on top of the $510 billion already booked), and incorporates existing capital and underlying earnings. It concludes that American banks need $275 billion to keep their tangible common equity above a floor of 4% of assets and $500bn for 6%. o cont.: The Treasury has only $110 billion left in its bail-out kitty. America’s ten biggest banks have $300-odd billion worth, about half of it from the state. Their capacity to absorb losses would rise if this was converted into common stock. This solution does have unpleasant side-effects. The government would end up with a 27% voting stake in the top-ten banks combined if all hybrid capital was converted at its book value. o Guha: Analysts have wildly different expectations as to the total amount of capital that the stress tests will identify as needed. Keefe, Bruyette and Woods, a brokerage firm, said yesterday its version suggests "$1,000bn (€760bn, £680bn) of capital would be needed industrywide". Others think much less capital will be required. o April 24 Financial Stability Oversight Board: "Going forward, the Oversight Board believes it will be important for the Treasury to continue to have the ability and flexibility to take effective actions under the TARP to stabilize financial markets." http://www.rgemonitor.com/

318 FAS 140 Consolidation of Variable Interest Entities (VIE) and QSPEs: 'Stress Test' Methodology Envisions $900bn Apr 30, 2009 Overview: FASB: Nov 12: The Financial Accounting Standards Board voted to enhance the disclosures related to interests in variable interest entities and off-balance sheet securitizations that all public companies are required to make for periods ending after Dec. 15, 2008. Some of the required info might however reside with third parties. (FinWeek) July 30: FASB postpones FAS 140 implementation until November 15, 2009. o April 30: According to authorities' Stress Test methodoloy, the 19 banks subject to the tests would re-intermediate $900bn of off-balance sheet assets onto their balance sheets with according capital requirements. o Ritholtz June 4: FASB has decided to “eliminate the concept of the Qualified Special Purpose Entity (QSPE)” in the revised financial-accounting standard, FAS 140--> Banks have been using QSPEs to effectively boost their leverage and hence their return on capital by creating off-balance sheet assets to be sold later on--> Up to $5 trillion (with t) of dollars worth of derivatives buried on banks' QSPEs o July 2: Wall Street lobbying hard to delay FAS140 revision due by 2009 that could "prolong credit crisis" o CreditSights (via Blbg): Variable Interest Entities (VIE) include ABCP Conduits, Structured Investment Vehicles (SIV), CDOs, structured finance transactions, investment funds. Mandatory unwinding and firesales loom as the net asset value [(assets-liabilities)/#shares] of these asset-backed instruments declines with rising delinquencies/defaults among borrowers. o CPA Journal: A VIE must be consolidated on balance sheet if/when originator provides financial support at some point (i.e. must have a variable interest), or owns a controlling interest, or is the primary beneficiary. Conduits have $784bn in commercial paper outstanding as of March 08. o Hendler (CreditSights): " The securities in the VIEs may be worth as little as 27 cents on the dollar once they're put back on balance sheets" o Fitch: q3 Illiquid Level 3 financial assets (SFAS 157) over equity (times): BS 1.56; GS 1.84; LEH 1.68; MER 0.70; MS 2.74 (latter with some differences in inputs) o Structured Investment Vehicle SIVs (=subgroup of VIE) volume shrinks to $300bn from $400bn in August 07 ---> American Securitization Forum panel: market for so- called structured investment vehicles (SIVs) is effectively dead and likely to stay that way.

319

May 6, 2009 Time For Basel III? EU Adopts Higher Capital Requirements And Charges For Structured Securities Overview: May 6 John Rega (Bloomberg): EU banks will get stricter oversight, higher capital requirements and curbs on financial engineering starting 2011. Banks will have to keep a 5 percent stake in loans or other assets they package into securities for sale to investors, and they can only buy securities from investment banks that do the same. Provisions include controls on liquidity risk to guard against banks having trouble gaining access to day-to-day funding, as happened to Northern Rock, and limits on a bank’s exposure to any individual risk, a feature of the IKB case. o FSF, Economist April 2: FSF has acted to close many of the loopholes banks had exploited: 1) Off-balance-sheet vehicles, models that allow capital ratios to be gamed by understating assets’ risks, over-reliance on wholesale funding and gung-ho compensation policies will all be verboten. 2) Simple ratios of equity to assets will be monitored, as well as the more fiddly risk-based approach of Basel 2. 3) Banks will be required to build up capital during the good times, although the exact mechanism and amounts of capital have yet to be decided. 4) Regulators will have to scrutinize the risk of the system overall and not just that of individual lenders. o cont.: That is the easy bit. The FSF sidesteps several trickier issues. One is mark-to- market accounting where it is ambivalent, for example endorsing the idea that banks be allowed to shift assets into loan books where they need not be written down immediately. Second, the FSF shies away from discussing enforcement. The old system failed partly because the rules were flawed, but also because regulators were captured. o John Plender: The latest Basel bank capital accords, which failed to avert the financial crisis, have been criticised for: - A poor focus on liquidity. - Internal risk rating that allowed banks a high degree of discretion. - Encouraging pro-cyclicality in the system. - Giving an excessive role to unregulated credit rating agencies. o Shin: Basel II rests on the principle that the purpose of regulation is to ensure the soundness of individual institutions against the risk of loss on their assets. However, the proposition is vulnerable to the fallacy of composition. It is possible, indeed often likely, that attempts by individual institutions to remain solvent can push the system to collapse. o cont.: Basel II offers incentive to load up on risk in good times but recoil aggressively in times of risk--> from a systemic perspective this kind of behavior is the main driver of boom-bust episodes such as the current one. o cont.: Unfortunately, the recoiling from risk by one institution generates greater materialised risk for others. Put differently, there are pervasive externalities in the financial system which extend also to the real economy. Solution for internalizing

320 costs of externalities such as leverage, asset growth, and the maturity mismatch between assets and liabilities: Pigouvian tax (see also CEPR Geneva Report) o Roubini/Pedersen (NYU Stern Faculty Report): Our proposal is to impose a new systemic capital requirement and systemic insurance programme. o cont.: We propose to define a bank’s systemic risk as the extent to which it is likely to contribute to a general financial crisis. This measure can be estimated using standard risk-management techniques already used inside banks – but not across banks, as we propose – to weigh how much each trading desk or division contributes to the overall risk of a bank. We set this out in an NYU Stern project on restoring financial stability. o cont.: We propose two ways to manage systemic risk. First, the regulator would assess each bank’s systemic risk. The higher it is, the more capital the bank should hold. This would seek to ensure that the banking system as a whole had sufficient capital relative to the system-wide risk. o cont.: Second, each institution would be required to buy insurance against its systemic risk – that is, against its own losses in a scenario in which the whole financial sector is doing poorly. In the event of a pay-off on the insurance, the payment should not go to the company, but to the regulator in charge of stabilising the financial sector. This would provide incentives for a bank to 1) limit systemic risk (to lower its insurance premium), 2) provide a market-based estimate of the risk (the cost of insurance), and 3) reduce the fiscal costs and the moral hazard of government bail-outs (because the company does not get the insurance pay-off). Since the private sector may not be able to put aside enough capital for all the systemic risk insurance, government could provide part of it. Government already provides such partnership on insurance with the private sector in insurance.

Updated: New York, May 06 12:04

EU Revamps Bank Capital, Asset-Backed Rules in Crisis (Update1) By John Rega May 6 (Bloomberg) -- banks will get stricter oversight, higher capital requirements and curbs on financial engineering in an overhaul approved today by lawmakers responding to the global credit crisis. The European Parliament in Strasbourg, France, voted 454- 106 to complete an agreement with the EU’s 27 countries and put the law into force in 2011. Banks will have to keep a 5 percent stake in loans or other assets they package into securities for sale to investors, putting restraints on structured finance deals blamed for encouraging lax lending. The initiative aims to restrain risk at banks after the collapse of a credit bubble touched off the deepest economic crisis since World War II and put EU governments on the hook for 2.8 trillion euros ($3.7 trillion) of capital and guarantees.

321 “People should be more careful, more transparent and have better control,” said Othmar Karas, the Austrian Christian Democrat who sponsored the bill, in a debate before the vote. The law is needed “so that we have a stable financial market in Europe, worthy of trust and faith.” The measure updates the EU’s law implementing global capital standards called Basel II for all the bloc’s banks. While changes were planned before the turmoil, the legislation was shaped by events such as the rescues of U.K. mortgage lender Northern Rock Plc and IKB Deutsche Industriebank AG of Germany. Liquidity Risk Provisions include controls on liquidity risk to guard against banks having trouble gaining access to day-to-day funding, as happened to Northern Rock, and limits on a bank’s exposure to any individual risk, a feature of the IKB case. “We’ve got to send a clear signal to the financial markets that business as usual is over,” said Elisa Ferreira, a Portuguese Socialist member who earlier sought stricter rules on asset-backed securities. “With a 4 percent economic contraction and 26 million unemployed, Europe should be doing more, better, faster for the financial markets.” The retention requirement on structured finance was devised by Charlie McCreevy, the commissioner for financial services, to address how the crisis spread from U.S. mortgage markets via bonds linked to subprime home loans. European banks won’t be able to buy such securities if the original lender or sponsoring investment bank -- wherever located -- doesn’t keep what McCreevy referred to as “skin in the game.” Gaining Currency The idea drew opposition from a majority of EU governments before gaining currency as the bankruptcy of Lehman Brothers Holdings Inc. deepened the crisis. International market regulators called for an expansion of the concept yesterday. “The retention rule has emerged as something that’s not nonsense, but plain common sense,” McCreevy said in the Parliament’s debate. The Parliament rejected an amendment to boost the ownership threshold to 10 percent. Lawmakers opted to stand by a bargain negotiated with national governments. The accord speeds the measure to enactment, with a mandate on the EU’s executive agency to review the ownership level. The retention rules “will in fact impede revival of securitization” needed to fund mortgages, car loans and consumer spending, John Purvis, a U.K. Conservative, said in his last speech before retiring from the Parliament. While backing the compromise, he said, “I fear much of this overhasty legislation will reveal unintended and unexpected consequences.” To contact the reporter on this story: John Rega in Brussels at [email protected]. Last Updated: May 6, 2009 09:30 EDT http://www.bloomberg.com/apps/news?pid=20601087&sid=a.ZM99aODYiM&refer=home

322 Regulating banks. Basel brush From The Economist print edition, Apr 2nd 2009 Regulators’ new blueprint for bank supervision avoids the trickiest bits IT HASN’T got to the stage of taxi drivers demanding a crackdown on tier-one capital, but in general terms the world agrees that banks need to be regulated until they weep. The detail is best left to the experts, and ahead of the G20 summit, they worked overtime, producing several big reports for the Financial Stability Forum (FSF), which brings together central banks, financial regulators and treasuries from the big Western economies. Investors’ confidence in the old rules, governed mainly by the Basel 2 regime, is at rock bottom and some fear that banks are still massaging their balance-sheets. One of London’s leading investors in financial firms complains of “window dressing and truth dodging” which, he thinks, “gives the lie to the complacent assumption that nothing like Japan in the 1990s could ever happen in the West.” That suggests tacit collusion by some regulators, possibly even those sitting on the FSF. Against this backdrop of scepticism, the FSF has acted to close many of the loopholes banks had exploited. Off-balance-sheet vehicles, models that allow capital ratios to be gamed by understating assets’ risks, over-reliance on wholesale funding and gung-ho compensation policies will all be verboten. Simple ratios of equity to assets will be monitored, as well as the more fiddly risk-based approach of Basel 2. Banks will be required to build up capital during the good times, although the exact mechanism and amounts of capital have yet to be decided. Regulators will have to scrutinise the risk of the system overall and not just that of individual lenders. That is the easy bit. The FSF sidesteps several trickier issues. One is mark-to-market accounting where it is ambivalent, for example endorsing the idea that banks be allowed to shift assets into loan books where they need not be written down immediately. That is unfortunate given that political pressure and intense lobbying by banks now seem likely to force American standard- setters to water down their rules. It may also be inconsistent with America’s toxic-asset plan, which needs loans and securities to be carried at market-clearing prices to work. If the thrust of the new capital rules is to create conservative standards and to reduce management discretion over them, it seems odd not to endorse the same principles for accounting. The FSF shies away from discussing enforcement. The old system failed partly because the rules were flawed, but also because regulators were captured: witness supervisors’ decision to allow the leveraged takeover of ABN AMRO, a Dutch lender; the widespread use of hybrid debt to inflate capital; and the permissive stance of the Securities and Exchange Commission towards American broker-dealers like Lehman Brothers. This time the rules need to be enforced, and that may require a big shake-up of the regulators themselves. Finally, consider the taxi driver. He may accept that the banks needed to be bailed out, but in the future wants to protect his high-street bank, which enjoys implicit taxpayer backing, from the risk-takers who should live and die by the sword. Yet the industry has moved in the opposite direction. Deposit-taking giants such as JPMorgan Chase and Bank of America have bought investment banks, and bailed-out lenders such as Royal Bank of Scotland, Citigroup and UBS plan on keeping much of their investment-banking units intact. The FSF has addressed the fine print, but the question of how to ensure taxpayers do not underwrite private risk-taking again remains unanswered. http://www.economist.com/finance/displaystory.cfm?story_id=13415215

323 miércoles 06/05/2009 8:00

RGE Monitor's Newsletter: The Impact of the Chrysler Bankruptcy

Greetings from RGE Monitor! On April 30, Chrysler filed for Chapter 11 Bankruptcy protection from its current creditors. As such, Chrysler will be able to operate as a going concern, while the company renegotiates its debt structure and other obligations. The U.S. government has described Chrysler’s action as a ‘prepackaged surgical bankruptcy’, in which it hopes that the company will be able to exit the bankruptcy process within 30-60 days. If Chrysler achieves this, then it will emerge with a new global partnership with the Italian based Fiat. Instead of cash, Fiat will provide the equivalent of billions of dollars in R&D related investments for a 35% stake in the new Chrysler. Ho wever, many experts think that a quick trip into bankruptcy might be unrealistic.

In the administration’s view, cost cuts, implemented by Cerberus and the new management brought in by Bob Nardelli, who cut into Chrysler’s R&D budget and new product development, left Chrysler, the smallest of the Detroit automakers, with a very thin line up of new vehicles. The Obama administration set partnering with Fiat as a precondition for any further government assistance. Nevertheless, Chrysler was unable to avoid the bankruptcy process, because some creditors balked at the terms being offered in the proposed debt to equity swap by the government. Fiat is vying to get a 35% stake in Chrysler, without paying anything for it. What it brings to the table is billions of dollars in R&D that have positioned it well to produce new cars in the future. Fiat exited the U.S. market decades ago. The marriage between Fiat and Chrysler is based on hars h realities, as evidenced by continuing layoffs in Chrysler’s bloated U.S. and Canadian operations, but it seems to be a symbiotic relationship, aimed to help both car makers survive the new realities of an even more competitive landscape. Moreover it is a reflection of the considerable overcapacities in the global auto sector which may require further consolidation both in several national and international markets.

The short term outcome of Chrysler’s bankruptcy filing may come to determine the path for General Motors, if not the entire U.S. auto industry. If bankruptcy proceedings for Chrysler go as the company and the U.S. government have planned, then Chrysler’s filing may very well turn out to be just a test case before the bankruptcy filing of GM itself. GM has until the end of May to convince the government that it has a viable business plan to restructure outside of an official bankruptcy filing for Chapter 11 reorganization. If it fails to renegotiate its debt and convince its current creditors to undergo a debt for equity swap, as Chrysler failed to do, then GM will have no option but to file for Chapter 11 protection. GM’s new CEO, Fritz Henderson has vowed to do whatever is reasonably necessary to prevent the automaker from going under including seeking loan packages from U.S., Canadian and European governments (especially Germany). However, GM can no longer

324 afford its extensive European operations and is in the process of looking for bidders. The significant role the auto sector plays in employment, exports and industrial production have heightened the political importance of responding to their vulnerabilities, which have been exacerbated by the credit crunch, prompting rescue packages including bridge loans, incentives to purchase domestic vehicles and increases in tariffs on imported cars and auto parts. In the face of rising unemployment in other sectors, governments hope to avoid any disorderly bankruptcy proceedings. Furthermore, the Chrysler-Fiat merger could set off a chain of consolidations within the auto sector which continues to have significant production overcapacities. Even emerging economies are likely to contribute slower auto demand growth in coming years. In Russia, automakers including Toyota have repeatedly shuttered production and domestic automakers are now increasing car loans in order to encourage purchases. Other countries like China also face the near-term challenge of consolidating its many automakers into several companies large enough to take advantage of economies of scale, increasing their share of the domestic market and possibly expand abroad. Fiat is also trying to position itself to obtain an ownership stake in GM’s European affiliate Opel. The plan, which includes the other GM subsidiaries in Europe - Vauxhall in Britain and Saab in Sweden, would create a new global auto company with annual sales of up to 7 million cars and €80 billion ($106 billion) in revenues, which would secure Fiat a winning position in the post-crisis market. The move however is likely to face political hurdles, as neither the German nor Italian governments would like to deal with the job losses (an estimated 8,000-9,000 jobs) likely from such a merger, particularly not in an electi on year (Germans vote this fall). According to press reports, Berlin issued a list of conditions for Fiat, which includes stating where the headquarters would be located, where the taxes would be paid, the number of expected job losses and the future of Opel plants in Germany. GM though has the final say in assessing Fiat’s offer. Yet, the German economic minister suggested that Fiat needs German state credits in lieu of adequate financing, which might increase the German government leverage. However, supporting the formation of a global car maker with the German government’s credit guarantees may enrage other German carmakers such as the VW Group, BMW and Mercedes-Benz. The pressure on domestic jobs has increased the political importance of responding to the automakers woes in many countries. In February, France raised protectionist fears after introducing state aid for the domestic car makers in return for an unwritten pledge to keep jobs and production at home. It posed a test for the EU’s single market rules and triggered an angry response from the Eastern European countries that would be hurt the most by the measure. Other countries like Argentina and Russia have increased restrictions on auto or parts imports in an attempt to support domestic industries. These might actually have the opposite effect; those in Russia hurt the business of used car sellers. However, some government attempts to st oke auto demand may well erode future demand. So-called ‘cash for clunkers’ deals in which governments provide incentives for consumers to trade in their old cars for new (and often more fuel efficient) ones, have had the desired effect, boosting auto sales in countries like Germany and China for the types of cars targeted. These measures are helping to erode the inventory of manufacturers in a relatively orderly manner, but may be deferring the adjustment process that the automakers face. Moreover, rising unemployment is likely to weigh on consumption especially of

325 large credit-dependent purchases like cars. The bankruptcy also has significant repercussions on the corporate bond market. Chrysler’s ba nkruptcy filing was preceded by tough negotiations among creditors and the government to conclude an out of court restructuring in which lenders would receive 29 cents on the dollar in cash in exchange for wiping out about $6.9 billion of Chrysler's debt. A group of about 20 secured creditors refused to sign off on the deal, arguing that their stake was worth more and demanding that their seniority rights be observed. However, recent empirical evidence shows that as default rates increase, recovery rates are falling fast in this cycle. Moody’s reported that in the past seven months, completed CDS auctions resulted in a recovery rate of 30 cents on the dollar for loans and about 15 cents on the dollar for bonds compared to 85 and 70 cents on the dollar, respectively, for all of 2008. The latest research by Edward Altman yields similar results stressing t hat distressed exchanges to avoid bankruptcy have surged since 2008 and that they usually yield significantly higher recovery rates to participating bondholders. In fact, S&P warns that due to loose covenants and missing early warning triggers, the losses even for secured creditors in this cycle might turn out to be substantial if a company cannot reorganize and liquidate.

Henry Hu from Texas University points to the ‘empty creditor’ phenomenon to explain why some lenders prefer to hold out and force a bankruptcy seemingly against the company’s and thus their own best interest. In short, creditors with enough credit default swaps may simultaneously have control rights and incentives to cause the debtor firm's value to fall. And if bankruptcy occurs, the empty creditor may undermine proper reorganization, especially if his interests (or non-interests) are not fully disclosed to the bankruptcy court. See: Distressed Debt Investors Dictate The Terms: How Big An Issue Are 'Empty Creditors' With CDS Hedges? Another example is the case of the Kazakh bank BTA. Gillian Tett reports that Morgan Stanley in mid-April called for repayment of a loan thus forcing the already troubled lender into partial default. The fact that just after calling the loan, Morgan Stanley demanded ISDA to initiate a CDS settlement of contracts written on BTA, exposing Morgan Stanley to the ‘empty creditor’ criticism even if many details are missing. Dynamics of this kind make defaults more likely and need to be taken into account when forecasting the severity of the current corporate default cycle.

But are credit markets finally thawing? Indeed, corporate bond issuance has picked up substantially since December especially in the high-yield segment amid tighter spreads since the immediate Lehman aftermath. On a more cautious note, the IMF notes that given shortening credit lines and still tight bank lending standards (confirmed in the April Bank Loan Officer Survey), corporations are taking advantage of this window of opportunity to refinance themselves in the bond market despite substantially higher costs. An additional factor fueling this frontloaded corporate bond activity is the likely future crowding-out by sovereign and government guaranteed debt. While the high-yield segment has returned 17.4% YTD in 2009, the fate of Chrysler and GM shows that the default rate may not yet have reached its peak.

326 Business

May 6, 2009 U.S. Says Bank of America Needs $33.9 Billion Cushion By LOUISE STORY and ERIC DASH The government has told Bank of America it needs $33.9 billion in capital to withstand any worsening of the economic downturn, according to an executive at the bank. If the bank is unable to raise the capital cushion by selling assets or stock, it would have to rely on the government, which has provided $45 billion in capital through the Troubled Asset Relief Program. It could satisfy regulators’ demands simply by converting non-voting preferred shares it gave the government in return for the capital, into common stock. But that would make the government one of the bank’s largest shareholders. Executives at the bank, one of the largest being examined, sparred with the government over the amount, which is higher than executives believed the bank needed. But J. Steele Alphin, the bank’s chief administrative officer, said Bank of America would have plenty of options to raise the capital on its own before it would have to convert any of the taxpayer money into common stock. “We’re not happy about it because it’s still a big number,” Mr. Alphin said. “We think it should be a bit less at the end of the day.” The government’s determination that Bank of America doesn’t need as much capital as it has already received from taxpayers is an indication that even some of the most troubled banks may not need more government money than has been allocated to them. The Treasury Department declined to comment on Tuesday evening. Citigroup, by contrast, has already decided to allow the government to convert some of its investment into common stock. Under the arrangement worked out between the Treasury and Citigroup earlier this year, the Treasury will receive mandatory convertible preferred shares, meaning preferred shares that can be converted to voting shares of common stock at the will of the government. If Bank of America relied on that conversion for the majority of the capital it needs to maintain, the government would become one of the bank’s largest shareholders. Regulators have told the banks that the common shares would bolster their “tangible common equity,” a measure of capital that places greater emphasis on the resources that a bank has at its disposal than the more traditional measure of “Tier 1” capital. Citigroup, the largest and most deeply troubled of the banks, is expected to need to raise capital as insurance against any further downturn in the economy.

327 The government told the bank it would need $50 billion to $55 billion in capital, a requirement that would force it to raise $5 billion to $10 billion in new capital, according to people briefed on the final results. Citigroup executives say the bank can easily cover any shortfall, and is considering several options to close that gap. The Obama administration plans to publicize the results of stress tests on Thursday. The results are expected to reveal that a number of them need additional capital, and many banks have negotiated with the government on what the actual capital requirements should be since they learned of the preliminary findings last week. The tests are also expected to show that several banks, including Bank of New York Mellon, Goldman Sachs and JPMorgan Chase, are healthy enough to repay TARP funds. Mr. Alphin noted that the $34 billion figure is well below the $45 billion in capital that the government has already allocated to the bank, although he said the bank has plenty of options to raise the capital on its own. “There are several ways to deal with this,” Mr. Alphin said. “The company is very healthy.” Bank executives estimate that the company will generate $30 billion a year in income, once a normal environment returns. The company has faced criticism over its acquisition of Merrill Lynch, the troubled investment bank, and last week, shareholders voted to strip the bank’s chief executive, Kenneth D. Lewis, of his title as chairman of the board. The board said last week that it still unanimously supports Mr. Lewis in his role as chief executive. Mr. Alphin said since the government figure is less than the $45 billion provided to Bank of America, the bank will now start looking at ways of repaying the $11 billion difference over time to the government. In the case of Citigroup, which has also received two taxpayer lifelines, executives say the bank can easily cover any shortfall, and is considering several options to close that gap. Among them are efforts to accelerate the sales of several businesses within Citi Holdings, a holding tank for assets it plans to shed, or to expand its common stock conversion plans to a broader base of private investors who hold Citigroup preferred stock. Both measures would avoid an increase in the government’s expected 36 percent ownership stake. Taxpayer-supported Banks have been eager to wean themselves from the government’s purview, and many analysts have questioned how useful the stress tests will be in assessing their true health. Also Tuesday, senior government officials said the Treasury Department is planning to require taxpayer-supported banks seeking to free themselves from the government’s grip to show that they can repay the lifelines without additional subsidies that have helped them survive the financial crisis. Banks have had an indirect subsidy adopted by the government last fall that allows them to issue debt cheaply with the backing of the Federal Deposit Insurance Corporation.

328 The Treasury is expected to announce as early as Wednesday that healthier banks must show that they can issue debt without the guarantees before they are allowed to exit the Troubled Asset Relief Program, or TARP. The banks also must demonstrate that they will be able to sell stock to private investors and pass a government stress test to show that they are healthy enough to survive without the taxpayer aid. Edmund L. Andrews contributed reporting. Louise Story y Eric Dash, “U.S. Says Bank of America Needs $33.9 Billion Cushion” http://www.nytimes.com/2009/05/06/business/06stress.html?th&emc=th

Bank of America Mulls Sale of Stake in China’s Second-Largest Bank Published: May 6, 2009 Filed at 2:05 a.m. ET

HONG KONG, May 6 (Reuters) - Bank of America (NYSE:BAC) could soon sell shares in China's second-largest bank that could raise about a quarter of the $34 billion in additional capital it is reported to need after a government stress test. Bank of America is allowed to sell 13.5 billion shares in China Construction Bank (OOTC:CICHY) (OOTC:CICHF) -- a 6 percent stake worth around $8.3 billion -- when a lock-up period ends on Thursday. That would draw down BofA's stake in the Chinese lender to 10.6 percent, a level CCB has already said is reasonable. Western banks are aware that selling out of Chinese banks is not always well received by Beijing politicians. CCB shares dipped 1.5 percent in Hong Kong on Wednesday. Three Hong Kong-based investment bankers who spoke to Reuters said it is not yet clear how much, if any, of its CCB shares BofA will sell when the lock-up ends. The bankers were not authorised to speak publicly about the matter. "Bank of America intends to remain a long-term shareholder and strategic partner in China Construction Bank," said BofA spokesman Scott Silvestri. Raising money by selling the CCB stake would help BofA boost its capital at a critical time for the bank, which has been deemed to need an additional $34 billion in capital after stress tests in the United States, a source familiar with the results told Reuters. "There has been healthy short selling in CCB shares in recent days so the market is factoring in a very high chance that BOA will sell part of its shares this week," said Philip Chan, head of research at CAF Securities, the research arm of Agricultural Bank of China. (OOTC:BACHY) "With the stress test results also due on May 7 and the market expecting BofA to raise capital there will be pressure on the management to divest some non-core assets," he said. BofA is eligible to receive a $165 million CCB dividend if it waits until after June 23, according to CCB's last earnings release. In June 2005, BofA agreed to pay $3 billion for a 9 percent stake in CCB -- a shareholding that later grew to 16.6 percent. The deal, like other Western banks buying

329 into Chinese lenders, was meant to be a long-term, cross-border partnership. But the financial crisis has led several Western banks to sell their stakes in Chinese banks to raise much-needed cash. Shares in CCB have risen more than 12 percent so far this year, in line with rival ICBC, but underperforming a 39 percent jump at Bank of China. Industrial and Commercial Bank of China (OOTC:IDCBY) (OOTC:IDCBF) is the largest bank in the world by market value, while CCB is second. "BAC (Bank of America) could increase capital through sales of businesses such as FirstRepublic and Columbia and investments such as CCB," analysts at JP Morgan wrote earlier this week. Shares in ICBC dropped 5.9 percent on April 27, a day before a portion of the strategic foreign holding in the bank was freed for sale. The stock bounced right back after and American Express (NYSE:AXP) sold a part of their stake. http://www.nytimes.com/reuters/2009/05/06/business/business-bankofamerica- ccb.html?ref=business

May 6, 2009 BACK TO BUSINESS As Investors Circle Ailing Banks, Fed Sets Limits By ERIC LIPTON CAINSVILLE, Mo. — No one seems to want to own a business in this dusty, windswept corner of rural America, population 370, with its crumbling sidewalks and boarded-up storefronts. Except, that is, for J. Christopher Flowers, a media-shy New York billionaire who last year bought the First National Bank of Cainesville, one of the United States’ smallest national banks. Mr. Flowers, a private equity manager, has no particular love for rural Missouri; in fact, he has never set foot in Cainsville. Rather, he wants to use the national bank charter he picked up in this farm town to go on a nationwide buying spree. With that charter in hand, Mr. Flowers plans to take over a handful of large struggling banks, casualties of the economic crisis. In some cases, he hopes, the federal government will help. But Mr. Flowers, whose investments in banks overseas have made him one of the richest men in America, has run into a major obstacle in the United States: the Federal Reserve, and its very notion of what a bank should be. The Fed does not mind if private equity firms have a minority interest in banks — the Obama administration even wants them to invest. But the Fed will not let them take control, a stance the firms are lobbying regulators mightily to change, especially given that stress test results to be released Thursday are expected to show a glaring need for capital in the banking system.

330 It’s not personal, Fed officials say. It’s just that as the nation recovers from one of the worst banking crises in history, the Federal Reserve wants to make sure that it does not set the stage for the next financial implosion by turning banks over to private equity firms, some of the riskiest players in the business world. So while Mr. Flowers was able to buy the bank here with his own money, he cannot tap into the billions his firm, J. C. Flowers & Company, has raised.

How this battle — and others being fought in the aftermath of the economic crisis — plays out will help determine the future shape of the financial industry. For all the talk of the banking crisis, Mr. Flowers and other giant private equity players are circling distressed banks around the country, competing to buy into the industry. Bidding wars are now breaking out among private equity firms, including the Carlyle Group, which is going up against Mr. Flowers’s firm for a stake in BankUnited of Florida. They and other investors see banks as the recession’s biggest prize: potential money machines that could one day generate fabulous returns, particularly after the federal government eats the losses of failed banks, then heavily subsidizes their sale. But like Mr. Flowers, some of them would prefer to take over the banks completely, replace their managements and take all the profit. “I don’t think the Republic is going to be brought to its knees if private equity owns banks, personally,” Mr. Flowers said from his Midtown Manhattan office with its expansive views of Central Park. “We invest around the world — Japan, Germany, England, no problem.”

The Fed is resisting this pitch, for several reasons. Current law prohibits mixing banking and commerce, based on a fear that if industrialists own banks, they will dominate — and try to manipulate — the economy, as they did during the early-20th-century heyday of John Pierpont Morgan. The government also wants the ability to stabilize a teetering bank by drawing on the funds of its parent company. That is hard to do with private equity firms, which have numerous businesses owned by funds, each of which is walled off to protect investors. For these reasons, banks generally cannot be owned by nonfinancial companies like the Carlyle Group, whose assets are as varied as an interest in Dunkin’ Donuts and United Defense Industries, a maker of combat vehicles and missile launchers.

331 The equity firms counter that banking desperately needs cash if the economy is going to recover, and that they are the only big sources of money around. An executive at the Carlyle Group said the industry had an estimated $400 billion in “dry powder,” or ready-to-invest reserves. To push their case at the White House, the Treasury and the Fed, Mr. Flowers and others in his industry have enlisted an all-star cast of advisers, lobbyists and lawyers. They include H. Rodgin Cohen, chairman of the Sullivan & Cromwell law firm and Wall Street éminence grise, and Randal K. Quarles, a managing director of the Carlyle Group and a Treasury under secretary in the administration of President George W. Bush. Part of their strategy, Mr. Flowers said, is to persuade the Treasury secretary, Timothy F. Geithner, to pressure the Fed to back down. “Chris is obviously a get-it-done type of person — and he wants to get this done,” said Mr. Cohen, who represents Mr. Flowers. “He believes, as I do, that it is unfortunate to deprive the banking system in the United States of this key source of capital.” While they press their case, the firms have found some ways around the rules. They have formed so-called club deals, in which teams of private equity firms and other investors each buy up to the legal limit of a bank — about a quarter or a third, depending on the type of bank — with their individual pieces adding up to 100 percent control. IndyMac, the failed California bank, was sold by the Federal Deposit Insurance Corporation last fall to one such club, which includes funds controlled by Mr. Flowers; the hedge fund billionaires George Soros and John Paulson; and Michael S. Dell, founder of the Dell computer company. The investors are barred from acting in concert to, in effect, take control of the bank — an unwieldy arrangement but one that regulators insist they can enforce. As part of the IndyMac deal, the F.D.I.C. agreed to take most of the risk from future losses on loans acquired by the partnership — leading Mr. Flowers to quip at one investor forum in New York in January that “the government has all the downside and we have all the upside.” Mr. Flowers has come up with another way around the restrictions. There is no limit on an individual’s taking over a bank, so he purchased all of the First National Bank of Cainesville in his own name and with his own funds. But that deprives him of the billions his equity firm has set aside to buy banks, so his new bank sits in this tiny town, waiting for a change in the rules. First National — whose second story is boarded up and whose $17 million in assets are worth about a third of what Mr. Flowers paid for an Upper East Side town house in 2006 — seems an unlikely launching pad for a new American banking empire. It is so tradition-minded that it refused to change the spelling of its name, even after the town did so back in 1925 to honor its founder, Peter Cain. Suddenly, in February, the First National Bank name was dropped and “Flowers Bank” was painted on the window. New bank executives showed up, passing out packs of promotional sunflower seeds with the bank’s new logo, urging the mostly elderly town residents to get ready to “Grow with Us.” “Everyone wonders, who is this Flowers guy?” said Lefty McLain, as he finished up the ham, mashed potatoes and butter beans lunch special at the Little Store, an all-in-one restaurant, deli, pool hall and gossip post here in the one-block downtown.

332 Mr. Flowers, while still in his 20s, founded Goldman Sachs’s financial services merger business, helping line up the $62 billion merger of NationsBank and BankAmerica (now Bank of America) and the $34 billion takeover of Wells Fargo by Norwest. By 1998, he had left Goldman to start his own business, focusing at first overseas, with the 2000 purchase from the Japanese government of the failed Long-Term Credit Bank of Japan, which was renamed Shinsei Bank, its name meaning “new life.” Mr. Flowers, now 51, made a sizable chunk of his fortune when he and his partners took the bank public four years later. But the deal left some in Japan steaming, as they wondered how an American businessman could make such an enormous profit when the government was never repaid most of the trillions of yen it had spent bailing out the failed bank. The bank is now in trouble again, from investments in subprime mortgages that went sour and exposure to Lehman Brothers, which went bankrupt. His holding in Hypo Real Estate in Germany is also suffering because of bad real estate investments, even after Mr. Flowers and Shinsei poured money into it. German regulators are threatening to take over Hypo and force Mr. Flowers out. These kinds of high-risk investments make United States banking officials nervous, though Mr. Flowers points out, accurately, that many Japanese banks are struggling, not just Shinsei. The private equity firms are pitching to regulators a way to let them take control of banks while respecting banking traditions. Essentially, they would separate the entities — they call them silos — that buy the banks, walling off their other private equity investments from any newly created bank holding company. Fed officials will not speak about banks for the record, but they have told the firms that they view the silo concept as little more than a subterfuge. Mr. Flowers and other executives have lobbied hard; their efforts have included a recent meeting with William C. Dudley, chairman of the New York Fed. At the meeting, Mr. Flowers and his colleagues bragged about how they could raise as much as $10 billion in 48 hours to help with a bank takeover if they were given the chance, according to one executive in attendance. Mr. Flowers, in an interview, said he was confident he would prevail. Even if he cannot make the Fed reverse its policy, he will consider it a victory if the Fed approves an individual deal. He has estimated his banking empire will one day earn at least a 35 percent return on banks it has bought in the United States. “I find it to be an extraordinary time to invest,” he said. He was even more blunt when he spoke to an industry group in New York earlier this year. “Lowlife grave dancers like me will make a fortune,” he predicted. http://www.nytimes.com/2009/05/06/business/06equity.html?th=&emc=th&pagewanted =print

333 Wednesday, May 6, 2009

Bank Tests Yield Early Progress Firms Race to Shore Up Books By Binyamin Appelbaum, Washington Post Staff Writer The Obama administration's plan to "stress-test" 19 large banks is yielding benefits even before the findings are released tomorrow. The announcement of the tests in February roiled the markets initially. But the 12-week wait for results has since provided a respite, allowing investors to breathe deeply and giving time for a raft of federal rescue programs to start showing results. The banks, eager to demonstrate that they don't need more federal aid, have spent the time racing to get stronger. The healthiest banks, such as Goldman Sachs and J.P. Morgan Chase, have tried to show that they can walk without government crutches, for example by issuing debt without federal assistance. Weaker banks such as Citigroup have agreed to sell valuable business units and moved with greater urgency to offload troubled assets. The main purpose of the stress tests remains largely unfulfilled. Federal officials want banks to raise more capital, from the government if necessary, so that they will have the financial strength to increase lending and help lift the economy from recession. The success of that process, which begins tomorrow and could take six months, ultimately will depend in large part on whether investors believe the government's assertion that many banks are healthy and deserving candidates for new investment. Otherwise, investors might not provide the needed capital. But in persuading investors to wait patiently for the results, the Obama administration has already succeeded in achieving a goal that largely eluded its predecessor. "The administration gets full credit for designing and communicating that there would be a new mechanism to determine needs across the system. This was a sophisticated way to establish a timetable that was readily understandable to the market," said David Nason, a Treasury aide in the Bush administration who now works for Promontory Financial. The seeds of the stress test were planted in the fall, after Henry M. Paulson Jr., then Treasury secretary, forced nine of the largest banks to accept investments totaling $125 billion. This first round of money was intended to stabilize the financial system, but Treasury officials recognized that some of those banks would need more money. The idea of conducting a special examination to determine the needs of each bank emerged as a logical approach, participants recalled. The deteriorating condition of Citigroup, however, forced the government to act before a plan was complete. A second ad hoc rescue soon followed, for Bank of America, further frustrating senior officials such as Sheila C. Bair, chairman of the Federal Deposit Insurance Corp., who pushed for the development of a standardized approach. The major innovation introduced in February by Treasury Secretary Timothy F. Geithner was the emphasis on measuring all of the major banks against common standards, leveling out differences in the way firms projected losses. At the time, the Treasury did not plan to disclose the results to the public, adhering to the long-standing practice of banking regulators that such information is kept secret to preserve confidence

334 in banks and keep information from rivals. But senior officials said it became clear that investors would dismiss the stress tests unless the government provided data to back its assertions about which banks were healthy and which needed additional capital. The government now plans to release about 150 pages of detailed findings tomorrow, an unprecedented portrait of the nation's largest banks. Many financial analysts regard this transparency as one of the virtues of the stress tests because it allows investors to differentiate among banks, encouraging renewed investment in the strongest firms. The government has tried to manage public expectations about the tests by arguing that the banks will be fine while acknowledging that they have big problems. Financial analysts said the government's efforts have calmed the markets. Bank of America's share price has climbed by 129 percent since the tests were launched. Wells Fargo is up 78 percent, even though both companies are likely to be ordered by the government to raise additional capital. Even Citigroup, the most troubled of the large banks, has risen 27 percent. "I think the stress test itself really spooked the system, and I think the government did a lot of damage control over the stress tests to kind of tell people that it's going to be okay," said Paul Miller, a financial analyst with FBR Capital Markets. Miller said recent events have helped the government's case, as the largest banks posted strong first- quarter earnings goosed by a combination of diminished competition on Wall Street and the flow of cheap loans from the Federal Reserve. Still, Miller cautioned that the stress-test process may not be enough to repair problems at the weakest firms. Senior administration officials said all 19 tested banks probably could survive the downturn without more capital by cutting back on lending and hoarding their resources. By forcing the banks to accept more capital, the government hopes to convince them that they are safe in increasing lending. The point of the stress tests is not to rescue banks from failure, they said. It is to rescue the economy. The government hopes the new capital will come mostly from private investors. But many banks are likely to receive additional support from the government. The Treasury has allowed banks to exchange common shares for the government's preferred shares, eliminating required dividend payments. Banks that do not require additional capital are likely to push for permission to repay the government's existing investments. The government has allowed 11 smaller banks to repay the money, but it has not yet allowed any larger banks to do so. Some government officials said banks should not be allowed to repay the Treasury while continuing to tap other sources of aid, such as a Federal Deposit Insurance Corp. program that allows banks to issue debt at lower interest rates by guaranteeing repayment. A senior government official said Monday that companies would be allowed to repay federal investments only once they demonstrate an ability to issue debt outside the shelter of the FDIC's program. The government plans to impose other conditions on repayment, as well, the official said. The Treasury may announce the details as early as today. J.P. Morgan, Goldman Sachs and BB&T have successfully issued debt in recent weeks without a government guarantee. http://www.washingtonpost.com/wp- dyn/content/article/2009/05/05/AR2009050503229_pf.html

335 Tuesday, May 5, 2009

Obama Targets Overseas Tax Dodge Plan Would Crack Down On Individuals, Firms With Money Abroad By Lori Montgomery and Scott Wilson, Washington Post Staff Writers President Obama yesterday announced a major offensive against businesses and wealthy individuals who avoid U.S. taxes by parking cash overseas, a battle he said would be fought with new tax laws, new reporting requirements and an army of 800 new IRS agents. During an event at the White House, Obama said his proposal would raise $210 billion over the next decade and make good on his campaign pledge to eliminate tax advantages for companies that ship jobs abroad. "I want to see our companies remain the most competitive in the world. But the way to make sure that happens is not to reward our companies for moving jobs off our shores or transferring profits to overseas tax havens," Obama said, flanked by Treasury Secretary Timothy F. Geithner and Internal Revenue Service Commissioner Douglas Shulman. The nation's largest business groups immediately assailed the proposal, arguing that it would subject them to far higher taxes than their foreign competitors must pay and ultimately endanger U.S. jobs. Key Democrats were cool to the plan, and said Obama's ideas should be considered as part of a broader effort to streamline the nation's complex corporate tax code. "Further study is needed to assess the impact of this plan on U.S. businesses," Sen. Max Baucus (D-Mont.), chairman of the Senate Finance Committee, which has jurisdiction over U.S. tax law, said in a written statement. "I want to make certain that our tax policies are fair and support the global competitiveness of U.S. businesses." Yesterday's announcement offered the first details of a tax plan that was sketched out in the $3.4 trillion budget request that Obama sent to lawmakers earlier this year and that Congress approved last week. If the measures do not survive congressional scrutiny, the lost revenue would increase already-elevated deficit projections, unless lawmakers find money elsewhere. Obama said his plan could serve as "a down payment on the larger tax reform we need to make our tax system simpler and fairer." The proposal takes aim at what corporate executives consider to be one of the most critical features of the U.S. tax code: permission to indefinitely defer paying U.S. taxes on income earned overseas. Currently, U.S. companies can avoid paying taxes on foreign profits until they bring the money back home. So a U.S. company doing business in Ireland, for example, must pay the Irish tax of 12.5 percent, like every other company doing business in Ireland. But the U.S. firm would owe an additional 22.5 percent to the U.S. Treasury (the difference between Ireland's tax rate and the 35 percent U.S. tax rate) unless it reinvests the money overseas. The United States is the last major economic power to tax the profits of locally headquartered companies if that income is earned abroad. Other nations, including most recently Japan and Britain, are moving to a territorial system that taxes only corporate profits earned within their borders.

336 Instead of following that trend, Obama proposes to move in the opposite direction. He argues that the current system gives tax breaks to U.S. multinationals at the expense of companies that operate solely on American soil. In 2004, the most recent year for which statistics are available, U.S. multinationals paid an effective U.S. tax rate of just 2.3 percent on $700 billion in foreign profits, according to the administration. "It's a tax code that says you should pay lower taxes if you create a job in Bangalore, India, than if you create one in Buffalo, New York," the president said yesterday. To level the playing field, Obama would bar firms from taking deductions for expenses that support their overseas investments until they pay U.S. taxes on the profits. He would also crack down on firms that overstate their foreign tax bills. And he would reverse a Clinton-era rule known as "check the box," which permits firms to more easily transfer cash between countries. In practice, Obama officials said, "check the box" has been used to shift income away from higher-tax countries and into tax havens such as Bermuda and the Cayman Islands, allowing firms to reduce their tax bills both at home and abroad. Those provisions would take effect in 2011 and would raise about $190 billion by the end of the next decade. In return, Obama proposes to make permanent an existing tax credit for companies that spend money on domestic research and development programs, worth about $75 billion over the next decade. Obama also proposes to crack down on wealthy people who evade taxes through offshore bank accounts, primarily by targeting financial institutions in tax-haven . That plan, which would net another $9 billion over the next decade, appears to have few opponents. By contrast, more than 200 U.S. companies and trade groups have signed a letter asking congressional leaders to oppose Obama's proposal to limit their ability to defer U.S. tax payments. The letter, signed by Alcoa, General Electric, McDonald's and Microsoft, among others, warned that restricting the deferral rules would make it difficult to compete abroad. The U.S. Chamber of Commerce also denounced Obama's plan. And John Castellani, president of the Business Roundtable, a coalition of the nation's largest firms, called it "the wrong proposal at the wrong time for the wrong reasons" that will "make us less competitive in the international marketplace, where, by last count, 95 percent of the world lives." Rosanne Altshuler, co-director of the Tax Policy Center, a joint project of the Urban Institute and the Brookings Institution, said some of Obama's proposals have merit. But "the big question mark is whether limiting deferral will lead to more jobs in the U.S., and it's not clear to me that this is what will happen." Instead, Altshuler said, the result may be to create a tax advantage for U.S. firms to be acquired by foreign owners, an "unintended consequence" that "would probably be bad." "There's a big difference between abusive and legitimate tax policy that recognizes the global economy," said Sen. Charles E. Grassley (Iowa), the senior Republican on the Senate Finance Committee. "To the extent the president continues on the road of cracking down on tax abuse, he can count on my support. But if he's using tax shelters as a stalking horse to raise taxes on corporations at the cost of U.S. jobs, he'll lose me." http://www.washingtonpost.com/wp- dyn/content/article/2009/05/04/AR2009050400703.html?wpisrc=newsletter

337 Business

May 5, 2009 Obama Calls for New Curbs on Offshore Tax Havens By JACKIE CALMES and EDMUND L. ANDREWS WASHINGTON — President Obama on Monday called for curbing offshore tax havens and corporate tax breaks to collect billions of dollars more from multinational companies and wealthy individuals. The move would appeal to growing populist anger among taxpayers but is likely to open an epic battle with some major powers in American commerce.With the proposals he outlined at the White House, the president sought to make good on his campaign promise to end tax breaks “for companies that ship jobs overseas.” He estimated the changes would raise $210 billion over the next decade and help offset tax cuts for middle-income taxpayers as well as a permanent tax credit for companies’ research and development costs. The changes, if enacted, would take effect in 2011, when administration officials presume the economy will have recovered from the recession. But business groups were quick to condemn the White House for proposing tax increases amid a global downturn. “This plan will reduce the ability of U.S. companies to compete in foreign markets, which will not only reduce jobs, but will also cripple economic growth here in the United States. It couldn’t come at a worse time,” said John J. Castellani, president of the Business Roundtable, a trade association of major businesses. The proposals would especially hit pharmaceutical, technology, financial and consumer goods companies — among them Goldman Sachs, Microsoft, Pfizer and Procter & Gamble — that have major overseas operations or subsidiaries in tax havens like the Cayman Islands. They have some of the mightiest lobbying armies in Washington, as well as influential patrons in Congress. That combination will test Mr. Obama’s ability to stand up to powerful interests and marshal support among lawmakers at the same time that he is trying to win passage of major health and energy measures. At issue are tax laws that were originally intended to prevent multinational corporations from being double-taxed, by the United States and by foreign countries, by allowing companies to defer reporting their foreign income to the Internal Revenue Service and to get tax credits in the United States for foreign taxes paid. Economists are divided over whether higher taxes would give corporations incentives to move jobs overseas or impair economic growth at home. In the coming debate, both Mr. Obama and the business lobby will claim that their way will save jobs. The top corporate tax rate is 35 percent, but the Treasury Department estimated that in 2004, the most recent year for which data is available, American multinationals paid $16 billion in taxes on $700 billion in foreign income — an effective rate of 2.3 percent.

338 339 Mr. Obama’s tax-raising initiative comes amid government bailouts for major financial institutions, auto companies and insurance giants, and polls show growing opposition. In February, a Senate proposal to give multinational companies a big tax cut if they brought profits back to the United States was defeated by a surprisingly large margin. The president, in his remarks, reflected the public’s restlessness in some of his most populist language to date. Mr. Obama said most Americans paid taxes as “an obligation of citizenship,” but some businesses and rich people were “shirking” their duties, “aided and abetted by a broken tax system, written by well-connected lobbyists on behalf of well-heeled interests and individuals.” “It’s a tax code full of corporate loopholes that makes it perfectly legal for companies to avoid paying their fair share. It’s a tax code that makes it all too easy for a number — a small number of individuals and companies to abuse overseas tax havens to avoid paying any taxes at all,” the president said. “And it’s a tax code that says you should pay lower taxes if you create a job in Bangalore, India, than if you create one in Buffalo, New York.” The Democratic chairmen of the House and Senate tax-writing committees, Representative Charles B. Rangel of New York and Senator Max Baucus of Montana, said in statements that some of Mr. Obama’s proposals reflect ideas from their panels. But Mr. Baucus kept his distance, saying “further study is needed to assess the impact of this plan on U.S. business.” Congressional Republicans were relatively quiet. Senator Charles E. Grassley of Iowa, the senior Republican on the Senate Finance Committee and a frequent critic of tax schemes, said the president could “count on my support” to crack down on abuses. “But if he’s using tax shelters as a stalking horse to raise taxes on corporations at the cost of U.S. jobs, he’ll lose me.” Business groups had feared Mr. Obama would seek repeal of the tax-deferral law but he stopped short of that. Instead, he would prohibit companies from taking deductions in the United States for expenses on overseas investments until they have paid domestic taxes on the profits from those investments. Treasury estimated the proposal would raise $60.1 billion from 2011 through 2019. General Electric has deferred American taxes on $75 billion in foreign profits by keeping them outside the United States, according to its annual report for 2008, and said it has no plan to ever repatriate that money. Citigroup has deferred taxes on $22.8 billion in foreign income. The administration would raise $86.5 billion by ending a practice in which companies create foreign subsidiaries to shift income in ways that avoid taxes. The Government Accountability Office has found that 83 of the 100 largest American companies have subsidiaries in tax havens; it counted 83 subsidiaries for Procter & Gamble alone. Financial services companies had even more, with Citigroup showing 427 and Morgan Stanley, 273. Another proposal would close a loophole that allows companies to inflate the credits they claim for foreign taxes to the I.R.S., for an estimated $43 billion in new revenues. Separate steps to crack down on wealthy individuals would raise nearly $9 billion.

340 Tax experts, including some with Democratic leanings, caution that the proposals could put American corporations at a competitive disadvantage. The United States is part of a dwindling minority of industrialized countries that tries to tax corporate profits on a global basis. Most European governments tax corporations on the basis of their profits within their borders. “If other countries are adopting systems that are friendlier to multinational corporations, then companies will have an incentive to locate their corporate headquarters outside the United States,” said Alan Auerbach, a professor of economics at the University of California, Berkeley, who advised Senator John Kerry during his 2004 presidential campaign. James Hines, an economics professor at the University of Michigan, suggested the president’s proposals could be seen as creating unfair trade advantages for domestic goods and services. Jackie Calmes Edmund L. Andrews, “Obama Calls for New Curbs on Offshore Tax Havens”, NYT, 5/Mayo/ 2009 http://www.nytimes.com/2009/05/05/business/05tax.html?_r=1&th&emc=th

May 5, 2009 Obama Plan Leaves One Path to Lower Taxes Wide Open By LYNNLEY BROWNING The Obama administration’s plan to restrict or shut down several widely used tax loopholes takes away many — but not all — of the sophisticated tax moves commonly used in corporate America. The most widely used tactic not covered by the plan is known as transfer pricing, which multinational corporations employ routinely to reduce the taxes they owe to the United States by keeping their profits offshore in low-tax or no-tax havens. The highly complex tactic has become a cause of growing concern within the Internal Revenue Service in recent years because it deprives the Treasury of billions of dollars a year, according to private-sector estimates. One senior government official briefed on the matter, who spoke on the condition of anonymity because he said he was not authorized to comment publicly, said on Monday that transfer pricing abuses were the single largest source of tax avoidance in corporate America. Rosanne Altshuler, an economics professor at Rutgers, called transfer pricing “the elephant in the room” that was not addressed under the Obama plan. Corporate America “will still have the ability to do and use transfer pricing — it’s still there,” said Robert Willens, an independent tax and accounting expert in New York. Like the two tax loopholes covered under the Obama plan — the proposal restricts the ability of companies to defer taxes owed on profits earned overseas, and eliminates a popular method, known as check the box, for reducing taxes through transfers of money to overseas affiliates — transfer pricing involves the same issue of lowering taxes through maneuvers involving overseas subsidiaries and affiliates. As part of the tax code, the tactic allows corporations, typically Fortune 500 companies like Wal-Mart, Exxon Mobil and General Electric, to reduce their United States taxes

341 by calculating the prices they charge on goods and services transferred between their global divisions. While corporations are supposed to compute those costs as if they had been assessed between independent, neutral entities, and to pay any taxes owed on them — the top rate is around 35 percent — corporations often fudge the numbers to their advantage, according to senior analysts. In other words, corporations routinely abuse the tactic to minimize their taxes by undercharging or overpaying their foreign subsidiaries for goods and services. With the Obama plan closing other loopholes, corporations are “now going to get crazy with their transfer pricing,” said Lee Sheppard, a commentator for Tax Analysts, a trade publication. On another front, Robert S. McIntyre, the director of Citizens for Tax Justice, a research group, said that the Obama plan to make permanent the research and development tax credit would provide more leeway for pharmaceutical and technology companies, which make extensive use of such credits, to lower their taxes in questionable ways. Such companies, Mr. McIntyre said, increasingly use the credits for purposes other than research, like salaries and overhead. http://www.nytimes.com/2009/05/05/business/05shelter.html?ref=business

342 ft.com/maverecon What’s left of central bank independence? Willem Buiter, May 5, 2009 10:54pm The modern independent central bank was born in New Zealand in 1989. It had a short life. The onset of the financial crisis of the north Atlantic region in August 2007 signalled the beginning of the end. Today, only the ECB still has a significant degree of operational independence left, and it will have to give that up if it is to be effective in the current phase of the crisis. In other words, the ECB is the last central bank to understand that, if it is to play a significant financial stability role, it cannot retain the degree of operational independence it was granted in the Treaty over monetary policy in the pursuit of price stability. Inflation targeting was invented around the same time and central bank independence, and also in New Zealand, with the Reserve Bank of New Zealand Act of March 1989 and the first Policy Targets Agreement (PTA) in March 1990. The Reserve Bank of New Zealand Act 1989 specifies that the primary function of the Reserve Bank shall be to deliver “stability in the general level of prices.” The Act says that the Minister of Finance and the Governor of the Reserve Bank shall together have a separate agreement setting out specific targets for achieving and maintaining price stability. This is known as the Policy Targets Agreement (PTA). A new PTA must be negotiated every time a Governor is appointed or re-appointed, but it does not have to be renegotiated when a new Minister of Finance is appointed. The Act requires that the PTA sets out specific price stability targets and that the agreement, or any changes to it, must be made public. The PTA can only be changed by agreement between the Governor and the Minister of Finance. Thus, neither side can impose unilateral changes. Note, however, that under the Reserve Bank Act the Government has the power to override the PTA. This override power, akin to the UK Treasury’s Treasury Reserve Powers, has not been invoked thus far. A case can be made for the Deutsche Bundesbank, established in 1957 as the sole successor to the two-tier central bank system which comprised the Bank deutscher Länder and the Land Central Banks of the Federal Republic of Germany, as the first modern independent central bank, but the de-facto independence of the Bundesbank was a product of Germany’s unique historical circumstances - notably the hyperinflation of the Weimar Republic’s hyperinflation during 1923 and the limited legitimacy of the other state institutions following the Nazi era and World War II. I therefore consider the Bundesbank to have been a pre-modern independent central bank. From New Zealand, central bank independence spread to the UK (1997), Japan (1997), the Euro Area (1999) and many other corners of the universe. Two kinds of central bank independence are commonly distinguished - target independence and operational independence. Target independence Fundamental target independence - the right to choose its own fundamental objective or objectives - is possessed by no central bank. Even the most independent of all central banks, the ECB, has its multiple fundamental objectives laid down in an external document - the Treaty Establishing the European Community. Article 105 states that

343 “The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 4.” Article 2 of the Treaty states: “The Community shall have as its task, by establishing a common market and an economic and monetary union and by implementing common policies or activities referred to in Articles 3 and 4, to promote throughout the Community a harmonious, balanced and sustainable development of economic activities, a high level of employment and of social protection, equality between men and women, sustainable and non-inflationary growth, a high degree of competitiveness and convergence of economic performance, a high level of protection and improvement of the quality of the environment, the raising of the standard of living and quality of life, and economic and social cohesion and solidarity among Member States.” I still think it will come as a surprise to ECB Executive Board member Jürgen Stark that one of the objectives of the ECB is to promote equality between men and women - albeit without prejudice to the objective of price stability. The Bank of England’s monetary policy objectives are laid down in the Bank of England Act 1998. They are to deliver price stability and, subject to that, to support the Government’s economic objectives including those for growth and employment. The Fed has a triple mandate, given in Section 2a. of the Federal Reserve Act: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”. Of all leading central banks, only the ECB sets its own quantitative operational targets. It defines price stability is an annual rate of inflation (measured by the HICP index) below but close to two percent. The Bank of England’s operational is set by the Chancellor of the Exchequer. It is currently a two percent annual inflation rate for the HICP (known in the UK as the CPI). The Fed has no quantitative target for any of its three fundamental objectives. Under Chairman Ben Bernanke, it has been edging slowly towards an implicit inflation target, captured by the average or median 3-years ahead inflation forecasts of the members of the FOMC. Whether this implicit inflation target is defined in terms of the CPI or the consumer expenditure deflator, and in terms of the headline inflation rate or the core inflation rate is unclear. Operational Independence Operational independence is the freedom or ability of a central bank to pursue its objectives (regardless of who sets them) as it sees fit, without interference or pressure from third parties. It is not a binary variable but a matter of degree. Operational independence from an elected, sovereign government is not easily achieved. It requires political independence: the central bank cannot seek or take instructions from any government/state body or other institution/body. It requires technical independence: the central bank must have the tool(s) to do the job. It means that the central bank cannot be coerced or induced to extend permanent financial assistance to the government or to

344 private agents - it cannot be raided by government or private actors. It requires financial independence, that is, a separate budget and a secure capital base. It requires security of tenure and of terms of employment; this can be achieved through a minimum term of office, removal from office only for incapacity or serious misconduct (and not for gross incompetence), and pay and other conditions of employment that cannot be manipulated by outsiders. Finally, it requires that there be some other independent body, e.g. a court, to settle disputes between the central bank and the government. This list suggests that operational independence is not a binary variable but a matter of degree, that a high degree of operational independence is difficult to achieve and that, if it is achieved, the central bank is, almost by definition, not substantively accountable to any other agency. As an illustration of the problems standing in the way of operational independence of the central bank, consider the issue of its financial independence. The ability of the central bank to pursue its price stability mandate or, operationally, to achieve its inflation target, is constrained by its financial resources. Unlike the Treasury, the central bank does not have the power to tax. The asymmetry is even stronger when hen one realises that among the entities the Treasury can tax is the central bank. Frequently, the Treasury is also the legal owner of the central bank. In the UK, for instance, the Treasury owns all the common stock of the Bank of England. This raises the question: how independent can you be of the party that owns you and is able to tax you at will? The answer is that this depends on the ability of the Treasury to commit itself not to deplete the financial resources of the central bank, whether by calling for extraordinary dividends, through a forced share re-purchase, by taxing the central bank or by raiding its gold reserves. The credibility of that commitment is determined by the same political factors that prompted the delegation of monetary policy to an operationally independent central bank in the first place. It is an open issue. The financial independence of the ECB is due in no small measure to the fact that the ECB does not face a single controlling owner, or a single fiscal actor (Treasury or Ministry of Finance) capable of taxing it. The ECB is owned by the National Central Banks of the European Union. These in turn are owned (with a number of exceptions) by their national Treasuries/Ministries of Finance. Raiding the financial resources of the ECB would effectively require the unanimous agreement of the Finance Ministers of the EU. In addition, the ECB would be able to appeal the matter to the European Court of Justice. Very few conventional central banks facing a single national Treasury are in the same comfortable position. Table 1 shows the stylised conventional financial balance sheet of a central bank:

Table 1 Conventional central bank balance sheet Assets Liabilities C: Currency D: M: Treasury debt Base money BD: Bank reserves

L: N: TD: Treasury deposits

345 Private sector Non- CBB: Central debt monetary bank bills and liabilities bonds R: Foreign W: exchange Financial net worth or equity reserves

On the asset side the central bank has claims on the Treasury, D, claims on the private sector, L, and foreign exchange reserves, R. Claims on the Treasury includes Treasury securities held outright, and loans to private parties collateralised by Treasury securities. Claims on the private sector includes private securities held outright, unsecured loans to the private sector and loans to the private sector secured against private assets. On the liability side is the monetary base, M, the sum of currency in circulation, C, and banks’ balances held with the central bank, BD, and non-monetary central bank liabilities, including Treasury deposits with the central bank, TD, and central bank bills and bonds, CBB. The excess of the assets over the liabilities in the conventional financial net worth or equity of the central bank, W. It need not be positive, even though central bankers generally would not be very happy to work with a hole in their balance sheet. The reason central banks conventional net worth or equity can be negative without this automatically causing a default by the central bank on its obligations, is that there are a number of future cash flows (positive and negative) that are not capitalised and put on the conventional balance sheet. The most important missing asset is the present discounted value of the profits the central bank can earn thanks to its ability to issue non-interest-bearing bank notes and bank reserves that need not be remunerated at market rates. I denote the present value of this future seigniorage revenue by S. On the liability side is the present discounted value of the cost of running the central bank, E and the present value of the net payments the central bank makes to the Treasury, T. Adding the unconventional assets and liabilities of the central bank to the conventional ones contained in Table 1 gives us Table 2, which shows the comprehensive balance sheet of the central bank or its intertemporal budget constraint.

Table 2 Comprehensive central central bank balance sheet (central bank intertemporal budget constraint) Assets Liabilities C: M: Currency D: Base Treasury debt BD: money Bank reserves

L: N: TD: Private sector Non- Treasury debt deposits

346 monetary CBB: liabilities Central bank bills and bonds R: Foreign E: Present discounted exchange value of cost of reserves running central bank S: Present discounted value of T: Present discounted seigniorage value of net profits (interest payments to Treasury saved on non- (taxes) interestbearing monetary liabilities). V : Comprehensive net worth or equity

Comprehensive net worth or equity of the central bank, V, is the conventional net worth or equity, W, plus the unconventional asset, S, and minus the unconventional liabilities, E and T, that is: V = W + S - E - T Comprehensive net worth has to be non-negative, or the central bank is kaput. What can the central bank do when it gets raided by the Treasury or if it suffers a capital loss on its assets, say as a result of its repo operations (where it makes loans against possibly dodgy private collateral), or as a result of credit easing through the outright purchases of private securities, or through unsecured loans to the private sector? After it cuts its expenses to the bone (sets E equal to zero), all it can do is to ‘print money’ to stay solvent. Increased money issuance will, sooner or later, lead to higher inflation. That means higher nominal interest rates and therefore a higher value of central bank profits on its investment account (S) in Table 2. Financial solvency will have been restored (assuming that the central bank is not operating on the slippery slope of the seigniorage Laffer curve), but it may well be the case that the lowest inflation rate necessary to restore financial solvency for the central bank is different from (and most likely higher than) the inflation target The ECB has achieved a remarkable and unique degree of formal operational independence There can be little doubt that the ECB is the central bank with the highest degree of formal or legal operational independence. Since it also sets its own operational objectives (medium term HICP inflation below but close to two percent per annum ), it can also be characterized as the most independent central bank, when operational independence and target/goal independence are taken together. The ECB’s operational independence and its mandate are enshrined in the Treaty establishing the European Community and the associated Protocol. These can only be amended through a Treaty

347 revision requiring the unanimous consent of the EU member states (currently 27 in number). As regards formal, legal safeguards guaranteeing political independence, financial independence and security of tenure and conditions of employment, the ECB scores as high as or higher than any other central bank. Highly unusually, there is nothing in the Treaty and Protocol governing the ESCB and the ECB that permits the political authorities (in this case the Council of the European Union) to repatriate, or take back, under extreme circumstances, the power to conduct monetary policy from the ECB. The Bank of England Act 1998 created the Treasury Reserve Powers for this purpose; the Reserve Bank of New Zealand Act 1989 contains a similar provision. Dispute resolution through the European Court of Justice provides a further safeguard for the ECB’s operational independence. There is just one potential chink in the ECB’s operational independence armour. This relates to the ECB’s technical independence. There is some question as to whether the ECB has the tools to do the job of ensuring price stability. Responsibility for exchange rate policy is divided between the ECB and the Council of Ministers. There is no substantive problem for central bank independence from the power of the Council of Ministers, acting unanimously, to enter into formal exchange rate arrangements with non-EU countries. Joining a new Bretton Woods would clearly be a political decision, to be taken by the political leadership of the EU, not by the ECB. However, the Council can also formulate general orientations for the exchange rate. Only a qualified majority is required for this. Divided responsibility for the exchange rate could make a mockery of central bank independence. Not surprisingly, the ECB asserts that it cannot be given binding exchange rate orientations without its consent, and it has good sense on its side. Every French minister of finance since 1999 and a number of other ministers of finance have begged to disagree, however. The issue has not yet been put to the test. Unconventional monetary policies require close central bank - Treasury cooperation Every time a central bank makes a loan at the discount window or engages in a reverse repo secured against private collateral, it takes credit risk (default risk). In the Euro Area, the ECB even takes credit risk when in accepts the Treasury debt of some of the Euro Area member states as collateral in its lending operations. There is no guarantee that cross-border fiscal solidarity in the Euro Area will ensure that sovereign debt issued by fiscally incontinent member states will be made good by Germany and other member states with deep pockets. With central banks outside the Euro Area now actively engaged in credit easing through the direct acquisition of private securities (commercial paper, corporate bonds, mortgages and ABS) and possibly in the future through unsecured lending to the private sector, the exposure of central banks to credit risk is becoming larger and could become huge in some countries before this crisis is over. Central banks could therefore be faced, if they suffer a large capital loss, either to engage in aggressive base money creation to maintain solvency, endangering their inflation targets and price stability mandates, or to go to the nearest Treasury with a begging bowl, thus undermining the central bank’s independence. To prevent this, the Bank of England has agreed a full indemnity with the Treasury for any capital losses it incurred through defaults on its outright purchases of private

348 securities (it does not, however, have any indemnity from the UK Treasury for losses it may incur on lending collateralised against private securities). The Fed has not obtained a full fiscal indemnity even for its outright purchases of private securities. Like the Bank of England, it also has no fiscal indemnity of any kind for losses on collateralised lending. Under the TALF, for instance, the Fed could take on a full trillion dollars’ worth of exposure to the private sector, with the US Treasury only providing an indemnity for such losses up to a limit of $100 billion. In the worst-case-scenario, the Fed could be $900bn in the hole through the TALF. The total exposure of the Fed to private sector default risk is massive and growing. It includes the three Delaware-based SPVs (Maiden Lane I, II and III) created to deal with Bear Stearns’ toxic waste and AIG’s nasty legacies in a non-transparent, off-balance sheet and tax-free manner), plus the other exposure acquired both through outright purchases or through loans secured against private assets in the dozen-plus special facilities created since the start of the crisis. The Fed has been acting effectively like an off-budget, off-balance-sheet and off-the-Congressional-radar-screen SPV of the Treasury. Even if one believes this was the right thing to do under the circumstances, the fact remains that it seriously compromises the future independence of the Fed. Inevitably, when the central bank takes on significant credit risk in its monetary policy management, liquidity management and credit enhancement policies, close cooperation between the central bank and the fiscal authorities is essential. Cooperation and coordination do not necessarily mean loss of independence. The ECB, unfortunately, often talks as if cooperation and coordination, including binding agreements, between the ECB and the fiscal authorities of the Euro Area would in and of itself constitute an infringement on its independence. So all it is up for is regular cheap talk with the Ecofin or with the Eurogroup finance ministers. As the crisis lengthens and deepens, the absence of close cooperation between the fiscal authorities in the Euro Area and the ECB will make both the ECB and the fiscal authorities progressively less effective. This is in addition to the problems the ECB encounters as a result of the absence of even a minimal ‘fiscal Europe’, in the design and implementation of unconventional monetary policy involving outright purchases of private securities or unsecured lending to banks or other private counterparties. Stick to your knitting and don’t get too close It is a mistake for central bankers to express, in their official capacities, views on what they consider to be necessary or desirable fiscal and structural reforms. Examples are social security reform and the minimum wage, subjects on which Alan Greenspan liked to pontificate when he was Chairman of the Board of Governors of the Federal Reserve System, and Ben Bernanke’s tendency to lecture on everything, from equality and opportunity to teenage pregnancy. It is not the job of any central banker to lecture, in an official capacity, the minister of finance on fiscal sustainability and budgetary restraint, or to hector the minister of the economy on the need for structural reform of factor markets, product markets and financial markets. This is not part of the mandate of central banks and it is not part of their areas of professional competence. The regrettable fact that the Treasury and the Ministry of the Economy tend to make the symmetric mistake of lecturing the operationally independent central bank on what they perceive to be its duties (which generally amounts to a plea for lower interest rates or other more expansionary policy measures) does not justify the central bank’s persistent transgressions.

349 There are but a few examples of central banks that do not engage in public advocacy on fiscal policy and structural reform matters. There used to be two I was aware of, the Bank of England and the Reserve Bank of New Zealand. Unfortunately, Mervyn King undid 12 years of effort by his predecessor, Eddie George, and by his more enlightened earlier self, when, in front of the Treasury Committee on March 24, 2009, he said the following in response to a question from one of the Treasury Committee members, a Mr. Love: Question: “The IMF in successive reports has forecast a larger and larger decline in world output and, therefore, one presumes in the short-term the continuing of that series. Is there an argument to be made for a second fiscal stimulus to respond to what is likely to be a further decline in the world’s economic output?” Mr King: “I am sure the Government will want to be cautious in this respect. There is no doubt that we are facing very large fiscal deficits over the next two to three years, there can be no doubt about that. I think it is right to accept that when the economy turns down and the automatic stabilisers kick in, so the increased benefit expenditures and lower tax revenues are bound to lead to higher fiscal deficits and it does not make sense to try to offset that so we are going to have to accept for the next two to three years very large fiscal deficits. Given how big those deficits are, I think it would be sensible to be cautious about going further in using discretionary measures to expand the size of those deficits. That is not to rule out targeted and selected measures that may find those areas, whether it is in the labour market, whether it is in corporate credit, that can do some good, but the fiscal position in the UK is not one that would say, “Well, why don’t we just engage in another significant round of fiscal expansion?” We can do more monetary easing if necessary. Monetary policy should bear the brunt of dealing with the ups and downs of the economy. …” I happen to agree with Governor King on the undesirability of a further discretionary fiscal stimulus for the UK. But why on earth did he say this in public? This was definitely a sliding tackle, nowhere near the ball, with both feet aimed firmly at sensitive parts of the political anatomy of the Chancellor and, even more, of the Prime Minister. It politicises the Bank of England and makes it fair game for any government minister or member of the opposition who wants to put pressure on the bank or attack it in public. Not smart. President Trichet of the ECB is already so far down the road of telling governments what to do and what not to do in the fiscal and structural reform domains, that one is hardly surprised by yet another lecture on budgetary policy from the Eurotower. Traditionally, continental European central bankers speak very little about monetary policy in public, and are often unwilling to engage in public debate or answer questions about their monetary duties, but carry on endlessly about budgetary and structural reform matters. It’s always easier to speak about things you have no responsibility for, that are not part of your mandate and about which you probably don’t know very much. The opposite problem has been encountered in the US, when Ben Bernanke has been so often seen shoulder-to-shoulder with past and present Secretaries of the Treasury, that it is hard to tell (except for the beard) where one begins and the other ends. A Chairman of the Fed ought not to publicly endorse or reject fiscal measures, budgets or plans. It’s not his mandate and not his competence. It also further politicises the Fed and undermines its future independence. Central bankers indeed have a duty to explain how their current and future interest rate decisions are contingent on economic developments that may include or may be

350 influenced by, the actions of the fiscal authorities and the success or failure of structural reforms. The central bank should clarify what its reaction function is, given the economic environment in which they operate, which includes the fiscal authorities and the government and ‘social partners’ engaged in structural reforms. Independent central bankers can, and where possible should, cooperate with and coordinate their actions with those of the fiscal authorities and with those charged with structural reform. If central banks, Treasury ministers and ministers of the Economy were to act cooperatively toward each other, and with credible commitment towards the private sector, good things may well happen. The reason this does not happen in the EU, or even in the Euro Area, is not a question of principle, but of logistics. There is no coordinated fiscal policy in the EU or in the Eurozone, so the pursuit of coordination between fiscal and monetary policy in the EU or in the Eurozone is simply not possible. Mr. Jean-Claude Junker could have private breakfasts and/or public lunches with Mr Jean-Claude Trichet every day of the week, every week of the year, it would not bring monetary and fiscal policy coordination in the Eurozone an inch closer to realisation. Central banks and banking supervision and regulation Even a nano-second of reflection will convince you that financial stability requires the close cooperation and coordination of the source of ultimate, unquestioned liquidity (the central bank), the ultimate deep pockets (the Treasury) and the supervisor/regulator. Recognition that such a tripartite or quadripartite arrangement is necessary for financial stability (both ex-ante, that is, the prevention of instability, and ex-post, that is, dealing with the instability that happens is spite of (or because of) the ex-ante best efforts) does not answer the question as to how many institutions should be involved, and what the lines of authority among them should be. In the limit, a single institution, the Treasury, could be the recapitaliser of last resort, the supervisor/regulator for the financial sector and the ultimate authority over the central bank’s activities. The US appears to be evolving in that direction. Much of the debate concerns the merits of two (reasonably independent) institutions - the Treasury and the central bank/supervisor/regulator - as opposed to three (reasonably independent) institutions - the Treasury, the central bank and the supervisor/regulator). I will come down, with qualms, in favour of a different triad: the Treasury, the central bank/supervisor and the regulator. Central banks, as the ultimate source of unquestioned domestic currency liquidity play a central role in macro-prudential supervision. I don’t think there is ever any need for the central bank to make the rules, to be the regulator. Its view should certainly be heard by the regulator, but the manifest threat of regulatory capture means that the central bank should stay as far from making the rules as possible. Enforcing the rules will be difficult enough, given the relentless pressure of the financial sector (including the banks) on those charged with its supervision. The regulation and supervision of financial institutions and markets is a deeply political activity. Property rights are being assigned, restricted, qualified or taken away. Banks are stopped from doing things they want to do and forced to do things they do not want to do. Barriers to entry and exit are created, lowered or removed. Such activities don’t fit the image of an independent, a-political central bank very well. I consider it to be inevitable that when a central bank becomes deeply involved in the supervision of systemically important financial institutions and markets (let alone in their regulation), it will become politicised and lose its independence, even in the

351 domain of conventional monetary policy (setting the official policy rate). This view is strongly supported by the increasing politicisation of the Fed - by far the least operationally independent of the leading central banks in the advanced industrial countries. The same fate may await the Bank of England as it gets to play a larger role in macro- prudential supervision. When a central bank as macro-prudential oversight of, and responsibility for, the banking system, there is always a risk that monetary policy will be perverted to keep the supervisory state clean (no major bank insolvencies on my watch; better not raise the OPR right now;, never mind the inflation target). It is an unfortunate fact of life that the deep knowledge of the relevant individual financial institutions can only be acquire through close and frequent interaction with and exposure to those in charge of these institutions. Cognitive regulatory capture, and cognitive supervisor capture are therefore always a threat. There are many reasons why the ECB is the most independent central bank in the world. I have discussed many of them earlier in this post. But a reason not yet mentioned but, in my view, very important, is the fact that the ECB plays no meaningful supervisory and regulatory role. Some members of the ECB’s Executive Board and Governing Council are pushing to change this. And there is a powerful argument that the source of ultimate euro liquidity has to play a central role in Euro Area financial stability and that this requires both the power to collect relevant information from individual systemically important financial institutions and the power to prescribe and proscribe certain kinds of behaviour by financial institutions and other market participants. There are two problems with this extension of the role of the ECB into the supervisory domain. There are no Treaty-based obstacles to any kind of financial supervisory role by the ECB, as long as it does not involve insurance (whatever that means). But even some ECB Executive Board members are concerned that a significant supervisory role for the ECB would politicise the institutions and provide the Great Unwashed heads of state and of government (especially those from Paris) with a means of breaching the ‘noli me tangere’ cordon sanitaire that the ECB has constructed to preserve its sole control over monetary and (de facto) exchange rate policy. I have the opposite concern. The ECB is so ludicrously over-independent, even for the performance of the traditional monetary policy tasks, that there is a real risk that, should it be granted a role in banking and financial supervision, it would be able to hide the (unavoidably political) supervisory decisions and actions behind the Treaty shield of monetary policy independence. It is one thing to have monetary policy makers that are utterly unaccountable in any substantive sense (in the eyes of the ECB, accountability means ‘reporting obligations’!). So have financial supervisors that cannot be held to account substantively - that cannot be fired for incompetence, for instance - would be intolerable. I would favour granting the ECB greater financial supervisory powers, provided is independence were reduced and its substantive accountability enhanced. I believe many policy makers will take the same view. This means that it is unlikely to happen. We are therefore likely to see an evolution where leading central banks other than the ECB become progressively less independent but more relevant for crisis resolution and financial stability, while at the same time the ECB remains independent but becomes increasingly less relevant as its capacity to prevent financial instability and to respond to it, should it nevertheless happen remains minimal.

352 This threatening irrelevance of the ECB is caused by two factors, largely beyond its control. The first is the absence of a ‘fiscal Europe’. This means that the ECB is more restricted in the amount of private credit risk it can take onto its balance sheet than central banks that are clearly backed by a fiscal authority (national central banks outside the Euro Area, backed by their national treasuries). Credit easing policies therefore pose greater risks to the ECB price stability mandate than similar policies do in the UK and the US. The second cause of the increasing irrelevance and ineffectiveness of the ECB in these later stages of the financial crisis is the excessive independence granted the ECB in the Treaty. Governments will be extremely reluctant to transfer supervisory or regulatory powers to a central bank that is under no constraint to pay any attention whatsoever to the elected and accountable politicians, both in the executive and legislative branches of government. So I conjecture that central banks are facing a choice: remain relevant to crisis prevention and resolution, but lose much of your independence, or remain independent and become irrelevant.

353

Economy

May 5, 2009 Where Home Prices Crashed Early, Signs of a Rebound By DAVID STREITFELD SACRAMENTO — Is this what a bottom looks like? This city was among the first in the nation to fall victim to the real estate collapse. Now it seems to be in the earliest stages of a recovery, a hopeful sign for an economy mired in trouble and anxiety. Investors and first-time buyers, the traditional harbingers of a housing rebound, are out in force here, competing for bargain-price foreclosures. With sales up 45 percent from last year, the vast backlog of inventory has diminished. Even prices, which have plummeted to levels not seen since the beginning of the decade, show evidence of stabilizing. Indications of progress are visible in other hard-hit areas, including Las Vegas, parts of Florida and the Inland Empire in southeastern California. Sales in Las Vegas in March, for example, rose 35 percent from last year. “It’s fragile, and it could easily be fleeting,” said an MDA DataQuick analyst, Andrew LePage. “But history suggests this is how things might look six months before prices bottom out.” Hope for housing was on full display in the stock market on Monday. News that pending home sales rose in March instead of falling, coupled with improved construction spending, propelled a strong rally. One broad market average, the Standard & Poor’s 500-stock index, is now in positive territory for the year, after being down 25 percent on March 9. No one in Sacramento is predicting that local housing prices, which have been cut in half from their mid-2005 peak, are going to reclaim much of that ground anytime soon. Instead, this is what passes for wild-eyed optimism: a belief that things have finally stopped getting worse. “A period of price stagnation would boost a lot of spirits,” Mr. LePage said. When a market bottoms, foreclosures usually stop piling up and banks become more willing to make loans, confident the collateral backing them will not fall in value. Nationally, signs of progress in real estate are still faint at best. Existing home sales in March were down 7 percent from last year, according to the National Association of Realtors. The supply of unsold homes was about 10 months, a number that has changed little over the last year and is abnormally high. But first-time buyers were an impressive 53 percent of the market — and that was largely before a first-time buyer’s tax credit of $8,000 became available.

354 With the tax credit in place and interest rates low, the pace of sales may be picking up. The Realtors’ group said Monday that the number of houses under contract in March was up 1 percent from a year earlier. Those pending deals will be reported in the existing-home sales for April and May. Sales volume tends to recover long before prices. In fact, some analysts think price declines in many markets are accelerating. First American CoreLogic, a real estate data firm, reported that “the depth and breadth of price declines continued to worsen in February.” Fitch Ratings recently revised its estimate of future declines to 12.5 percent, from 10 percent, saying the drop would extend to the end of next year. Amid the uncertainty, Sacramento is drawing scrutiny as a test case. The area boomed in the first part of the decade; the population of Sacramento County increased 10 percent, to 1.4 million, as San Franciscans sought cheaper places to live. When the market peaked and the ability to refinance all those costly mortgages dried up, the carnage began. There have been 28,898 foreclosures in Sacramento County since 2005. Sales in the top half of the market remain slow. The Federal Reserve reported on Monday that half of all banks recently tightened their lending standards on prime mortgages. Many would-be buyers, here as elsewhere, simply cannot get financing. Sellers, meanwhile, are reluctant to lower their prices, preferring to bide their time. New construction is nearly nonexistent. What drives the market here, then, are all those foreclosures. Two-thirds of the 2,092 existing single-family houses and condominiums sold here in March were bank repossessions, up from 8.5 percent two years ago, according to MDA DataQuick, a real estate research firm. These cut-rate properties are engendering the same frenzy and frustration that symbolized the boom, as Rebecca and Chris Whitman discovered when they started looking for a house in December. Ms. Whitman’s new job as an athletics director at Sacramento State required an immediate move from Chico, two hours north. In two months the couple looked at 100 houses, nearly all foreclosures priced under $200,000, making verbal offers on 20. Only rarely did they get a response. Banks trying to unload large numbers of properties are less interested in traditional transactions with individuals than all-cash offers from investors. As interest rates fell, the Whitmans were able to increase their price limit. They ended up buying from investors. A syndicate had bought a three-bedroom foreclosure on a cul- de-sac in eastern Sacramento last fall for $172,000, made a few improvements and was flipping it — another boom-era element that is back. The Whitmans bought it three weeks ago for $224,500. “We think we got a good deal,” said Ms. Whitman, 31. Their monthly payment, including property taxes, will be about $1,200. Renting an equivalent house, with space for their two dogs, two cats and the baby they are expecting, would have been hundreds of dollars more. When buying is cheaper than renting, markets begin to turn. At the current rate of sales, there is less than three months of inventory in the Sacramento market. In normal times, that would indicate a seller’s market.

355 Except these are not normal times. The unemployment rate in the county is 11.3 percent, the highest in decades. That will prompt more foreclosures all by itself. Furthermore, banks have lifted various processing moratoriums that lowered foreclosures last fall. These two factors yielded a rise in the number of default notices filed in Sacramento County in March to 2,819, a record. Thousands more bank-owned houses are likely to come to market this summer and fall. “That will stall any progress toward stability,” said Michael Lyon, chief executive of Lyon Real Estate. “The prospects for a recovery are fool’s gold.” Mr. Lyon expects further price declines and slowing sales. But David Berson, the chief economist for the mortgage insurer PMI, argues that such bleakness from the people whose livelihood is selling houses is itself a positive sign. “Things are awful at the bottom, and we’re at the bottom,” Mr. Berson said. “No question about it. But the trend going forward should be higher sales, and that will eventually affect prices.” http://www.nytimes.com/2009/05/05/business/economy/05turnaround.html?th&emc= th

356 Opinion

May 5, 2009 OP-ED CONTRIBUTOR Bailout Justice By JOHN ASHCROFT Washington I CAN imagine the Treasury secretary’s face turning pale as he is told by the attorney general that one of the financial institutions on government life support has been indicted by a grand jury. Worse, I can imagine the attorney general facing not too subtle pressure from the president’s economic team to go easy on such companies. This situation is hypothetical, of course, but in March, the F.B.I. director, Robert Mueller, warned Congress that “the unprecedented level of financial resources committed by the federal government to combat the economic downturn will lead to an inevitable increase in economic crime and public corruption cases.” Yet no one has discussed the inherent conflict of interest that the government created when it infused large sums of money into these companies. The government now has an extraordinarily high fiduciary duty to safeguard the stability and health of companies that received hundreds of billions of bailout money. At the same time, the Justice Department has the duty to indict a corporation if the evidence dictates such severe action — and an indictment is often a death sentence for a corporation. The quandary is obvious. How, then, does the Justice Department bring charges against a corporation that is now owned by the government? The tsunami of corporate scandals that shook our economy in 2001 — Enron, WorldCom, Adelphia and others — provides us with an instructive example. The Justice Department moved swiftly to bring corporate wrongdoers to justice. But we also learned that when dealing with major companies or industries, we had to carefully consider the collateral consequences of our prosecutions. Would there be unintended human carnage in the form of thousands of lost jobs? Would shareholders, some of whom had already suffered a great deal, lose more of their investment? What impact would our actions have on the economy? We realized that we had an obligation to minimize the harm to innocent citizens. Among the options we pursued were deferred prosecution agreements. These court-authorized agreements were not new but under certain circumstances offered more appropriate methods of providing justice in the best interests of the public as well as a company’s employees and shareholders. They avoid the destructiveness of indictments and allow companies to remain in business while operating under the increased scrutiny of federally appointed monitors. In September 2007, for instance, the Justice Department and the nation’s five largest manufacturers of prosthetic hips and knees reached agreements over allegations that they gave kickbacks to orthopedic surgeons who used a particular company’s artificial hip and knee reconstruction replacement products. The allegations meant that the companies faced indictment, prosecution and a potential end to their businesses.

357 Think of the effect on the community if these companies had been shuttered: employees would have lost their jobs, shareholders and pensioners would have lost their savings and countless people in need of hip and knee replacement would have been out of luck, as these five companies accounted for 95 percent of the market. The Justice Department could have wiped out an entire industry that has a vital role in American health care. Instead, the companies paid settlements to the government totaling $311 million. They agreed to be monitored by private sector individuals and firms with reputations for integrity and public service, with the necessary legal and business expertise and the institutional capacity to do the job. The monitoring costs were borne exclusively by the companies, saving taxpayers tens of millions of dollars that could be then used for other investigations and law-enforcement priorities. (I was a paid monitor for one of these companies, Zimmer Holdings.) In these types of circumstances, a deferred prosecution agreement is clearly better for everyone. The government must hold accountable any individuals who acted illegally in this financial meltdown, while preserving the viability of the companies that received bailout funds or stimulus money. Certainly, we should demand justice. But we must all remember that justice is a value, the adherence to which includes seeking the best outcome for the American people. In some cases it will be the punishing of bad actors. In other cases it may involve heavy corporate fines or operating under a carefully tailored agreement. In 2001, we did not know the extent of the corporate fraud scandals. Every day seemed to bring news of another betrayal of trust by top executives of another company. But we learned that there was often a better solution than closing those companies. I believe that if we apply to this current crisis the lessons learned a few short years ago, we can achieve the restoration of trust in the financial system and the long-term vitality of the American economy. John Ashcroft was the United States attorney general from 2001 to 2005. http://www.nytimes.com/2009/05/05/opinion/05ashcroft.html?th&emc=th

358 May 3, 2009 Distressed Debt Investors Dictate The Terms: How Big An Issue Are 'Empty Creditors' With CDS Hedges? Overview: WSJ: As refinancings of LBO companies and other distressed borrowers become difficult, secured and unsecured distressed lenders are dictating terms and taking control of the remaining assets, in or out of bankruptcy. Henry Hu (Texas U. via WSJ) 'Empty Creditor' phenomenon: someone (or institution) who may have the contractual control but, by simultaneously holding credit default swaps, little or no economic exposure if the debt goes bad. Indeed, if a creditor holds enough credit default swaps, he may simultaneously have control rights and incentives to cause the debtor firm's value to fall [despite usually higher recoveries without bankruptcy, see Altman/Karlin]. And if bankruptcy occurs, the empty creditor may undermine proper reorganization, especially if his interests (or non-interests) are not fully disclosed to the bankruptcy court. However, Altman/Karlin note that 45% of deals restructured to avoid bankruptcy defaulted anyway after 2 years (median). o April 30 WSJ: Chrysler files for Chapter 11 bankruptcy after a Treasury-brokered proposal for Chrysler's lenders to accept $2.25 billion, or 29 cents on the dollar, in cash in exchange for wiping out about $6.9 billion of Chrysler's debt failed to close. A group of 20 secured lenders representing 30% of creditors, balked at that offer, 70% of debtholders agreed. According to people involved, dissident creditors intend to object to the company’s reorganization plan in bankruptcy court arguing that their secured underlying debt is worth more than the Trasury offer and that they should have an advantage over unsecured creditors. o April 17 Moody's (via Bloomberg): Sellers of credit-default swaps on 22 defaulted companies in the past seven months had to pay an average of 70 cents on the dollar for loans and 84.7 cents for bonds to buyers of protection, data from Markit and Creditex show. That compares to losses of 13 cents on the dollar for loans and 30 cents for bonds in all of 2008--> see als Fridson and HY Blog. o Jan 26 S&P:US companies face a greater risk of liquidation because sources of finance to let them reorganize under the country’s bankruptcy code are drying up in the global financial crisis--> Lenders, even those with priority claims, face big losses, if a company cannot reorganize and liquidates. o May 1 Bloomberg: Berkshire Vice Chairman Charles Munger said he supports an outright ban of credit- default swaps to prevent speculators from profiting on the failure of companies. o April 20 Gillian Tett: In mid-April Morgan Stanley and another bank suddenly demanded repayment on loans extended to the troubled Kazakh bank BTA. BTA was unable to comply, and thus tipped into partial default. That sparked fury among

359 some other creditors, and shocked some Kazakhs, who wondered why Morgan Stanley would have taken an action that seemed likely to create losses. Indeed, just after calling in the loan, Morgan Stanley also asked ISDA to start formal proceedings to settle credit default swaps contracts written on BTA. o Hu/Black (Texas U.), BofA: Distress renegotiations less likely with hedge funds than with private equity due to the former's short-term focus. Also: those who buy credit protection in general bet on default, not restructuring. o via FT: However: Physical bond settlement favors default because protection buyer receives face value in exchange for underlying bond. Cash settlement, on the other hand, includes substantial hair cut depending on recovery rate and protection buyer might be better off restructuring o Charles Davi (Derivatives Dribble): Rather than waste all that time and effort trying to sabotage a restructuring, you can cash in before a bankruptcy ever occurs. As the spread widens beyond the point at which you bought in, your end of the trade is "in the money," and so it already has intrinsic value that you can realize in a variety of ways. o Altman/Karlin: In 2008, bondholders of ailing companies were affected by a reemergence of an important corporate restructuring strategy, known as a Distressed Exchange (DE). Thirteen companies in 2008 completed this desperate attempt to avoid a formal bankruptcy filing – about twice as many as any single year in the last 25 years, involving twice as much in dollar amount than in the entire prior history (1984-2007). o cont.: The recovery rate to bondholders participating in distressed exchanges over the last 25 years is significantly higher (i.e. 49%) than recoveries on other, more dramatic types of default – namely payment defaults and bankruptcies (37.25%). However, almost 50% of all companies completing distressed exchanges prior to 2008 ultimately filing for bankruptcy. o cont.: Another important consequence of a completed distressed exchange was that it was possible, but not likely, to trigger a default event in the credit default swap (CDS) market. This was known as a MOD-R (modified restructuring) default. As of April 2009, DEs will not be considered a default event. Therefore, only a failure to pay interest or a bankruptcy will qualify after March 2009--> see 'Big Bang' protocol in the CDS Market o Edward Altman (via FT): So far, NYU index for defaulted bonds is down 33% and for defaulted loans down 16%. The only way to make money in this market is to short distressed credits in the CDS market which is unregulated and where you can take a leveraged position. Historically, when default rates are rising but haven't peaked yet you lose a lot of money. As soon as the market turns it is a bonanza. “Distressed Debt Investors Dictate The Terms: How Big An Issue Are 'Empty Creditors' With CDS Hedges?”, http://www.rgemonitor.com/520?cluster_id=7407

360 May 2, 2009 'Big Bang' In The CDS Market: Industry Group Adopts Standardized Rules For 'Plain Vanilla' CDS

Overview: SIFMA and ISDA industry groups agree to central clearinghouse but don't want to lose flexibility and fees from OTC derivatives trading. Solution: "Big Bang" strategy: Faced with tougher regulation dealers plan to overhaul CDS trading by March 2009: 1) For the first time, the market will have a committee of dealers and investors making binding decisions that determine when buyers of the insurance-like derivatives can demand payment and could influence how much they get by e.g. deciding which bonds can be delivered in settlement; 2) In one of the most noticeable changes for traders, those who buy protection will pay an upfront fee depending on current market prices, and then a fixed $100,000 or $500,000 annual payment for every $10 million of protection purchased. (Now, upfront payments are only required for riskier companies) (Harrington, Jan 30). o April 8 (Ng/Barrett) WSJ: The reforms, however, don't address credit-default swaps tied to mortgage securities and complex debt instruments, such as those insured by American International Group Inc. o April 8 Harrington: "Big Bang" underway: 2,023 entities have signed up as of late April 7 in New York, as measured by the ISDA, and agree to abide by the committee’s decisions and auctions that determine the value of underlying securities. These hardwiring rules are necessary for the establishment of a central clearinghouse and for the implementation of the Geithner/NY Fed plan (see below) o cont.: Rules of the new committee will require an 80 percent majority among the 15 members before a credit event can be declared. Credit events allow a firm that bought protection against default to demand payment from its counterparty. Matters failing to get an 80 percent agreement would be sent to a panel of arbitrators. o cont.: The International Swaps and Derivatives Association, or ISDA, will serve as secretary of the committee and will be required to publish each matter brought before the committee on its Web site, including information on the firm that brought it and how each member of the committee voted. o March 26 Geithner / NY Fed regulator plan: -Regulating Credit Default Swaps and Over-the-Counter Derivatives for the First Time; - Instituting a Strong Regulatory and Supervisory Regime; - Clearing All Contracts Through Designated Central Counterparties; - Requiring Non-Standardized Derivatives to Be Subject to Robust Standards;

361 - Making Aggregate Data on Trading Volumes and Positions Available; - Applying Robust Eligibility Requirements to All Market Participants o February 1 RiskMagazine: Tri-Optima has reported that its portfolio compression service, triReduce, eliminated $30.2 trillion in notional principal from the credit default swap (CDS) market in 2008. Note: The new net notional outstanding is therefore reduced from 57.8T to 28.8 trillion. The compression process does not necessarily reduce counterparty risk if it increases concentration among fewer counterparties. o Lex: As in almost every other class of assets, the withdrawal of hedge funds has hurt CDS liquidity: perhaps two-thirds of market-makers by number, and one-third by capacity, have pulled out. o Liquidity withdrawal argument consistent with March 2009, Coval, Jurek, Stafford (Harvard/Princeton U.): "Our analysis suggests that the dramatic recent widening of bond credit spreads is highly consistent with the decline in the equity market, the increase in its long-term volatility, and an improved investor appreciation of the risks embedded in structured products. Indeed the observed widening of the CDX spread is, if anything, somewhat low relative to what the structural model forecasts conditional on the market declining by 40% and its long-term volatility doubling."

“'Big Bang' In The CDS Market: Industry Group Adopts Standardized Rules For 'Plain Vanilla' CDS”, RGE Monitor, 02/05/2009, en: http://www.rgemonitor.com/691?cluster_id=13698

362 The Wall Street Journal

OPINION APRIL 9, 2009 'Empty Creditors' and the Crisis How Goldman's $7 billion was 'not material.' By HENRY T.C. HU

The defining moments of our financial crisis are now familiar. Last September, Lehman collapsed and AIG was teetering. Because an AIG collapse was viewed as posing unacceptable systemic risks, the Federal Reserve provided the company with an emergency $85 billion loan on Sept. 16. But a curious incident that fateful day raises significant public policy issues. Goldman Sachs reported that its exposure to AIG was "not material." Yet on March 15 of this year, AIG disclosed that it paid $7 billion of its government loan last fall to satisfy obligations to Goldman. A "not material" statement and a $7 billion payout appear to be at odds. Why didn't Goldman bark that September day? One explanation is that Goldman was, to use a term that I coined a few years ago, largely an "empty creditor" of AIG. More generally, the empty-creditor phenomenon helps explain otherwise-puzzling creditor behavior toward troubled debtors. Addressing the phenomenon can help us cope with its impact on individual debtors and the overall financial system. What is an empty creditor? Consider that debt ownership conveys a package of economic rights (to receive principal and interest), contractual control rights (to enforce the terms of the agreement), and other legal rights (to participate in bankruptcy proceedings). Traditionally, law and business practice assume these components are bundled together. Another foundational assumption: Creditors generally want to keep solvent firms out of bankruptcy and to maximize their value. These assumptions can no longer be relied on. Credit default swaps and other products now permit a creditor to avoid any actual exposure to financial risk from a shaky debt -- while still maintaining his formal contractual control rights to enforce the terms of the debt agreement, and his legal rights under bankruptcy and other laws. Thus the "empty creditor": someone (or institution) who may have the contractual control but, by simultaneously holding credit default swaps, little or no economic exposure if the debt goes bad. Indeed, if a creditor holds enough credit default swaps, he may simultaneously have control rights and incentives to cause the debtor firm's value to fall. And if bankruptcy occurs, the empty creditor may undermine proper reorganization, especially if his interests (or non-interests) are not fully disclosed to the bankruptcy court. Goldman Sachs was apparently an empty creditor of AIG. On March 20, David Viniar, Goldman's chief financial officer, indicated that the company had bought credit default swaps from "large financial institutions" that would pay off if AIG defaulted on its debt. A Bloomberg News story on that day quotes Mr. Viniar as saying that "[n]et-net I would think we had a gain over time" with respect to the credit default swap contracts.

363 Goldman asserted its contractual rights to require AIG to provide collateral on transactions between the two, notwithstanding the impact of such collateral calls on AIG. This behavior was understandable: Goldman had responsibilities to its own shareholders and, in Mr. Viniar's words, was "fully protected and didn't have to take a loss." Nothing in the law prevents any creditor from decoupling his actual economic exposure from his debt. And I do not suggest any inappropriate behavior on the part of Goldman or any other party from such "debt decoupling." But none of the existing regulatory efforts involving credit derivatives are directed at the empty-creditor issue. Empty creditors have weaker incentives to cooperate with troubled corporations to avoid collapse and, if collapse occurs, can cause substantive and disclosure complexities in bankruptcy. An initial, incremental, and low-cost step lies in the area of a real-time informational clearinghouse for credit default swaps and other over-the-counter (OTC) derivatives transactions and other crucial derivatives-related information. Creditors are not generally required to disclose the "emptiness" of their status, or how they achieved it. More generally, OTC derivatives contracts are individually negotiated and not required to be disclosed to any regulator, much less to the public generally. No one regulator, nor the capital markets generally, know on a real-time basis the entity-specific exposures, the ultimate resting places of the credit, market, and other risks associated with OTC derivatives. With such a clearinghouse, the interconnectedness of market participants' exposures would have been clearer, governmental decisions about bailing out Lehman and AIG would have been better informed, and the market's disciplining forces could have played larger roles. Most important, a clearinghouse could have helped financial institutions to avoid misunderstanding their own products, and modeling and risk assessment systems - - misunderstandings that contributed to the global economic crisis. Mr. Hu is a professor at the University of Texas Law School. Henry T.C. Hu “'Empty Creditors' and the Crisis. How Goldman's $7 billion was 'not material.'”, TWSJ, 09/04/2009, http://online.wsj.com/article/SB123933166470307811.html

364 Opinion

May 4, 2009 OP-ED CONTRIBUTOR Inflation Nation By ALLAN H. MELTZER Pittsburgh IN the 1970s, with inflation rising, I often described the Federal Reserve as knowing only two speeds: too fast and too slow. At the time, the Fed’s idea was to combat recession by promoting expansion, printing money and making it easier for businesses and households to borrow — and worry only later about the inflation that resulted. That strategy produced a sorry decade of slow productivity growth, rising unemployment and, yes, rising inflation. If President Obama and the Fed continue down their current path, we could see a repeat of those dreadful inflationary years. Back then, as now, the members of the Fed were well aware of the harmful effects of inflation. In private, they vowed not to let it get out of hand and several times even started to do something about it. But when their anti-inflationary moves caused the unemployment rate to rise to 6.5 percent or 7 percent, they forgot their promises and again began expanding the money supply and reducing interest rates. By 1979, reported rates of inflation, worsened by the oil shock, had reached double digits. Opinion polls showed that the public now considered inflation to be the main economic problem. President Jimmy Carter’s choice for chairman of the Fed, Paul Volcker, said that he would fight inflation more deliberately than his predecessors. The president agreed with him, as did the chairmen of the Congressional banking committees. With the public acceptance of the importance of low inflation, support in the administration and in Congress, and a chairman committed to the task, the Fed finally set out to correct what it had too long neglected. Instead of working only to avoid unemployment, the Fed sought to bring inflation back under control. Instead of flooding the market and banks with money, the Fed tightened its reserves. And instead of keeping interest rates in a narrow, relatively low range, Mr. Volcker let the market dictate the interest rate, allowing the prime rate to go as high as 21.5 percent. These disinflation policies continued in earnest with the 1980 election of Ronald Reagan. Even so, the public, having already seen three or four failed attempts to tame inflation, didn’t really believe that Mr. Volcker and President Reagan would stay the course. In my reading of the evidence, a decisive change in attitudes occurred only in the spring of 1981, when the Federal Reserve raised interest rates even though the unemployment rate was approaching 8 percent. This was new. This was different. People began to expect lower inflation and, in this belief, slowed the increase in wages and prices, contributing to the decline in actual inflation. Naturally, there were critics. But their criticisms were not strong enough to reverse policy. At the 1982 convention of the National Association of Home Builders, Paul

365 Volcker said that if he were to let up on anti-inflation efforts prematurely, “the pain we have suffered would have been for naught — and we would only be putting off until some later time an even more painful day of reckoning.” As always in periods of high interest rates, home builders had been especially badly hurt, but when the chairman finished his speech, they gave him a standing ovation. Though they disliked his policy, they admired his determination to do what was needed. The pain did not end. And the anti-inflation policy continued until the unemployment rate rose above 10 percent, many savings and loan institutions faced bankruptcy, and most Latin American countries defaulted on their debt. These were the unavoidable side effects of the public’s gradual adjustment to the new economic environment. This process continued until 1983, when the reported inflation rate fell below 4 percent. Paul Volcker is now the head of President Obama’s Economic Recovery Advisory Board. Mr. Volcker and the administration’s many economic advisers are all fully aware of the inflationary dangers ahead. So is the current Fed chairman, Ben Bernanake. And yet the interest rate the Fed controls is nearly zero; and the enormous increase in bank reserves — caused by the Fed’s purchases of bonds and mortgages — will surely bring on severe inflation if allowed to remain. Still, they all reassure us that they can reduce reserves enough to prevent inflation and they are committed to doing so. I do not doubt their knowledge or technical ability. What I doubt is the commitment of the administration and the autonomy of the Federal Reserve. Mr. Volcker was a very independent chairman. But under Mr. Bernanke, the Fed has sacrificed its independence and become the monetary arm of the Treasury: bailing out A.I.G., taking on illiquid securities from Bear Stearns and promising to provide as much as $700 billion of reserves to buy mortgages. Independent central banks don’t do what this Fed has done. They leave such fiscal action to the legislative branch. By that same token, Mr. Volcker’s Fed had to avoid financing the large (for that time) Reagan budget deficits to be able to bring down inflation. The central bank was made independent expressly so that it could refuse to finance deficits. But is there a political consensus that the much larger Obama deficits will not pressure the Fed to expand reserves to buy Treasury bonds? It doesn’t help that the administration’s stimulus program is an obstacle to sound policy. It will create jobs at the cost of an enormous increase in the government debt that has to be financed. And it does very little to increase productivity, which is the main engine of economic growth. Indeed, big, heavily subsidized programs are rarely good for productivity. Better health care adds to the public’s sense of well-being, but it adds only a little to productivity. Subsidizing cleaner energy projects can produce jobs, but it doesn’t add much to national productivity. Meanwhile, higher carbon tax rates increase production costs and prices but do not increase productivity. All these actions can slow productive investment and the economy’s underlying growth rate, which, in turn, increases the inflation rate. Some of my fellow economists, including many at the Fed, say that the big monetary goal is to avoid deflation. They point to the less than 1 percent decline in the consumer price index for the year ending in March as evidence that deflation is a threat. But this statistic is misleading: unstable food and energy prices may lower the

366 price index for a few months, but deflation (or inflation) refers to the sustained rate of change of prices, not the price level. We should look instead at a less volatile price index, the gross domestic product deflator. In this year’s first quarter, it rose 2.9 percent — a sure sign of inflation. Besides, no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation. When will it come? Surely not right away. But sooner or later, we will see the Fed, under pressure from Congress, the administration and business, try to prevent interest rates from increasing. The proponents of lower rates will point to the unemployment numbers and the slow recovery. That’s why the Fed must start to demonstrate the kind of courage and independence it has not recently shown. Milton Friedman often said that “inflation was always and everywhere a monetary phenomenon.” The members of the Federal Reserve seem to dismiss this theory because they concentrate excessively on the near term and almost never discuss the medium- and long-term consequences of their actions. That’s a big error. They need to think past current political pressures and unemployment rates. For the next few years, they cannot neglect rising inflation. Allan H. Meltzer, a professor of political economy at Carnegie Mellon University, is the author of “A History of the Federal Reserve.” Véase Allan H. Meltzer, “Inflation Nation”, NYT, 4/05/2009, disponible en: http://www.nytimes.com/2009/05/04/opinion/04meltzer.html?th&emc=th

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Opinion May 4, 2009 OP-ED COLUMNIST Falling Wage Syndrome By PAUL KRUGMAN Wages are falling all across America. Some of the wage cuts, like the givebacks by Chrysler workers, are the price of federal aid. Others, like the tentative agreement on a salary cut here at The Times, are the result of discussions between employers and their union employees. Still others reflect the brute fact of a weak labor market: workers don’t dare protest when their wages are cut, because they don’t think they can find other jobs. Whatever the specifics, however, falling wages are a symptom of a sick economy. And they’re a symptom that can make the economy even sicker. First things first: anecdotes about falling wages are proliferating, but how broad is the phenomenon? The answer is, very. It’s true that many workers are still getting pay increases. But there are enough pay cuts out there that, according to the Bureau of Labor Statistics, the average cost of employing workers in the private sector rose only two-tenths of a percent in the first quarter of this year — the lowest increase on record. Since the job market is still getting worse, it wouldn’t be at all surprising if overall wages started falling later this year. But why is that a bad thing? After all, many workers are accepting pay cuts in order to save jobs. What’s wrong with that? The answer lies in one of those paradoxes that plague our economy right now. We’re suffering from the paradox of thrift: saving is a virtue, but when everyone tries to sharply increase saving at the same time, the effect is a depressed economy. We’re suffering from the paradox of deleveraging: reducing debt and cleaning up balance sheets is good, but when everyone tries to sell off assets and pay down debt at the same time, the result is a financial crisis. And soon we may be facing the paradox of wages: workers at any one company can help save their jobs by accepting lower wages, but when employers across the economy cut wages at the same time, the result is higher unemployment. Here’s how the paradox works. Suppose that workers at the XYZ Corporation accept a pay cut. That lets XYZ management cut prices, making its products more competitive. Sales rise, and more workers can keep their jobs. So you might think that wage cuts raise employment — which they do at the level of the individual employer. But if everyone takes a pay cut, nobody gains a competitive advantage. So there’s no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy’s problems on other fronts.

368 In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don’t go down with your paycheck. America came into this crisis with household debt as a percentage of income at its highest level since the 1930s. Families are trying to work that debt down by saving more than they have in a decade — but as wages fall, they’re chasing a moving target. And the rising burden of debt will put downward pressure on consumer spending, keeping the economy depressed. Things get even worse if businesses and consumers expect wages to fall further in the future. John Maynard Keynes put it clearly, more than 70 years ago: “The effect of an expectation that wages are going to sag by, say, 2 percent in the coming year will be roughly equivalent to the effect of a rise of 2 percent in the amount of interest payable for the same period.” And a rise in the effective interest rate is the last thing this economy needs. Concern about falling wages isn’t just theory. Japan — where private-sector wages fell an average of more than 1 percent a year from 1997 to 2003 — is an object lesson in how wage deflation can contribute to economic stagnation. So what should we conclude from the growing evidence of sagging wages in America? Mainly that stabilizing the economy isn’t enough: we need a real recovery. There has been a lot of talk lately about green shoots and all that, and there are indeed indications that the economic plunge that began last fall may be leveling off. The National Bureau of Economic Research might even declare the recession over later this year. But the unemployment rate is almost certainly still rising. And all signs point to a terrible job market for many months if not years to come — which is a recipe for continuing wage cuts, which will in turn keep the economy weak. To break that vicious circle, we basically need more: more stimulus, more decisive action on the banks, more job creation. Credit where credit is due: President Obama and his economic advisers seem to have steered the economy away from the abyss. But the risk that America will turn into Japan — that we’ll face years of deflation and stagnation — seems, if anything, to be rising.

Paul Krugman, “Falling Wage Syndrome”, NYT, 4/Mayo/2009, disponible en: http://www.nytimes.com/2009/05/04/opinion/04krugman.html?th&emc=th

May 3, 2009, 12:46 pm Bank capital hocus-pocus Aha. When the proposal to bulk up bank capital by converting the government’s preferred shares into common equity came out, I pronounced myself baffled. But was I missing something? Via Henry Blodget, Paul Kasriel of Northern Trust says the same thing, in more detail. PS: Kasriel should be careful about hypothetical examples involving Gotham City Bank. I used Gothamgroup — and the legal department got a call from the Gotham Bank of New York, which had to be assured that it wasn’t about them.

369 May. 2, 2009, 9:23 AM Geithner's New Bank Fix Is Bogus, Too

Henry Blodget Tim Geithner has a clever new way to "recapitalize" banks that fail the stress test: Convert the taxpayer's preferred stock to common stock. From Geithner's perspective, this technique has several advantages: • The banks will suddenly seem healthy, because their assets-to-common equity ratios will rise. • Geithner doesn't have to ask Congress for more baillout money yet. • Taxpayers won't understand that they're giving up a nice dividend and a safer security just to make the banks look better. • If Geithner is right that what's wrong with the banks is just a temporary liquidity problem, the taxpayer should do well when the stocks rise. (We don't think he's right.) Unfortunately, the plan also has two major flaws: First, it's smoke and mirrors. Second, the taxpayers will be even more exposed to losses than they are now. Why? Because the banks will still have the same amount of crap assets on their balance sheets, and they'll have no more capital available to absorb these losses when they hit. The only thing that will change is that the taxpayer will now get hit first as these losses flow through, instead of getting hit second, as is the case now. The banks' bondholders, meanwhile, will still be protected to the tune of 100 cents on the dollar (by administration policy). If the common equity is wiped out by the losses, therefore, the government will have to dig into the taxpayer's pockets to cover any shortfall. (See Paul Kasriel's detailed explanation below). In other words, Geithner has hatched yet another plan to avoid dealing with the bank problem once and for all. How would he do that? As we've argued, we think the best way would have been to seize the banks and restructure them. Since Geithner has opted against the route, however, the next best way would be to convert unsecured bank debt to equity, not just the taxpayers' preferred stock (the taxpayers' preferred stock should have been senior to all the bondholders, but that's spilt milk at this point). Converting actual debt to equity would give the banks a much bigger cushion with which to absorb losses. It would split the bank ownership up among current common shareholders, taxpayers, and current debtholders, which would help Geithner avoid having to take full control. It would also, finally, stop exposing the taxpayer to further losses. The idea that bondholders should share the bank pain is finally gaining some momentum. Let's hope that continues in the coming weeks.

Why is Geithner's new plan just "accounting alchemy?" Paul Kasriel “Preferred Equity into Common Equity – Accounting Alchemy?” April 27, 2009 Northern Trust Global Economic Research

370 df > Consider Balance Sheet One of hypothetical Gotham City Bank. Assets equal liabilities plus common equity.

But suppose the Treasury believes that Gotham should have a ratio of common equity to total assets of 10% rather than the 5% it currently has. No problem. Treasury will just convert $5 of the preferred shares it owns in Gotham to $5 of common equity. This is shown in Balance Sheet Two. Now Gotham is well capitalized, right? Wrong. The depositors and the bond holders always were in line in front of the preferred shareholders in case Gotham had to be liquidated. So, moving $5 from the preferred equity category to the common equity category does not make the depositors and bond holders any better off. Are taxpayers any worse off? Not really. If Gotham’s original $5 of common equity was not going to be enough of a cushion to protect depositors and bondholders, then taxpayers were not going to get all of their preferred-share holdings back anyway.

Now suppose that $30 of Gotham’s loans and investments become uncollectible, as shown in Balance Sheet Three. This means that all of Gotham’s common equity has been wiped out. Infact, Gotham now has an equity “deficiency” of $20. No problem, according to Treasury. It will simply convert its remaining $10 of preferred equity to common equity. That won’t cut it in this case. As shown in Balance Sheet Four, Gotham still has a common equity deficiency of $10. In other words, if Gotham were to be liquidated, there are only $70 of assets to pay off $60 of deposits and $20 of bonds. Either the Treasury would have to come up with $10 of new funds or bondholders would have to take a 50% haircut. If the Treasury wanted to keep Gotham open and with a ratio of common equity to total assets of 10%, Treasury would have to inject $17 of new funds, all of which would be common equity. In other words, Treasury, meaning us taxpayers, would own 100% of Gotham.

371 In sum, Treasury’s plan to enhance the capitalization of some financial institutions by beating preferred equity shares into common equity shares is accounting alchemy. Geithner's New Bank Fix Is Bogus, Too Henry Blodget http://www.businessinsider.com/henry-blodget-geithners-new-bank- capital-plan-is-bogus-too-2009-5

Bailouts Of Bondholders Will Sock Taxpayers With $10-$14 Trillion Loss

Hooray! Obama Finally Considering Swapping Bank Debt For Equity*

372 Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework - Comprehensive Version. Part 2 June 2006 http://www.bis.org/publ/bcbs128b.pdf

4. Hybrid debt capital instruments

49(xi). In this category fall a number of capital instruments which combine certain characteristics of equity and certain characteristics of debt. Each of these has particular features which can be considered to affect its quality as capital. It has been agreed that, where these instruments have close similarities to equity, in particular when they are able to support losses on an on-going basis without triggering liquidation, they may be included in supplementary capital. In addition to perpetual preference shares carrying a cumulative fixed charge, the following instruments, for example, may qualify for inclusion: long-term preferred shares in Canada, titres participatifs and titres subordonnés à durée indéterminée in France, Genussscheine in Germany, perpetual debt instruments in the United Kingdom and mandatory convertible debt instruments in the United States. The qualifying criteria for such instruments are set out in Annex 1a.

5. Subordinated term debt

49(xii). The Committee is agreed that subordinated term debt instruments have significant deficiencies as constituents of capital in view of their fixed maturity and inability to absorb losses except in a liquidation. These deficiencies justify an additional restriction on the amount of such debt capital which is eligible for inclusion within the capital base.

Consequently, it has been concluded that subordinated term debt instruments with a minimum original term to maturity of over five years may be included within the supplementary elements of capital, but only to a maximum of 50% of the core capital element and subject to adequate amortisation arrangements.

373 04.05.2009 Lessons of the Global Financial Crisis: 1. The End of Ponzi Prosperity By: Satyajit Das

We Are All Keynesians Now! In January 1971, Richard Nixon recanted years of opposition to budget deficits declaring: "Now, I am a Keynesian." Nixon had borrowed the line from Milton Friedman who had used it in 1965. Then, we embraced Monetarism and flirted with "supply side" economics, christened "voodoo economics" by President George Bush Senior. Now, in the wake of the Global Financial Crisis ("GFC"), it seems that we are all Keynesians again. The GFC is really a "Minsky moment". In Stabilizing an Unstable Economy (1986), Hyman Minsky outlined a hypotheses that excessive risk taking, driven in part by stability lead to market breakdowns - stability is itself destablising. The current crisis is financial, economic, social and increasingly ideological. Nikolas Sarkozy, President of France, has pronounced the death of laissez-faire capitalism: "c’est fini". World leaders have penned fevered attacks on neo-liberalism. Even religious leaders have spoken out. Dead economists have been resurrected in support of political positions. As Keynes himself observed: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back." No "pure" economic model has been implemented in living memory, except perhaps in North Korea. The theories themselves rarely work. John Kenneth Galbraith is reported as saying: "Milton’s [Friedman’s] misfortune is that his policies have been tried." Criticisms of the ancien regime are substantive and deserved. There have been undoubtedly egregious market failures, management excesses and errors in the lead up to the GFC. But the key lessons of the crisis may be subtler than first evident.

374 Growth has been driven by cheap and abundant debt and uncosted carbon emissions and other forms of pollution. The reality is that this period of growth may be coming to an end. All brands of politics and economics have been informed by assumptions about the sustainability of high levels of economic growth and the belief that governments and central bankers can exert a substantial degree of control over the economy. Harry Johnson, the famed Chicago economist, writing about England in the 1970s with his wife Elizabeth in (1978) The Shadow of Keynes provides a vivid description of this pre-occupation: "…faster economic growth is the pancea for all..economic and for all that matter political problems and that faster growth can be easily achieved by a combination of inflationary demand-managementpolocies and poltically appealing fiscal gimmickry." Goldilocks Economy P.J.O’Rourke writing in Eat The Rich (1998) observed that: "Economics is an entire scientific discipline of not knowing what you’re talking about." Recent global prosperity derived from a fortunate confluence of low inflation and low interest rates. In the 1980s, brutally high interest rates and recessions squeezed inflation out of the economy facilitating lower interest rates. Low energy prices, following the first Gulf War, helped keep inflation low and fuelled growth. The fall of the Berlin Wall in 1989 and the reintegration of the command economies of Eastern Europe, China and India into global trade provided low cost labour helping maintain the supply of cheap goods and services. Emerging economies provided substantial new markets for products and capital driven by the very high levels of savings in these countries. Deregulation of key industries, such as banking and telecommunications, fostered growth by increasing access to finance and improved essential infrastructure. Adoption of new technologies, such as information technology and the Internet, improved productivity and assisted growth, though the extent is disputed. Many countries switched from employer or government pension schemes to private retirement saving arrangements underwritten by generous tax incentives. Rapid growth in this pool of investment capital was also a factor in growth. Governments, irrespective of political persuasion, benefited from the favourable economic environment. The ability of governments and central banks to control and "fine tune" the economy with a judicial mixture of monetary and fiscal policy became an article of accepted faith. Voters were lulled into false confidence by a mixture of rising wealth, improved living standards and stability. Elegant theories about the "Great Moderation" or "Goldilocks Economy", with the benefit of hindsight, seem to be little more than narrative fallacies where a convincing but meaningless story is shaped to fit unconnected facts and coincidence is confused with causality. Ponzi Prosperity Growth, in reality, was founded on a series of elegant Ponzi schemes. Consumption rather than investment drove growth, particularly in the developed world. Debt fuelled consumption became the norm. In the new economy, there were

375 three kinds of people – "the haves", "the have-nots", and "the have-not-paid-for-what- they-haves". The consumption was financed by borrowings supplied by a deregulated financial system. Many workers’ earnings fell in inflation adjusted terms as a result of global competition and associated outsourcing and off shoring practices. The ability to borrow against the appreciation in owner occupied houses and other financial assets underpinned consumption. Investors, central banks with large reserves, pension funds and asset managers channeling privatised retirement savings, eagerly purchased the debt. Borrowing fueled higher asset prices allowing even greater levels of borrowing against the value of the asset. This virtuous cycle – a "positive feedback loop" – fueled the "doctor feel good" economy of recent years. "Financial engineering" replaced "real engineering" in many countries. Entire cities (London and New York) and economies (Iceland) become dominated by the rapidly growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10% in the early 1980s to 40% in 2007. The stockmarket value of financial services firms increased from 6% in the early 1980s to 23% in 2007. The reliance on financial innovation proved disastrous. In A Short History of Financial Euphoria (1994), John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version." Financially engineered growth extended into international trade flows. Since the 1990s, there has been a substantial build-up of foreign reserves in central banks of emerging markets and developing countries that became the foundation for a trade finance scheme. Many global currencies were pegged to the dollar at an artificially low rate, like the Chinese Renminbi, to maintain export competitiveness. This created an outflow of dollars (via the trade deficit driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers purchased US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flowed back to the US to finance the spending on imports. The process relied on the historically unimpeachable credit quality of the USA and large, liquid markets in dollars and dollar investments capable of accommodating the very large investment requirements. This merry-go-round kept US interest rates and cost of capital low encouraging further borrowing to finance consumption and imports to keep the cycle going. Foreign central banks holding reserves were lending the funds used to purchase goods from the country. The exporting nations never got paid at least until the loan to the buyer (the vendor finance) was paid off. Essentially, growth in global trade was also debt fuelled. Moderate debt levels are sustainable provided the value of the asset supporting the borrowing is stable and significantly higher than the amount of the loan. The borrower or the collateral for the loan must generate sufficient income to service and repay the

376 borrowing. In the frenzied market environment of low interest rates and ever rising asset prices, the level of collateral cover and ability to service the loans deteriorated sharply. In 2005, rising interest rates and a cooling in the US housing market set the stage for the GFC. Sigmund Freud once remarked that: "Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces." The GFC was the reality on which the fake pleasure of the Great Moderation and Goldilocks economy was smashed. Taking the Cure There is currently confusion between the disease and the cure. The "disease" is the excessive debt and leverage in the financial system, especially in the US, Great Britain, Spain and Australia. The "cure" is the reduction of the level of debt that is now underway (the great "de-leveraging"). The initial phase of the cure is the reduction in debt within the financial system. Some of the debt created during the Ponzi prosperity years will not be repaid. Non- repayment of this debt, in turn, has caused the failure of financial institutions. The process destroys both existing debt and also limits the capacity for further credit creation by financial institutions. Total losses from the GFC to financial institutions, according the latest estimates, will be in excess of US$ 2 trillion. Banks need additional capital to cover assets that were parked in the "shadow banking system" (the complex of off-balance sheet special purpose vehicles) but are now returning to the mother ship’s balance sheet. The global banking system, in aggregate, is close to technically insolvent. Commercial sources for recapitalisation are limited as losses mount and the outlook for the financial services industry has deteriorated. Government ownership or de facto nationalisation is the only option to maintain a viable banking system in many countries. Even after recapitalisation the capital shortfall in the global banking system is likely to be around US$ 1-3 trillion. This equates to a forced contraction in global credit of around 20-30% from existing levels. The second phase of the cure is the effect on the real economy. The problems of the financial sector have increased the cost and reduced availability of debt to borrowers for legitimate business purposes. The scarcity of capital means that banks must reduce their balance sheets by reducing their stock of loans. Normal financing and loans are now being effectively rationed in global markets. This forces corporations to reduce leverage by cutting costs, selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption. "Negative feedback loops" mean reduction in investment and consumption lowers economic activity, placing stresses on corporations and individuals setting off bankruptcies that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt.

377 Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages. The process echoes Joseph Schumpter’s famous maxim of "creative destruction". © 2009 Satyajit Das All Rights reserved. Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall). This article draws on the ideas first published in Satyajit Das "Built to Fail" in The Monthly (April 2009) 8-13 Véase Satyajit Das, “Lessons of the Global Financial Crisis: 1. The End of Ponzi Prosperity”, 4/05/2009, disponible en: http://www.eurointelligence.com/article.581+M553774d2c37.0.html

06.05.2009 Lessons of the Global Financial Crisis: 2. Whatever it takes By: Satyajit Das

The severity of the crisis was underestimated initially. Ben Bernanke, Chairman of the US Federal Reserve in March 2007 stated during Congressional Testimony: "At this juncture, the impact on the broader economy and financial markets of the problems in the sub-prime market seems likely to be contained." In April 2007 US Treasury Secretary Henry Paulson delivered an upbeat assessment of the economy: "All the signs I look at show the housing market is at or near the bottom… The U.S. economy is very healthy and robust." The grande mal seizure of financial markets in September and October 2008, with the bankruptcy of Lehman Brothers, a large US investment bank and near collapse of AIG, the world’s largest insurance group, highlighted the seriousness of the problems. Since then national and international "committees to save the world" have implemented a bewildering and ever changing array of measures to try to stave of economic collapse. The actions – dubbed WIT ("What it Takes") by Gordon Brown, the English Prime Minister - have been focused on trying to stabilise the financial system and maintaining growth in the real economy. Governments and central banks have moved to remove toxic debt from bank balance sheets, inject share capital to cover losses from bad debts and also guaranteed the bank’s own borrowings to allow them to continue to raise deposits and borrow. Bank of England Governor Mervyn King recently summed up the nature of the UK’s support for the banking system memorably: "The package of measures announced yesterday by the

378 Chancellor are not designed to protect the banks as such. They are designed to protect the economy from the banks." Governments have provided large amounts fiscal stimulus and support for the housing market (in the US). In addition to the normal "automatic stabiliser" effects of reduced tax income and higher social welfare spending in a recession that push budgets into deficit, governments have launched new spending initiatives focused on infrastructure and direct payments to those most affected by effects of the GFC. Central banks have cut interest rates to levels not seen for decades. It is not clear whether the actions taken will have the intended effect. As John Kenneth Galbraith noted: "In economics, hope and faith coexist with great scientific pretension". King Canute Addresses the Waves The pretence of global co-ordination in policy responses, reiterated at increasingly frequent G20 summits, does not accord with the reality of individual actions. Ireland’s anxious reaction to a "run" on Irish banks prompted a blanket government guarantee on bank deposits. This, in turn, led to a flight to Irish banks forcing the implementation of similar arrangements in other countries. The "electronic herd" did not notice that Ireland was guaranteeing deposits totaling over 200% of its own gross domestic production ("GDP") calling into question its ability to honour these commitments if called. There have been constant shifts in policy. TARP might well stand for Temporary Asset Relief Program (rather than its real name - Troubled Asset Relief Program) as there have been a succession of wholesale changes in the strategy. The financial initiatives have not led to a significant easing of credit conditions. This reflects the fact that the capital provided is only sufficient to cover continuing losses but insufficient to restore normal lending and financial activity. Money supplied to banks is not flowing into the real economy. Banks need funds to pay off maturing borrowings of their own as well support assets coming back onto their balance sheet (known by another three letter acronym - IAG - involuntary asset growth). Companies have also drawn down debt facilities, as their own financial position has deteriorated, requiring the banks to finance these requirements. Governments and central bankers have become frustrated at the failure of policy actions to help the resumption of normal financial activity. Where governments have taken substantial stakes in banks, there is a noticeable drift to "directed lending". Central banks and governments are increasingly bypassing the banking system and providing finance directly to businesses. The Federal Reserve may soon issue credit cards to all Americans under its own brand. The debates miss the point that debtors still have too much debt and are not able to service it. Until the debt is written down and restructured, credit growth may not resume. In the TARP Oversight Panel Report of 8 April 2009, Professor Elizabeth Warren observed: "Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury’s …. approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from non-functioning markets for troubled assets. On the other hand, it is possible that Treasury’s approach fails to acknowledge

379 the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth". The stimulus packages create different challenges. Well-intentioned infrastructure spending will take some time to have any meaningful effect. Skill shortages in key areas of expertise may slow down implementation. The need to avoid "leakage" where spending flows to overseas recipients in a globalised world is also paramount politically. The return on inadequately targeted infrastructure investment is also not necessarily high. Governments must also borrow to finance their spending. Many countries implementing fiscal stimulus packages already have large budget deficits and also substantial levels of outstanding public debt. In 2009, governments around the world will have to issue US$3 trillion in debt. The US alone will need to issue around US$ 2 trillion in bonds (a staggering US$40 billion a week!). This compares to around US$400-500 billion of annual debt that the US has issued in recent years. This debt must be issued at record low interest rates. China, Japan, Europe and other emerging countries have been major buyer of this debt. It is not clear whether they will continue to buy US government bonds, at least at previous levels. Wen Jiabao, China’s prime minister, provided a reminder of the importance of this issue in February 2009: "Whether China will continue to buy, and how much to buy, should be in accordance with China’s needs, and depend on the safety and protection of value of foreign exchange." Yu Yongding, a former adviser to the Chinese central bank, recently sought guarantees that the value of China’s US$682 billion holdings of US government debt won’t be eroded by "reckless policies". He asked that the US "should make the Chinese feel confident that the value of the assets at least will not be eroded in a significant way." At best, the tsunami of government debt may crowd out other borrowers exacerbating existing financing problems. At worst, there is a risk of a collapse of the growing "bubble" in government debt markets as investors refuse to purchase debt at current rates triggering additional losses. In January 2009, long-term interest rates moved up sharply as markets started to absorb the import of government initiatives. As James Carville, Bill Clinton’s campaign manager, once noted: "I want to come back as the bond market. You can intimidate everybody." Current initiatives resemble the "hair of the dog that bit you" cure where ingestion of alcohol is the treatment for a hangover. The current problems can be traced to high levels of debt accumulated by banks, consumers and companies. In effect, this debt is now being replaced by government debt. Simultaneously, the debt fueled consumption of consumers and companies is being replaced by debt funded government expenditure. Adjustment in the level of debt and asset prices is part of process of through which the global economic system re-establishes itself. Governments and central banks can smooth the transition but they cannot prevent the necessary adjustments taking place. Like King Canute, central bankers and finance ministers cannot hold back the tide.

Multiplication by Zero

380 Like an athlete using drugs to enhance performance, the global economy used debt and financial engineering to enhance global growth. Increasing stimulus was needed to maintain performance in an unsustainable Ponzi scheme. The removal of performance enhancing drugs has exposed fundamental weaknesses. A simple way to think about value in the global economy is in terms of Irving Fisher’s transaction equation: Real Economy = Financial Economy Where Real Economy = Quantity of Good times Price of Goods Financial Economy = Money Supply times Velocity of Money Therefore: Quantity of Good times Price of Goods = Money Supply times Velocity of Money The financial economy represents claims on the earnings and cash flows (both current and future) from producing and selling real goods and services. The financial economy consists of the money available and how rapidly the money can be circulated through the global economy (velocity). Banks provide much of the velocity of money in the economy through its borrowing and lending activities where a small amount of capital is leveraged to create larger amounts of money in the form of debt. Recent economic prosperity was primarily driven by growth in the financial economy – increased money supplied by central banks augmented the rapid growth of and innovation of financial techniques within the banking system that increased the velocity of circulation. This increased the value of the real economy by increasing prices and also stimulating the expansion in the supply of goods and services. The GFC has sharply reduced the financial economy, specifically it has decreased the velocity of money. As any student of mathematics knows anything multiplied by zero is itself zero. The reduction in the financial economy necessitates a corresponding reduction in the real economy, initially in prices and ultimately by reducing the quantity of real goods and services. Falling prices of financial assets (claims on real goods and services) and, more recently, reductions in production volumes reflect the required economic adjustment process. Government actions, however well intentioned, seem primarily to be based on the recognition that Ponzi or pyramid games are only bad if they end. All efforts are now seemingly directed at keeping the game going for as long as possible! In 1976, James Callaghan, the Prime Minister, delivered the following grim assessment of Britain’s economic situation that is still relevant today: "We have been living on borrowed time. We used to think you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candor that that option no longer exists." Government actions, however well intentioned and significant, may entail pouring water into a bottomless bucket. This article draws on the ideas first published in Satyajit Das "Built to Fail" in The Monthly (April 2009) 8-13

381 Politics May 4, 2009 Tests of Banks May Bring Hope More Than Fear By DAVID LEONHARDT The results of the bank stress tests to be released by the Obama administration this week are expected to include more detailed information about individual banks — assessing specific parts of their loan portfolios — than many analysts have been expecting. Using these results, the administration seems prepared to argue that, while a few banks may need additional money, the broad financial system is healthier than many investors fear. At the core of the test will be a judgment about whether each of the country’s 19 biggest banks has enough money to withstand a deep recession and, if not, how much more capital it needs to be able to lend at a healthy pace, according to regulators. Unless regulators change course this week, the tests are also likely to forecast potential losses in individual slices of the credit markets, like residential mortgages, credit card loans and commercial loans, for each bank over the next two years. The administration is expected to make the case that the needs of the troubled banks can be met with the bailout funds that Congress has already approved. That would be a departure from what administration officials were saying as recently as March and evidently reflects the recent improvement in banks’ conditions. “None of these banks are insolvent,” said a senior government official, who did not want to be identified before the public release of the test results. The official added: “These are manageable losses.” The stress tests are one more example of the extraordinary ways that the government is intervening in the economy, to cushion the blow from the current financial crisis and recession. Having already propped up the credit markets and the automobile industry, officials are now putting the finishing touches on an exercise with no obvious precedent. On Thursday afternoon, regulators expect to publish an analysis of the banks’ assets, akin to a sprawling research report written by a Wall Street analyst but one that comes with the government’s imprimatur. In effect, Treasury Department and Federal Reserve regulators will be handing over information to investors so that they can decide which banks they want to invest in — and which will ultimately need more bailout money. The analysis could become a template for future financial regulation. One way or the other, the stress tests have the potential to be a turning point in the financial crisis. If the tests fail to instill confidence, it will be the clearest sign to date that economists who have criticized the administration may be right that its rescue plan has not been aggressive enough.

382 President Obama may then need to ask a wary Congress for billions of extra dollars to shore up the credit system and perhaps even take over one or more large banks. Such moves, coming just after the administration offered a hopeful picture, could create political difficulties. But if the test results can persuade investors that many banks are in the early stages of recovery, investors may then become more willing to invest in relatively healthy firms, like Goldman Sachs and JPMorgan Chase, which, in turn, would become more comfortable making loans. “Everything has been in limbo, waiting for the stress tests to get out of the way,” Louis Crandall, chief economist at Wrightson ICAP, a research firm. With the results, Mr. Crandall said, “we’ll start to get a sense for the extent to which the financial system can recapitalize itself.” In particular, the administration may use the data from the tests to argue that many banks now have a greater cushion than they did in past financial crises, like the Latin American debt crisis of the 1980s. Then, some banks in the United States appeared to be insolvent, only to recover. The banks whose reserves are judged insufficient — Bank of America, Citigroup and a few regional banks lead the list of likely suspects — will be given six months to shore up their position, before being required to accept government money. The most obvious ways to do so will be to find new investors willing to buy a stake or to persuade existing owners of preferred stock (which is akin to a loan) to renegotiate their stakes. Another possibility is that the government may encourage significant cost-cutting. That could lead to layoffs and leave some of the world’s largest companies far smaller than they once were. Last week, Citigroup agreed to sell a brokerage firm to a Japanese financial group, largely to raise capital. Administration officials have said they will not allow any large bank to fail even if the economy takes another turn for the worse and they must go back to Congress for more money. Banks that are deemed to be healthy would be given the chance to repay the money they borrowed from the government last year if they met certain conditions. The conditions could include showing that they would still be healthy after the repayment; could issue long-term unsecured debt without government guarantees; and could raise money in equity markets. Repayment would allow the Treasury to reuse the money to help weaker banks. Of the $700 billion that Congress and the Bush administration set aside last year in the Troubled Asset Relief Program, only about $130 billion remains in Treasury coffers. One outstanding question is how tough Timothy F. Geithner, the Treasury Secretary, and other officials will be on the banks they judge to be weak. The government has delayed the release of the results from Monday, and bank executives are arguing for a more lenient approach. The Obama administration has angered Wall Street with some of its early steps, but it has also proven unable to be as tough as it initially suggested on several occasions. Last week, at the urging of Wall Street, the Senate defeated a bill that would have made it easier for homeowners to avoid foreclosure.

383 The administration’s critics worry that the stress tests will follow this pattern. They say that Mr. Obama and his advisers either have too rosy a view, or are stalling — and pretending to be somewhat optimistic, even as the banks’ problems fester — until they think Congress is willing to approve more bailout money. One of the critics’ concerns is that the stress tests — originally meant to show investors whether banks could survive an unexpectedly bad next two years — no longer seem to have an extremely dark forecast. As job losses have mounted, some economists’ forecasts for unemployment and growth have come to resemble the stress test’s assumptions. There are signs, though, that the assumptions will be tough enough to satisfy some skeptics. Jan Hatzius, a Goldman Sachs economist, has a more pessimistic outlook than many forecasters, and he said that he initially thought the stress tests would not take a sufficiently dark view. “But we are changing our mind about this,” he wrote in a note to clients last week. The tests now seem likely to assume loan-default rates higher than those of the Great Depression. Putting together a plan for the financial system to withstand such losses, Mr. Hatzius wrote, “would be a big step toward a resolution of the crisis.” http://www.nytimes.com/2009/05/04/us/politics/04stress.html?pagewanted=2&_r=1&th &emc=th

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Las inmobiliarias bajan precios para contener la competencia de la banca Las ofertas con financiación incluida agravan las dificultades de las promotoras LLUÍS PELLICER - Barcelona - 04/05/2009 La guerra de precios ya no es sólo cosa del gran consumo. También ha llegado al sector inmobiliario. La entrada de cajas y bancos en la venta de viviendas con ofertas que incluyen, además de grandes descuentos, facilidades en la financiación, ha arrastrado a las promotoras a realizar agresivas campañas de descuentos. La guerra de precios ya no es sólo cosa del gran consumo. También ha llegado al sector inmobiliario. La entrada de cajas y bancos en la venta de viviendas con ofertas que incluyen, además de grandes descuentos, facilidades en la financiación, ha arrastrado a las promotoras a realizar agresivas campañas de descuentos. Metrovacesa se lleva la palma con bajadas de precios que llegan al 55%. O Habitat, en proceso concursal, que publicita recortes del 32%. Pero también otras empresas menos conocidas tratan de deshacerse de su stock con pisos entre un 40% y un 60% más baratos. Otra vuelta de tuerca. La patronal de las inmobiliarias ha acusado a cajas y bancos de "competencia desleal". No sólo por anunciar a bombo y platillo grandes descuentos sobre el valor de tasación de los pisos que venden, sino especialmente por ofrecer mejores condiciones de financiación para la compra de sus viviendas. Las inmobiliarias han decidido lanzar grandes descuentos, más allá del 20% que dicen estar rebajando ya. Metrovacesa cerró la semana pasada una campaña en la que había pisos un 55% más baratos. Los descuentos en Madrid eran de hasta el 30%; en Barcelona, del 35%, mientras que en la Comunidad Valenciana y Andalucía iban del 40% al 55%. La inmobiliaria vendió en apenas dos semanas un tercio de las 247 viviendas de la promoción. Fuentes de la compañía explican que no es la primera vez que realizan estas campañas, y agregan que sacaron a la venta los últimos pisos sin vender de sus promociones. Aun así, en la página web había multitud de pisos de la misma promoción. No sólo siguen esta estrategia las grandes compañías. La consultora Roan se inventó un rastrillo de pisos en su sucursal del paseo de la Castellana. Unas 5.700 personas acudieron allí en cuatro días para interesarse por 500 viviendas en Madrid y la costa mediterránea que estaban en manos de promotores, particulares y entidades financieras. La consultora ha cerrado 184 ventas, pero prevé llegar a las 300. La empresa piensa montar más rastrillos en otras ciudades. El consejero de la consultora Real Estate Marketing, Jorge Rodríguez, explica que las promotoras concentran ahora su estrategia en el descuento directo. "La incorporación de un nuevo agente [los bancos] ha acelerado el proceso y estamos viendo campañas muy agresivas. Pero, ¿hasta dónde están dispuestos a perder unos y otros?", asegura. El directivo de una conocida promotora catalana dice que los descuentos dan resultados. "Modestos, pero resultados, si son grandes y sobre todo visibles", afirma. Y agrega que están viendo que el comprador comprueba que no sean un simple reclamo, sino reales.

385 El grupo Ternum ha captado 1.000 viviendas para sacarlas al mercado con una rebaja sobre el precio final de entre el 35% y el 40%. La única condición es estar separado de la pareja. Durante el primer año, además, el comprador no tiene que pagar nada. Su consejero delegado, Daniel Millán, asegura que están cerrando la incorporación de entre unos 5.000 pisos más a su cartera. Otra fórmula por la que se decantan los promotores es la de la subasta. Las que celebra la consultora CB Richard Ellis, por ejemplo, cuenta con pisos de empresas y entidades financieras. Más del 70% son de obra nueva, y los descuentos llegan al 45%. "Los promotores están abiertos a los descuentos, pero es complicado que bajen el precio más allá de la deuda que ellos tienen contraída con la banca. Ahí bancos y cajas lo tienen mejor", asegura Emilio Miravet, directivo de la consultora. http://www.elpais.com/articulo/economia/inmobiliarias/bajan/precios/contener/compete ncia/banca/elpepueco/20090504elpepieco_3/Tes

El PP pide que el Estado no pueda emitir deuda opaca AGENCIAS - Madrid - 04/05/2009 El PP ha registrado una proposición no de ley en el Congreso de los Diputados en la que pide que el Estado renuncie a emitir deuda opaca fiscalmente, en la que no conste la identidad del tenedor, y que esta práctica quede vetada. Se trata de deuda que se suele colocar en paraísos fiscales. Los populares quieren que el Gobierno presente ante la Cámara un proyecto de ley que elimine la posibilidad de realizar ese tipo de emisiones. El PP justifica la iniciativa en que estas prácticas chocan con las directrices pactadas en la última cumbre del G-20, celebrada en Londres. Así, señala que si el Gobierno mantiene la normativa que permite captar fondos en los paraísos fiscales, "sólo desea combatir" la existencia de los mismos "en teoría, pero no en la práctica". La iniciativa pretende, además, que se suprima el artículo 4 del real decreto de medidas de impulso a la actividad económica de abril de 2008. El Gobierno aprobó entonces un paquete de 11 medidas destinadas a impulsar la actividad económica y a aliviar la situación de familias y empresas. Entre otras cosas, se preveía atraer inversión extranjera mediante la mejora de la fiscalidad de la deuda pública y de otros instrumentos de renta fija para no residentes. Así, se aprobó ampliar la exención de pago de impuesto a los rendimientos derivados de deuda pública obtenidos en paraísos fiscales. http://www.elpais.com/articulo/economia/PP/pide/Estado/pueda/emitir/deuda/opaca/elpe pueco/20090504elpepieco_4/Tes

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EDITORIAL Locomotoras gripadas La crisis de nuestros principales clientes dificulta la recuperación por la vía del sector exterior 04/05/2009 La recuperación de la economía española tendrá que esperar a que salgan de la recesión las principales del mundo, las tradicionalmente consideradas locomotoras del crecimiento, como Alemania, Japón y EE UU. Es lo que se deduce de la revisión de las previsiones que se han hecho públicas estos días, dada la ausencia de factores propulsores autónomos de la economía española. Desplomado el sector de la construcción residencial y dominado el conjunto de la actividad empresarial por la persistencia de severas restricciones crediticias, la economía española camina hacia una contracción del PIB superior al 3%, con niveles de desempleo sin precedentes. No será fácil que para el conjunto de 2010 se entre en una zona de crecimiento. Con la demanda interna por los suelos, la única vía de contribución al despegue descansa en la demanda exterior: en las compras de bienes y servicios de nuestros principales socios. Pero el conjunto de la eurozona no va a crecer más que España en este año. El Gobierno de Alemania acaba de admitir que la contracción en el PIB de este año estará en el entorno del 6% (frente a una previsión del 2,25% en enero), convirtiéndolo en uno de los peores registros de las grandes economías y de la propia historia económica germana. Una parte sustancial de ese retroceso se debe al brusco descenso de las exportaciones tras una década en la que la economía germana había resistido la competencia de las potencias emergentes de Asia. Las previsiones que auguraban una mayor resistencia a la crisis de las economías menos dependientes de la combinación entre exceso de actividad inmobiliaria y endeudamiento hipotecario no se han verificado. Alemania es uno de los países menos afectados por esos problemas, lo que no le ha librado de convertirse en una de las economías en más acelerado retroceso. La globalización tomada en serio tiene estos efectos: la recesión global daña el potencial exportador incluso de las economías más equilibradas. Ocurre también en Japón. La única de las tres grandes que puede anticipar su recuperación es la economía estadounidense. De la estimación del crecimiento de su PIB en el primer trimestre emergen algunas señales favorables, fundamentalmente las vinculadas al comportamiento del consumo, apoyadas en la mejora de los indicadores de confianza. El liderazgo de EE UU en el abandono de la recesión será la consecuencia de la inequívoca orientación de sus políticas de demanda (la monetaria y la presupuestaria) a la neutralización de sus efectos sobre el desempleo, al tiempo que tratan de fortalecer las deficiencias en la base de capital público que esa economía venía arrastrando. Ello no impedirá la definición de un plan orientado a la reconducción de los desequilibrios resultantes como efectos secundarios de esas terapias expansivas, una vez que la recesión quede neutralizada. Una lección a asimilar a este lado del Atlántico. http://www.elpais.com/articulo/opinion/Locomotoras/gripadas/elpepuopi/20090504elpe piopi_1/Tes

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TRIBUNA: POR ULRICH BECK La revuelta de la desigualdad El enriquecimiento rápido convirtió a muchos en dependientes de la droga del dinero prestado. Ahora los ricos poseen un poco menos, pero a los pobres no les alcanza para vivir. La situación es (pre)revolucionaria POR ULRICH BECK 04/05/2009 La revuelta de la desigualdad sacude al mundo entero: de Moscú a Helsinki, de Londres a Washington y de Berlín a Buenos Aires. En Internet encontramos páginas que invitan a quemar o a colgar a los banqueros. El centro mundial de las finanzas en Londres aconseja a las empresas que exhorten a sus trabajadores a no pasearse más en traje y corbata para evitar riesgos. Aquellos que parecían ejercer un control irrevocable sobre las finanzas mundiales son ahora percibidos y calificados despectivamente como "extraterrestres", se les considera como personas de otro planeta. Cuando se obstinan en seguir cobrando primas y obteniendo privilegios, entonces son ejecutados, por lo menos moralmente, en los debates televisivos. Y probablemente esto sólo acaba de empezar. A partir de diversos componentes se obtiene así una explosiva mezcla política y social. No sólo aumenta la desigualdad, tanto en el marco nacional como en el global, sino que, ante todo, el rendimiento y el ingreso se han desacoplado ya por completo a los ojos de la ciudadanía. O peor aún: en el contexto del desmoronamiento de las finanzas mundiales se ha producido en las esferas más altas del poder un acoplamiento perverso entre gestión ruinosa e indemnizaciones millonarias. El pequeño secreto, que no hace más que agudizar la amargura, consiste en que este enriquecimiento codicioso se ha realizado de forma absolutamente legal, pero atenta a la vez contra todo principio de legitimidad. La ira popular se enciende a causa de esta contradicción entre legalidad y legitimidad con la que la élite financiera ha incrementado fabulosamente su riqueza. Pero esta ira se enciende más aún, justamente, porque esta desproporción ha burlado todas las mediciones de los rendimientos y porque las leyes vigentes siguen encubriendo tan clamorosas desigualdades. Aquí también aparecen contradicciones en la apreciación. Unos dicen: necesitamos más impuestos para los que más ganan, ya que el mercado no está en condiciones de corregir sus propios excesos. Los otros consideran, según el viejo esquema, que esto no es más que una política de la envidia, y reclaman derechos que se apartan de las leyes. La consecuencia de ello es que el grito de dolor socialista reclamando la igualdad es proferido justamente desde el centro herido de la sociedad y halla repercusión por doquier. Pero esta conciencia de la igualdad no hace ahora más que alimentar las desigualdades sociales de un modo políticamente explosivo. Las desigualdades sociales se convierten en material conflictivo que se inflama con facilidad, no sólo porque los ricos siempre son más ricos y los pobres más pobres, sino sobre todo porque se propagan normas de igualdad que están reconocidas y porque en todas partes se levantan expectativas de igualdad, aunque al final queden frustradas.

388 Una quinta parte de la población mundial, la que se encuentra en peor situación (posee, en su conjunto, menos que la persona más rica del mundo), carece de todo: alimentación, agua potable y un techo donde cobijarse. ¿Cuál fue la causa de que, en estos últimos 150 años, este orden global de desigualdades mundiales se mostrara a pesar de todo como legítimo y estable? ¿Cómo es posible que las sociedades del bienestar en Europa pudieran organizar costosos sistemas financieros de transferencia en su interior sobre la base de criterios de necesidad y pobreza nacionales mientras que buena parte de la población mundial vive bajo la amenaza de morir de hambre? La respuesta es que éste es -o era- el principio de eficiencia que legitimaba las desigualdades nacionales. Quien se esfuerce será recompensado con bienestar, rezaba la promesa. A la vez, el Estado nación procuraba que las desigualdades globales se mantuvieran encubiertas y que pareciera que fueran legítimas e inalterables. Porque hasta entonces las fronteras nacionales separaban nítidamente las desigualdades políticamente relevantes de las irrelevantes. ¿Quién se preocupa por las condiciones de vida en Bangladesh o en Camboya? La legitimación de las desigualdades globales se basa así en el disimulo del Estado nación. La perspectiva nacional exime de mirar la miseria del mundo. Las democracias ricas portan la bandera de los derechos humanos hasta el último rincón del planeta sin darse cuenta de que, de ese modo, las fortificaciones fronterizas de las naciones, que pretenden atajar los flujos migratorios, pierden su base legítima. Muchos inmigrantes se toman en serio la igualdad predicada como derecho a la libertad de movimientos, pero se encuentran con países y Estados que, justamente por la presión de las crecientes desigualdades internas, quieren poner fin a la norma de igualdad en sus fronteras blindadas. La revuelta contra las desigualdades realmente existentes se alimenta así de estas tres fuentes: del desacoplamiento entre rendimiento y ganancia, de la contradicción entre legalidad y legitimidad, así como de las expectativas mundiales de igualdad. ¿Es ésta una situación (pre)revolucionaria? Absolutamente. Carece, sin embargo, de sujeto revolucionario, por lo menos hasta ahora. Porque las protestas proceden de los lugares más distintos. La izquierda radical acusa a los directivos de los bancos y al capitalismo. La derecha radical acusa una vez más a los inmigrantes. Ambas partes se corroboran mutuamente en que el sistema capitalista imperante ha perdido su legitimidad. En cierto sentido, son los Estados nación los que se han deslizado involuntariamente hacia el rol de sujeto revolucionario. Ahora, de repente, éstos ponen en práctica un socialismo de Estado sólo para ricos: apoyan a la gran banca con cantidades inconcebibles de millones, que desaparecen como si fueran absorbidas por un agujero negro. Al mismo tiempo, aumentan la presión sobre los pobres. Semejante estrategia es como querer apagar el fuego con fuego. Este proceso sólo fue posible porque los decenios anteriores engendraron en muchos ámbitos de la economía una suerte de espíritu del superhombre nietzscheano. Pequeñas empresas locales eran transformadas en potencias globales por superhombres de la economía, y éstos cambiaron adecuadamente las reglas del poder en vigor. Llevaron las finanzas a la esfera de lo incalculable, que nadie, ni ellos mismos, podía entender. Pero su actuación parecía justificarse en que elevaron a cotas inauditas sus beneficios, su poder y sus ingresos. La ideología predicaba que cualquiera podía triunfar. Esto era válido tanto para el comprador de bajos ingresos que obtenía su primera propiedad como para el malabarista que ignora los riesgos incalculables. El paraíso en la tierra consistía en

389 que el primero podía comprar con dinero prestado y el segundo podía hacerse aún más rico, también con dinero prestado. Ésta era, y sigue siendo ahora, la fórmula de la irresponsabilidad organizada de la economía global. Ahora, en la caída libre de la crisis financiera, ambos salen perdiendo, aunque no exactamente de la misma manera. Mientras que los ricos poseen un poco menos, a los pobres apenas les alcanza para vivir. Después de haber subido, ahora el ascensor vuelve a bajar. Pero esto no amortigua la capacidad explosiva de la revuelta de la desigualdad que hoy se cuece. Más bien al contrario. Las demandas de más igualdad, que encuentran su expresión en las actuales protestas, alcanzan la autoconciencia de Occidente en su núcleo neoliberal. En los decenios pasados se falsificó el sueño americano y sus promesas de libertad e igualdad de oportunidades por la promesa cínica de enriquecimiento privado. En realidad, este espíritu ha convertido a muchas y a muy distintas sociedades en dependientes de la droga de vivir con dinero prestado. La rutina diaria de las personas se basaba en la obtención de dinero rápido y barato, así como en la disponibilidad ilimitada de combustible fósil. La vida misma ha perdido el control en ese anhelo permanente de obtener cada vez más y más. Ahora cabe preguntarse: ¿dónde están los movimientos sociales que esbozan una modernidad alternativa? De lo que se trata es de cosas tan concretas como de las nuevas formas de energía regenerativa, pero también de fomentar un espíritu cívico que supere las fronteras nacionales. Y de cualidades como la creatividad y la autocrítica, para que temas clave como la pobreza, el cambio climático o civilizar los mercados tengan un lugar central. http://www.elpais.com/articulo/opinion/revuelta/desiguald ad/elpepuopi/20090504elpepiopi_11/Tes

390 EDITORIAL

The recession and the return of taxes Published: May 3 2009 17:55 | Last updated: May 3 2009 17:55 As consumers and companies everywhere keep a firm grip on their wallets, governments are stepping in to fill the gap. In Europe, they are doing so less by deliberate action than through the “automatic stabilisers” of welfare states and progressive taxes. Other countries, such as the US, have enacted large stimulus packages. The results are the same: yawning public sector deficits. States are rightly boosting aggregate demand to halt the downward economic spiral, but indebtedness cannot increase without limit. As soon as the recession ends, public debt must be brought under control and more national income diverted from spending to debt service. How fast and how far should public finances be brought back in the black? The least ambitious choice is to stabilise public debt as a share of output but not reduce it, covering only interest exceeding the rate of economic growth. But this would be unacceptably unfair to future generations who would forever be paying for today’s recession. Surely governments must aim to reduce their debts in the long run, and devote a larger than minimal share of national income to debt reduction. This must be financed by a correspondingly lower share of output for private spending or publicly provided goods and services. How to split the sacrifice between the two will be the focus of fierce interest-group politics over the next years. This goes with the territory of cost-cutting: people fight harder to avoid losses than they do to secure gains. Taking pre-recession attitudes as our guide, however, there are few widespread objections to the mix of spending settled at in most rich countries. The post- recession belt-tightening should therefore be split in the same proportion. This means private spending must bear a large part of the burden, requiring a period of noticeably higher taxes. This runs the danger of making tax systems even more complex and inefficient than they already are (the UK’s decision to phase out the personal allowance is a case in point). But it also brings an opportunity to make the first steps towards badly needed tax reforms. Governments must choose taxes that spur economic efficiency, not expand those that are a drag on it. The former are easy to find, as the FT online debate on taxes showed with its suggestions of a carbon tax and (for the UK) a land value tax. Such taxes benefit both the economy and the public purse. As they pay down debts, they free up public revenue, allowing more harmful taxes to be cut. The crisis has made such changes politically possible. Now leaders must find the will and the foresight to commit to them. http://www.ft.com/cms/s/0/e15570ca-3802-11de-9211-00144feabdc0.html

391 COLUMNISTS: Wolfgang Munchau

Europe must learn from Japan’s experience Published: May 3 2009 19:18 | Last updated: May 3 2009 19:18 Our has been compared with several crises of the past, but Japan’s lost decade is perhaps most relevant. This is not because of the way the two crises developed – we do not yet know what will happen to us – but because of our failure to learn from Japan’s mistakes. Otto von Bismarck said only fools would learn from their own mistakes, while he preferred to learn from the mistakes of others. We are mostly fools. I am particularly struck by the similarity of the policy responses in Japan then and Europe today. Adam Posen, deputy director of the Peterson Institute in Washington, made the following observation in a book* he published in 2000 about the parallels between Japan’s lost decade and US policy during the savings and loan crisis. He wrote: “Bank regulators issued a litany of announcements meant to be reassuring about the extent of the bad loan problem and the adequacy of Japanese banks’ capital, each of which was correctly disbelieved by other financial firms, foreign banks, and by Japanese savers as understating the problem.” This is exactly what is happening in Europe today. Governments are not coming clean on the scale of the crisis. Süddeutsche Zeitung, the German newspaper, recently revealed an internal memo from Bafin, the country’s banking regulator, showing the estimated scale of write-offs would be more than €800bn ($1,061bn, £712bn), about a third of Germany’s annual gross domestic product. By comparison, the entire capital and reserves of its monetary and financial institutions were only €441.5bn in February. If the leaked number is true, it would mean the German financial system is broke. Bafin was outraged by the leak, and launched legal action. Senior officials tried to play down the significance of the number. This is what Dr Posen described in his critique of Japan. Robert Glauber, now at Harvard University, wrote in the same book that “the government’s timidity in informing taxpayers of the full cost to resolve the crisis produced a large, unnecessary delay. The delay in both cases turned a relatively small cost into a staggering large one”. Again, this is happening today. Both the Geithner plan in the US, and the recently announced, but not yet detailed German financial rescue plan, pretend that the rescue can be largely cost-free to the taxpayer. Japanese governments also made several attempts to resolve the crisis during the 1990s, but these plans were too timid. Japan’s lost decade ended only in 2002 after Heizo Takenaka, minister for financial services under Junichiro Koizumi, the former prime minister, forced the banks to write down bad debt, and to accept new capital from the government. Just like the Japanese, the US and European governments will do the right thing eventually. But just like the Japanese, they are determined to do all the wrong things first. What could we learn from Japan’s fiscal policy? The purpose of increased government expenditure during a severe financial crisis is to break down the toxic feedback loops between the real economy and the financial sector. In that respect, the European stimulus programmes are much less satisfactory than US policy, not so much in terms of

392 the gross headline numbers, but in terms of their net effect on economic growth. Just like Japan in the 1990s, the eurozone cannot deliver effective fiscal stimulus, in our case due an inflexible rule-based system of economic governance, heavy bureaucracy and an astonishing lack of co-ordination. I would not be surprised if the total economic effect of the US stimulus ended up twice as large as the total of the various European programmes. The only European institution that seems to have grasped the need to learn from Japan’s experience is the European Central Bank. European money market rates are close to zero, and while one can always argue about the finer details of monetary policy, central banks on both sides of the Atlantic are close to having exhausted their freedom of manoeuvre. The ECB will this week cut official interest rates again, probably by another quarter point, but even further rate cuts will not make much difference to real world interest rates. I consider myself agnostic about the benefits of quantitative easing, both in terms of its effectiveness in shifting long-term interest rates, and in terms of the difficulties central banks might encounter in the future. From the evidence I have seen from Japan, it was the resolution of the banking crisis more than the adoption of quantitative easing by the Bank of Japan that finally did the trick. All this leaves Europe with a policy mix only slightly better than Japan’s in the 1990s. Yet, Europe faces an additional problem. While Japan had its crisis when the rest of the world was booming, Europe has no such luck. I see nothing in our situation or our policy response to persuade me that it will take less than a decade to get out of this. [email protected] More columns at www.ft.com/wolfgangmunchau *Japan’s Financial Crisis and Its Parallels to US Experience, edited by Adam S. Posen and Ryoichi Mikitani, September 2000, www.petersoninstitute.org http://www.ft.com/cms/s/0/f3b080f6-380d-11de-9211-00144feabdc0.html

393 Negocios Primer plano La locomotora europea entra en vía muerta La caída de la demanda hunde a Alemania en su peor crisis desde la II Guerra Mundial JUAN GÓMEZ 03/05/2009 "Alemania se beneficiará especialmente cuando se reanime la economía mundial, del mismo modo que su caída nos está afectando especialmente a nosotros". El ministro alemán de Economía, Karl-Theodor zu Guttenberg, trataba el miércoles de poner así una nota de optimismo entre las calamitosas previsiones para 2009 que presentaba en Berlín. "Alemania se beneficiará especialmente cuando se reanime la economía mundial, del mismo modo que su caída nos está afectando especialmente a nosotros". El ministro alemán de Economía, Karl-Theodor zu Guttenberg, trataba el miércoles de poner así una nota de optimismo entre las calamitosas previsiones para 2009 que presentaba en Berlín. Sonó más bien fatalista: ahí fuera, en "la economía mundial", lejos del control y hasta del alcance del Gobierno, están las condiciones para que volvamos a levantar cabeza. No en vano, la caída de las exportaciones provocada por la crisis mundial ha doblegado a la primera economía europea, cuya producción industrial sufre por el desplome de la demanda en todo el mundo. Como consecuencia, el producto interior bruto (PIB) caerá el 6% este año. En 2010, 4.600.000 alemanes estarán en el paro. Serán casi cinco millones antes de que termine ese año. Los datos son claros. Alemania se enfrenta a la peor recesión desde que se fundó la República Federal en 1949. No cesan las comparaciones con la Gran Depresión de 1929, que contribuyó al caos que alentaron y aprovecharon los nazis para asaltar el poder en 1933. Al actual Gobierno de coalición entre los democristianos de Angela Merkel (CDU) y el Partido Socialdemócrata de Alemania (SPD) le quedan más de cuatro meses de difícil gestión hasta las elecciones de septiembre. Los principales rivales para esos comicios son todavía socios en el Gobierno y tienen que enfrentarse juntos a la crisis. El ministro Guttenberg, socialcristiano del CSU (partido hermano de la CDU en Baviera), está abocado así a entenderse con el socialdemócrata ministro de Hacienda, Peer Steinbrück, con quien debe pactar los gastos extraordinarios para contener la recesión. Guttenberg cree que la economía crecerá medio punto en 2010. Un rebrote muy discreto que sólo tendrá lugar, en todo caso, "cuando se reanime la economía mundial". No confían en ello los expertos, que auguran una nueva caída del 0,5%. Los pronósticos a más corto plazo señalan una espiral descendente, algo así como un torbellino que, de desatar toda su virulencia, podría traer consecuencias imprevistas en lo político y en lo social. En lo económico, lo imprevisto ya está aquí. Hace apenas un año, tanto los institutos de economía como los políticos alemanes se mostraban confiados en que la crisis pasaría sin mayores sobresaltos. La preeminencia de Alemania entre los fabricantes de productos industriales de gama alta, como automóviles o maquinaria especializada, daba una seguridad a los analistas que se ha demostrado del todo ilusoria. La caída de los pedidos, que según la patronal ha superado

394 el 60% en algunas empresas, provocará antes o después un recorte de salarios y un notable aumento del paro. El consumo interno acusará el golpe y con él, la recaudación de la Hacienda pública. La ola de despidos ya está afectando a los trabajadores menos cualificados. Las empresas tratan de mantener a los obreros especializados mediante la reducción de las jornadas laborales. Los sindicatos han presionado al Gobierno para que prolongue las ayudas para las jornadas reducidas, evitando los despidos. Se amortigua así, de momento, el impacto del desempleo en las clases medias. Un millón y medio de empleados se acogen ya a estas subvenciones. Sin embargo, y pese a la reciente prórroga de las ayudas a 24 meses, los analistas coinciden en que los despidos masivos están a la vuelta de la esquina si los empresarios no acaban por divisar la anhelada luz al final del túnel. Podrían, incluso, llegar antes de las elecciones de septiembre. Este mismo mes, la recesión ha impedido el repunte del mercado laboral que anualmente trae la primavera. El número de desempleados cayó en abril en un total de mil personas respecto al mes de marzo. La cifra resulta irrisoria si se tiene en cuenta que hay 171.000 parados más que en igual mes de 2008. La cifra de desempleo corregida de efectos temporales ha aumentado en 58.000 personas. Respecto al paro, las previsiones del Gobierno son más optimistas que las de los expertos. Lo cinco millones de parados a finales de 2010 son cosa segura para diversos analistas. Tras las vacaciones de verano, miles de empresas alemanas evaluarán si les conviene mantener las jornadas reducidas de sus trabajadores o más bien despedir a parte de ellos. El desacuerdo más patente entre el Gobierno y los institutos económicos está en el cálculo del crecimiento salarial. Dicen los expertos que los salarios alemanes caerán un 3,6% en 2009. Guttenberg acusó a los economistas independientes de haber hecho mal las cuentas y aseguró que el crecimiento será positivo y alcanzará el 1%. Una caída de los salarios brutos significaría para el Gobierno la disminución de los ingresos en concepto de Seguridad Social y seguros de desempleo, que podría desembocar en un recorte de las jubilaciones. Dinamita electoral. El diario Frankfurter Allgemeine Zeitung se declaraba incapaz de dilucidar "si la interpretación del Gobierno tiene razones fácticas o políticas". El galimatías macroeconómico también requiere fe. La que parece albergar la canciller Merkel, que sólo abandona el burladero para lanzar algún que otro tímido mensaje de esperanza. Como en la feria de Hannover, donde aventuró el 20 de abril que "quizá hayamos alcanzado ya el punto más bajo de la crisis". O quizá no, como le indicó el grupo de expertos invitados por ella el pasado 22 de abril a la Cancillería. La cita no fue ni mucho menos para echar cohetes. El jefe del Banco Federal (Bundesbank), Axel Weber, advertía a la canciller del riesgo de inflación en Alemania, mientras que los expertos del instituto IFO de Múnich insistían en que el verdadero riesgo es la deflación, la caída generalizada de los precios. Los representantes sindicales y empresariales aprovecharon el encuentro para exponer sus respectivas cuitas a la canciller. Con semejante panorama, no sorprende a nadie que alguno de los presentes se refieran al "ambiente funerario" que reinó en la reunión de expertos. Estaban entre ellos los mismos que el año pasado pronosticaban una "desaceleración económica" y un "aterrizaje suave" tras el reciente auge alemán. Kai Carstensen, del instituto IFO de investigación económica, reconoce que "había señales significativas ya hace un año para prever una recesión". Hubo un error de apreciación. "Creíamos que los

395 problemas del sector bancario se resolverían con las intervenciones del Estado". El hundimiento del banco neoyorquino Lehman Brothers, la ola de nacionalizaciones y quiebras bancarias en todo el mundo no entraban en los cálculos de los analistas. Ahora, la crisis generalizada no ha dejado indemne a ningún mercado. Los nuevos ricos que compraban en Shanghai o Moscú automóviles fabricados por Mercedes o Porsche y las multimillonarias inversiones en maquinaria pesada y de precisión made in Germany que se permitían hasta 2008 las economías hinchadas de petrodólares son agua pasada. En Alemania queda ahora una industria del automóvil con excesiva capacidad de producción y muelles medio vacíos en los grandes puertos exportadores de Hamburgo y Bremerhaven. Y ahora, ¿inflación o deflación? El abaratamiento del precio del dinero y la puesta en marcha de la máquina de imprimir billetes por parte del Banco Central Europeo (BCE) hacen temer la primera. El miedo de los consumidores a perder su empleo o a los recortes en las jubilaciones, sumado a la precaución debida a las dificultades para contratar créditos privados, permiten sospechar que los precios bajarán próximamente, con consecuencias dramáticas para los salarios, el desempleo y el consumo. El Gobierno no habla de deflación, pero tampoco espera que los precios aumenten demasiado: el 0,3% este año y el 0,7% el que viene. En 2008, el índice de precios al consumo (IPC) aumentó en un 2,6%. Está por ver cómo sale la industria alemana de la crisis internacional. En febrero, la producción industrial alcanzó sólo el 75% de la de febrero de 2008. La fabricación de automóviles cayó en el mismo mes a la mitad respecto a la de febrero del pasado año. Los pedidos totales se redujeron en un 40%, de modo que son de esperar nuevas caídas en todos los sectores productivos del país. La niña bonita de las industrias alemanas, la automotriz, sufrirá un nuevo bofetón cuando expiren, en 2010, los incentivos públicos por la compra de automóviles nuevos. De momento, la veterana Opel ya lucha por su supervivencia, víctima de la caída de su matriz estadounidense, General Motors. Con su retroceso previsto del 6%, la economía alemana será una de las más castigadas por la crisis. Sólo los japoneses lo tendrán peor, entre las grandes economías mundiales. No obstante, el Gobierno se ha negado repetidamente a aplicar un tercer plan de recuperación o de añadir más millones a los 80.000 que ha dedicado a reactivar la economía con dos planes de estímulo. "Nuestros programas anteriores están empezando ahora a surtir efecto", aseguró Guttenberg esta semana. Recordó el ministro que el plan alemán fue diseñado para aplicarse a lo largo de dos años. Alemania es partidaria firme de las ayudas del Fondo Monetario Internacional (FMI) a los países con problemas económicos graves. Estas ayudas redundan antes o después en beneficio de las potencias exportadoras. A fin de cuentas, tres cuartas partes del retroceso de la economía alemana se deben, según el Gobierno, a la tremenda caída de las exportaciones. En la Cámara de Comercio e Industria DIHK, el analista Ilja Nothnagel detecta una "recuperación de confianza en las empresas, aunque debe decirse que parte de niveles muy bajos". Divisa Nothnagel "señales en la economía que indican una lenta recuperación". Alemania podría beneficiarse de los programas internacionales de reactivación, como los aprobados por el presidente de Estados Unidos, Barack Obama. Uno de los sectores mejor dispuestos en la competencia internacional es el de las energías renovables, en el que diversas empresas alemanas podrían salir fortalecidas de la crisis internacional. Pese al aumento del paro, los pronósticos de Guttenberg no contemplan un retroceso significativo de la demanda interna. El Gobierno confía en las medidas paliativas ya

396 aplicadas, como la reducción de las cotizaciones a la Seguridad Social, los incentivos por tener hijos y las subidas de las jubilaciones. El consumo, dice Guttenberg, es un factor de estabilidad en Alemania. Entre los críticos al Gobierno aumenta el coro de los que piden un paulatino ajuste de la demanda interna y las exportaciones, para que la economía no dependa tanto de factores externos. Alemania, todavía "campeona mundial de exportaciones", no ha sabido incentivar el consumo interno de forma estable. El repunte de la venta de automóviles por las subvenciones públicas se acabará pronto. Sindicatos y partidos de izquierda piden rebajas fiscales y otros apoyos a los trabajadores para que aumente la demanda y se corrija el peso desmesurado de las exportaciones en la economía del país. Entre tanto, los futuros contendientes electorales que ahora gobiernan en coalición esperan capear el temporal hasta las federales. Las llamadas al optimismo del ministro Guttenberg y de la canciller no ocultan, sin embargo, los graves riesgos que traen el endeudamiento público, el aumento del paro y la insólita caída del PIB. Riesgos que, en primer lugar, atañen a su reelección en septiembre. Después, a todo lo demás. - Deuda récord La factura de los de astronómicos planes anticrisis no deja de crecer. El ministro de Hacienda, el socialdemócrata Peer Steinbrück (SPD), cuenta con un endeudamiento adicional de entre 70.000 y 80.000 millones de euros en 2009. Es el mayor de la historia y, probablemente, no se conoce su verdadero alcance. En septiembre hay elecciones, y es muy posible que, una vez votado un nuevo Parlamento, se conozcan más datos del déficit público. Alcanzará, por lo menos, el 6% del Producto Interior Bruto (PIB). Además, Steinbrück ha anunciado que las arcas públicas alemanas recaudarán este año entre 20.000 y 30.000 millones menos de lo previsto anteriormente. Hasta hace poco, las consecuencias de la crisis no se sentían en las arcas públicas. Los programas de rescate bancario alcanzaban sumas exorbitantes, pero se componían sobre todo de garantías y avales. Ahora, los costos de la crisis son bien visibles. Los expertos los consideran un mal menor y necesario. La cuestión, ahora, es cómo saldrá Alemania de ésta. Sólo podrá ser si la capacidad económica del país se mantiene más o menos intacta a través de la crisis. El Estado no será capaz de sanear sus cuentas hasta que recupere niveles de crecimiento considerables. Si no lo logra, la montaña de deudas podría acabar sepultando las arcas públicas por varias generaciones. – http://www.elpais.com/articulo/semana/locomotora/europea/entra/via/muerta/elpepueco neg/20090503elpneglse_2/Tes

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La era de Gordon Brown se desvanece Los reveses políticos y económicos deterioran día a día la imagen del primer ministro británico - Dirigentes del laborismo contactan con los liberales para pasarse de bando WALTER OPPENHEIMER - Londres - 03/05/2009 El 2 de mayo de 1997, Tony y Cherie Blair entraron triunfantes en Downing Street. El Partido Laborista británico volvía al Gobierno tras un largo calvario de casi dos decenios en la oposición. Doce años después, el laborismo vive inmerso en una profunda crisis y cada vez más convencido de que ha llegado de nuevo la hora del cambio. El 2 de mayo de 1997, Tony y Cherie Blair entraron triunfantes en Downing Street. El Partido Laborista británico volvía al Gobierno tras un largo calvario de casi dos decenios en la oposición. Doce años después, el laborismo vive inmerso en una profunda crisis y cada vez más convencido de que ha llegado de nuevo la hora del cambio. Los diputados laboristas huelen ya la derrota, y el primer ministro, Gordon Brown, ve cómo se evapora su autoridad semana tras semana. "Me da vergüenza ser diputado laborista", declaró el viernes el ex ministro del Interior y profundo blairista Charles Clarke. "El laborismo ha perdido sus antenas", aseguró ese mismo día otro ex ministro del Interior, David Blunkett. "No apostaría mi dinero por una victoria laborista en las próximas elecciones", reconoció el ex alcalde de Londres Ken Livingstone. "Tenemos una última oportunidad de reemplazar a Brown tras las elecciones locales y europeas de junio", propuso el diputado Frank Field, un conocido rebelde del partido. El diario proconservador The Daily Telegraph hizo estallar ayer una bomba política al asegurar que el Partido Laborista se enfrenta al peligro de una escisión de sus sectores más moderados, dispuestos a pasarse al Partido de los Liberales Demócratas en el caso de que el laborismo sucumba a la tentación de dar un radical giro a la izquierda si -como parece más que probable- pierde las próximas elecciones. El antiguo líder de los liberales-demócratas, Paddy Ashdown, asegura en una entrevista concedida al Telegraph que varios dirigentes laboristas le han confiado que están dispuestos a dejar el partido si los laboristas abandonan el centrismo que introdujo Tony Blair en los años noventa. Y el rotativo asegura que el actual líder liberal, Nick Clegg, ha autorizado en privado un "acercamiento secreto a blairistas descontentos, intentando persuadirles para que se unan a los liberales-demócratas en lugar de formar su propio partido". El actual Partido de los Liberales Demócratas surgió de la fusión en 1988 del viejo Partido Liberal y del recién creado Partido Social Demócrata (SDP, en sus siglas en inglés). El SDP había sido fundado en 1981 por la llamada "banda de los cuatro", los diputados Roy Jenkins, David Owen, Bill Rodgers y Shirley Williams, que se escindieron del Partido Laborista porque no estaban de acuerdo con el izquierdismo de su líder de entonces, Michael Foot. El miedo a un giro a la izquierda se ha plasmado sobre todo tras la improvisada decisión del Gobierno de Gordon Brown de incrementar del actual 40% al 50% el tipo máximo del IRPF, adelantando en un año un incremento ya previsto del 40% al 45%. La subida

398 no ha sido mal recibida por las encuestas en un momento en que la crisis financiera ha puesto a los ricos en el ojo del huracán. Pero el propio ministro del Tesoro y canciller del Exchequer, Alistair Darling, ha reconocido que fue una decisión precipitada que se tomó sin evaluar previamente con detalle su verdadero impacto recaudatorio. Muchos expertos creen que ese impacto será mínimo y que, en cambio, la medida retraerá la inversión en el Reino Unido. El nerviosismo de los laboristas es la culminación de varias semanas de permanente deterioro de la imagen de Gordon Brown. Los esperados beneficios propagandísticos de la cumbre del G-20, especialmente por la presencia del carismático nuevo presidente de Estados Unidos, Barack Obama, se evaporaron de inmediato con el estallido del llamado caso McBride: una campaña de desprestigio personal de los máximos dirigentes del Partido Conservador que preparaba Damian McBride, un íntimo colaborador de Brown que se vio obligado a abandonar Downing Street. El presupuesto para el año fiscal que empieza en abril es tradicionalmente un buen momento para el Gobierno. Pero el pésimo estado de la economía británica y la gigantesca montaña de deuda pública que tendrá que emitir el Tesoro para superar la crisis han hecho añicos el ya maltrecho prestigio del primer ministro, que entre 1997 y 2007 estuvo al frente de la economía. El deterioro de la imagen de Brown se ha acentuado dramáticamente esta semana. Primero, cuando el primer ministro se vio obligado a dar marcha atrás en su propuesta de reformar el sistema que financia los gastos de los diputados y sustituirlo por dietas de asistencia. Es un tema políticamente muy sensible en un país al que le encanta acusar de corrupción al continente y que vive con gran incomodidad la realidad de que sus propios diputados abusan del dinero público. Pero Brown no acertó ni en el fondo ni en la forma. Su ocurrencia de lanzar su propuesta a través de un vídeo en YouTube provocó una mofa generalizada por las constantes sonrisas forzadas de un primer ministro más incómodo que nunca ante las cámaras. Y su idea de pagar a los diputados por el simple hecho de que pasen por la oficina, sin siquiera tener que justificar sus gastos, provocó un rechazo generalizado de la oposición, pero también entre muchos diputados laboristas. Brown se vio obligado a dar marcha atrás para evitar que su propuesta fuera derrotada en los Comunes. La humillación fue aún mayor el miércoles, cuando los Comunes aprobaron una moción presentada por los liberales-demócratas defendiendo el derecho de los gurkas -guerreros nepaleses que combaten en el Ejército británico- a residir en el Reino Unido. Una treintena de laboristas votaron contra el Gobierno y muchos más se abstuvieron. Es la primera vez desde 1978 que el Gobierno pierde una propuesta presentada por la oposición. http://www.elpais.com/articulo/internacional/era/Gordon/Brown/desvanece/elpepiint/20 090503elpepiint_1/Tes?print=1

399 Negocios TRIBUNA: Laboratorio de ideas CARMELO MESA-LAGO Dilema en las pensiones privadas latinoamericanas CARMELO MESA-LAGO 03/05/2009 La mitad de los 20 países latinoamericanos tiene hoy sistemas de pensiones de capitalización individual y administración privada, que sustituyeron de manera total o parcial al sistema público de reparto. Comenzando en Chile en 1981, la región fue pionera mundial en "reformas estructurales" privatizadoras que, si bien tuvieron algunos aciertos, adolecieron de serias fallas en el diseño inicial o en su desempeño posterior, las cuales requirieron correcciones puntuales en varios países. Pero el año pasado dos de ellos fueron más lejos, con "re-reformas" diametralmente opuestas: Chile implantó el pasado julio una transformación comprensiva que mantuvo el sistema actual pero resolvió o alivió algunos de sus problemas y mejoró otros aspectos, mientras que en diciembre Argentina eliminó el sistema privado y forzó el traspaso de 9,5 millones de sus asegurados y el fondo acumulado de 23.000 millones de euros (más 3.500 millones de euros en futuras contribuciones anuales) al sistema público de reparto antes de la ley, 2,1 millones de asegurados habían optado voluntariamente por el traspaso pero el 72% decidieron quedarse en el sistema privado. Los otros ocho países (Bolivia, Colombia, Costa Rica, El Salvador, México, Perú, República Dominicana y Uruguay) probablemente seguirán una de estas dos vías; los otros diez mantienen sistemas públicos de reparto. ¿Cuál de los dos modelos de re-reforma es mejor? Cada país ha de abordar la "re-reforma" de la manera más adecuada según sus características y necesidades propias, pero debería ser precedida de un diálogo social que incluya a los trabajadores, pensionados y otros actores clave, y que promueva los principios internacionales de seguridad social de la OIT: universalidad, trato igual, solidaridad social, equidad de género, suficiencia de las prestaciones, regulación y supervisión públicas, gastos administrativos moderados, participación social en la gestión y sustentabilidad financiera-actuarial a largo plazo que garantice las pensiones futuras. Los sistemas privados generaron una importante acumulación de capital en las cuentas individuales, alcanzando el 64% del PIB en Chile pero sólo el 12% en Argentina, y mejoraron algunos aspectos de eficiencia. Pero en ambos países sus fallas superaron las ventajas: caída en la cobertura de la fuerza laboral; bajísima afiliación voluntaria de trabajadores independientes en Chile (aunque obligatoria en Argentina); pensiones asistenciales para los pobres pero restringidas por lista de espera y disponibilidad de recursos fiscales; parte de los asegurados sin derecho a recibir ni la pensión mínima (por no tener los 20 o 35 años de contribución requeridos) ni la asistencial (por no cumplir los requisitos de la prueba de ingreso); desigualdad de trato porque las fuerzas armadas fueron excluidas de la reforma y mantienen programas separados con pensiones superiores mayormente financiadas por el fisco (también parte de los funcionarios provinciales argentinos); carencia de solidaridad ya que las pensiones mínimas y asistenciales son enteramente sufragadas por el Estado; inequidad por género, como una cobertura de la mujer inferior a la del hombre, agravada por la acentuación de dicha

400 inequidad por el sistema privado (pensiones inferiores en parte porque la reforma inicial aumentó los años de contribución requeridos para la pensión mínima); atomización de las funciones de regulación y supervisión de todo el sistema; costos administrativos altos y estancados; ausencia de participación de trabajadores en la gestión de las administradoras a pesar de ser ellos los dueños de los fondos de pensiones; serio incumplimiento en el pago de contribuciones (mayor en Argentina que en Chile), y altos costos de transición (5% del PIB en Chile). La "re-reforma" chilena de la presidenta Bachelet fue precedida de un amplio diálogo social cuyas recomendaciones se incorporaron en la ley, resolvió o mejoró varias de las fallas explicadas, y promueve los principios de seguridad social. Extiende la cobertura al disponer la obligatoriedad legal gradual e incentivos para incorporar a los independientes, también abre la afiliación voluntaria a los que no desempeñan actividad remunerada y otorga un subsidio fiscal a los trabajadores jóvenes. Mejora la solidaridad mediante el otorgamiento estatal de una pensión básica solidaria universal a los pobres y grupos de más bajo ingreso, sin lista de espera ni limitantes fiscales, y resuelve la previa falta de protección a los afiliados que no calificaban a una pensión mínima ni a una asistencial. Asimismo mejora las pensiones existentes con un aporte fiscal a la pensión contributiva de los grupos de menor ingreso, aporte que disminuye según crece la pensión y se extingue cuando excede un tope. Mitiga la equidad de género concediendo a todas las madres un bono de maternidad por cada hijo nacido vivo, y el 60% del total de los beneficiarios de la nueva pensión básica son mujeres. También integra en una sola superintendencia la fiscalización de todas las pensiones y refuerza la regulación del sistema, instituye una comisión de usuarios para el monitoreo de la reforma, estimula la competencia e introduce mecanismos para reducir el costo administrativo, crea una entidad para facilitar la tramitación de los nuevos beneficios, informar a los beneficiarios y promover la educación previsional. Por último, promueve la contribución voluntaria de los empleadores a través de un ahorro voluntario, con pago diferido del impuesto a la renta, y sienta una base financiera sólida para la re-reforma con proyecciones fiscales hasta 2025 y evaluaciones actuariales anuales. En Argentina, a raíz de la crisis de 2001, hubo un amplio debate sobre el sistema previsional, pero sus lineamientos no fueron incorporados por la presidenta Fernández a su "re-reforma", la cual no es comprensiva, adolece de escasa regulación y vacíos legales, y es más débil en el cumplimiento de los principios de la seguridad social que la reforma chilena. No introduce incentivos para aumentar la muy baja cobertura, ni una pensión asistencial para todos los pobres y grupos de menor ingreso. Estipula prestaciones iguales o mejores para los asegurados traspasados al sistema público pero sin determinar cómo se calcularán. No introduce medidas para compensar a la mujer cuando deja el trabajo para criar a los hijos. Encarga la supervisión del sistema a una comisión del Congreso pero sus decisiones no son obligatorias, y no crea mecanismos de participación social en la gestión del sistema. Más aún, somete a riesgo la sustentabilidad financiera del sistema integrado porque traspasó sus recursos a un "fondo de garantía" administrado por una entidad pública legalmente autónoma, pero sin regulación de las inversiones ni cautelas que impidan que dichos recursos sean prestados al Gobierno para cubrir el déficit fiscal y pagar la deuda externa. A pesar de la jugosa inyección financiera a corto y mediano plazo recibida por el Estado, éste probablemente tendrá que hacer transferencias en el largo plazo para financiar las obligaciones futuras de los asegurados del cerrado sistema privado (no se hicieron cálculos actuariales para proyectar los costos). Por último, el traspaso al sistema público de los fondos en las

401 cuentas individuales propiedad de los asegurados, sin el consentimiento de éstos, puede provocar numerosos litigios judiciales a un alto costo fiscal, como sucedió en el pasado. Ninguna de las dos reformas resuelve el problema de desigualdad de trato al excluir ambas a las fuerzas armadas (en Argentina también a funcionarios provinciales y municipales) que reciben beneficios superiores a los del sistema general, con fuertes subsidios fiscales. ¿Cuál de los dos modelos seguirán los otros ocho países con sistemas privados de pensiones? El Gobierno boliviano ha anunciado que nacionalizará éstos y ya hay dos proyectos legales en discusión. Por el contrario, Uruguay introdujo recientemente cambios al estilo chileno para extender la cobertura, aumentar la competencia, reducir el costo administrativo y otorgar un bono de maternidad. Es probable que Colombia, Costa Rica, México, Perú y República Dominicana adopten este tipo de medidas; es difícil predecir el camino de El Salvador. La mitad de los países latinoamericanos con sistemas públicos de reparto enfrenta problemas, algunos similares y otros diversos a los de los sistemas privados, tema para un próximo artículo. http://www.elpais.com/articulo/semana/Dilema/pensiones/privadas/latinoamericanas/elp epueconeg/20090503elpneglse_7/Tes

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May 3, 2009 As a Professor, a Pragmatist About the Supreme Court By JODI KANTOR Many American presidents have been lawyers, but almost none have come to office with Barack Obama’s knowledge of the Supreme Court. Before he was 30, he was editing articles by eminent legal scholars on the court’s decisions. Later, as a law professor, he led students through landmark cases from Plessy v. Ferguson to Bush v. Gore. (He sometimes shared his own copies, marked with emphatic underlines and notes in bold, all-caps script.)

Obama for America, via Associated Press Barack Obama teaching law at the University of Chicago. Now Mr. Obama is preparing to select his first Supreme Court nominee to replace retiring Justice David H. Souter. In interviews, former colleagues and students say they have a fairly strong sense of the kind of justice he will favor: not a larger-than-life liberal to counter the conservative pyrotechnics of Justice Antonin Scalia, but a careful pragmatist with a limited view of the role of courts. “His nominee will not create the proverbial shock and awe,” said Charles J. Ogletree, a Harvard professor who has known the president since his days as a student. Mr. Obama believes the court must never get too far ahead of or behind public sentiment, they say. He may have a mandate for change, and Senate confirmation odds in his favor. But he has almost always disappointed those who expected someone in his position — he was Harvard’s first black law review president and one of the few minority members of the University of Chicago’s law faculty — to side consistently with liberals.

Joe Wrinn/Harvard University, via Associated Press This photo provided by Harvard University Law School shows Barack Obama as a student at the school in Cambridge, Mass., Feb. 6, 1990. Obama came to Harvard in the fall of 1988 after graduating from Columbia University and spending four years as a community organizer in Chicago

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Former students and colleagues describe Mr. Obama as a minimalist (skeptical of court-led efforts at social change) and a structuralist (interested in how the law metes out power in society). And more than anything else, he is a pragmatist who urged those around him to be more keenly attuned to the real-life impact of decisions. This may be his distinguishing quality as a legal thinker: an unwillingness to deal in abstraction, a constant desire to know how court decisions affect people’s lives. “The University of Chicago was and is full of eminent theorizers who wrap up huge areas of the law by applying some magic key,” said David Franklin, a former student. “He didn’t do any of that; he wasn’t interested in high theory at all.” Though Mr. Obama rarely spoke of his own views, students say they sensed his disdain for formalism, the idea — often espoused by Justices Scalia and Clarence Thomas, but sometimes by liberals as well — that law can be decided independent of the political and social context in which it is applied. To make his point, Mr. Obama, then a state senator, took students with him to Springfield, Ill., the capital, to watch hearings and see him hash out legislation. And he asked constant questions about consequences of laws: What would happen if a mother’s welfare grant did not increase with the birth of additional children? As a state legislator, how much could he be influenced by a donor’s contribution? Former students say that Mr. Obama does not particularly prize consistency or broad principle. Adam Bonin arrived in Mr. Obama’s class with the firm belief that drawing districts to ensure minority representation should be illegal. “It struck me as wrong that the legislature should pick and choose what interests should be represented in the legislature,” Mr. Bonin said. “What I took from the class and the reading materials was the reality that unless these voices are physically present in a legislature, they won’t be heard,” he said. “As long as everyone is grabbing for power, members of racial minority groups ought to do the same.” But when it came to sentencing laws, Mr. Obama led Mr. Bonin in a more conservative direction than the student had expected. The primary victims of black criminals were fellow blacks — and so minority neighborhoods had an interest in keeping sentencing laws tough, he taught. Pragmatism has its detractors, and in a confirmation battle, Mr. Obama’s nominee could face charges that he or she does not give enough weight to formal law. But although Mr. Obama is results-oriented, he retained an overall skepticism for what courts can accomplish, said David Strauss, a former colleague at University of Chicago. In Mr. Obama’s due process and voting right classes, he showed students the broad failures of Reconstruction-era amendments that tried to establish equality for blacks. “He sees the political process as the place that a lot of these large, difficult public policy questions ought to be resolved,” said Richard Pildes, a professor at New York University law school whom Mr. Obama met through their mutual interest in election law. Even as law review president, Mr. Obama de-emphasized his own views and instead made himself a channel for those of others. His decision making was “about the group

404 sentiment and what the group majority might agree to,” said Nancy McCullough, a fellow editor. In class and in conversation, Mr. Obama talked about judges all the time, but in heterodox terms that gave no clear sense of whose work he most prized. “I would imagine that if Barack had a free hand to appoint judges without having to worry about confirmations, about politics, that his idea of a great justice would be someone like a Thurgood Marshall,” said Geoffrey Stone, a former dean of the University of Chicago law school. Mr. Obama often expressed concern that “democracy could be dangerous,” Mr. Stone said, that the majority can be “unempathetic — that’s a word that Barack has used — about the concerns of outsiders and minorities.” But when a student asked Mr. Obama to name the circuit judge he would most like to argue in front of, he named Richard Posner, a conservative. Judge Posner was smart enough to know when you were right, Mr. Obama told the class. And in his seminar discussions, he poked holes in the arguments of Justices Marshall, a liberal, and Thomas, a conservative, alike. Mr. Obama’s selection of a new justice may challenge him in a way that running a law review and then teaching law never did. Both of those jobs were about cultivating robust debate, about encouraging multiple viewpoints. Now Mr. Obama must settle on a single legal thinker — at least for now. Thanks to his time in Cambridge and Chicago, he knows the options rather well. Cass R. Sunstein, Elena Kagan and Diane Pamela Wood, three names likely to be on Mr. Obama’s list, are all former colleagues at University of Chicago. When Mr. Sunstein was married last summer, Mr. Obama sent a long toast to be read at the wedding. Another possible nominee, Pamela S. Karlan, co-wrote an election law textbook that Mr. Obama not only taught from but also contributed comments to when it was in draft form. In class, Mr. Obama liked to tell students that the Supreme Court was not as far off as it seemed, that it was a dynamic institution that they should not be afraid to challenge and change. One day in class, Aleeza Strubel told Mr. Obama that she was confounded by a particular decision, a voting rights opinion she simply could not understand. He quizzed her carefully on the court’s logic but finally acknowledged it was rather hard to grasp. “When you clerk for Justice O’Connor,” Mr. Obama said, jokingly, “you’ll tell her she got it wrong.” http://www.nytimes.com/2009/05/03/us/politics/03obama.html?_r=1&hp

405 Business May 3, 2009 Chrysler’s Fall May Help Administration Reshape G.M. By DAVID E. SANGER and BILL VLASIC WASHINGTON — Fresh from pushing Chrysler into bankruptcy, President Obama and his economic team are hoping that the hard line they took last week gives them leverage to force huge changes in General Motors, a far larger and more complex company. Officials say that, difficult as Mr. Obama’s decision was on Wednesday to take all the risks of a Chrysler bankruptcy, the politics of reshaping G.M. will be far harder. Already a shadow of the company that once dominated the American landscape, G.M. will be forced to eliminate tens of thousands of additional jobs and close factories and dealerships nationwide. In Chrysler’s case, the tough job-cutting decisions had already been made and the government is taking only a small stake. An alliance with Fiat envisions selling the company’s cars in new markets around the world and adding cars that use Fiat’s fuel- efficient technology. But in G.M.’s case, Mr. Obama will be forcing deeper cuts and becoming the controlling shareholder. He will also be overseeing the radical downsizing of G.M.’s work force as he is trying to reverse rising unemployment. “G.M. is very different than Chrysler,” Rahm Emanuel, Mr. Obama’s chief of staff, said Friday. “But I suppose the one lesson for G.M., and all the other players, is that this is a moment when a Democratic president said, ‘I am really willing to let a company dissolve, and there’s not going to be an open checkbook.’ There’s got to be real viability.” No one thinks Mr. Obama is going to allow G.M. to be broken up, its assets sold or abandoned. But if the Chrysler legal process unfolds as the White House hopes it will in coming weeks, the bankruptcy option may look increasingly attractive for G.M. as well, officials on Mr. Obama’s automotive task force said. Bankruptcy may also be the only way to force the kind of paring down that Chrysler, with a third of G.M.’s workers and half the number of plants, did not have to endure. “The threat of bankruptcy is very important in the negotiations with the bondholders and the dealers and others,” said David E. Cole, chairman of the Center for Automotive Research in Ann Arbor, Mich. “Without a clear and present danger to them, they won’t make a reasonable deal.” G.M.’s latest restructuring plan — which the White House has yet to approve — calls for trimming 47,000 jobs worldwide, closing more than a dozen plants in the United States, eliminating four brands and shuttering 2,600 dealerships. Even that may not be enough. As the leaders of Mr. Obama’s task force faced down recalcitrant Chrysler creditors on Wednesday, a team of more junior officials was in Detroit assessing whether G.M. was cutting deeply enough to turn a profit.

406 “Our marching orders were to do both Chrysler and G.M. the way we would do a strictly commercial deal,” said a senior official on the task force, who would not speak on the record because the negotiations with G.M. were still in progress. “We’re not going to sit there and tell G.M. how many jobs to cut, or what models to eliminate. But we are going to look at the financials, the balance sheet, and see if the plan they come up with passes that test.” Because Chrysler was already the most marginal of what were once called the Big Three — this will be its third corporate reincarnation in a decade — Mr. Obama could afford to take a hard line. But when dealing with a company as politically sensitive and as large as G.M., the administration will have a far harder time separating the economic decisions from the political challenges. In Chrysler’s case, a handful of the company’s 46 lenders presented the biggest roadblock. Mr. Obama could portray them as obstructionists who put their demands for repayment ahead of preserving the company. But General Motors’ creditors number in the tens of thousands and include pension funds that bought the company’s unsecured bonds. G.M. bondholders have no claim on its plants or inventory, but they will probably attract more sympathy than Chrysler’s Wall Street lenders did. The Treasury Department will pay $2 billion to Chrysler’s bondholders, but it is offering only stock in a new G.M. to its creditors — 225 shares for each $1,000 in debt held, making them minority owners who are invested in the company’s success. “That’s the bargaining chip,” said Mr. Cole of the Center for Automotive Research. Ahead of the June 1 deadline, Mr. Obama holds all the leverage: The bondholders’ only alternative would be to get in a long line of creditors who will be paid relatively little, because G.M. bonds are trading at about 10 cents on the dollar. It “may not be such a bad deal in the end,” Mr. Cole said. G.M.’s case also differs from Chrysler’s in another crucial sense: there is no Fiat in the wings, no big private investor ready to bring new money and new technology. Instead, Mr. Obama will effectively use taxpayers as that investor, with the federal government getting slightly more than a 55 percent stake in the company in exchange for forgiving $10 billion in the automaker’s outstanding federal loans. The United Automobile Workers’ retiree trust would have just under 40 percent of the stock, under the G.M. plan. The huge federal stake in G.M. — even if temporary — means that for all of Mr. Obama’s protests that he is a reluctant investor, eager to fix the company and sell the controlling interest ( hoping for a hefty profit), he will be judged by whether his plan actually works. Mr. Obama has said repeatedly that he is not an automotive engineer and has no desire to pick models, engines, factories or corporate governance structures. But while he may not be choosing automotive designs, he has already started dictating the company’s direction. The president has made it clear that G.M. must produce small, fuel-efficient, low- carbon-emitting cars — steps G.M. has taken only haltingly. Its vehicles range from the Cadillac Escalade, which gets 12 miles to the gallon in the city, to the experimental Chevy Volt, an electric car that it says will go 40 miles gas-free.

407 Members of Mr. Obama’s auto task force say that even after the government owns a majority of the company, it will have no role in management. That, they say, will be farmed out to professionals, the work supervised by government-appointed members of a new G.M. board. But at some point, some task force members acknowledge, the drive for profitability is likely to collide with Mr. Obama’s fuel-efficiency and low-emission goals. G.M. produced heavy gas-guzzlers because they were among the most profitable in its line and, for a long time, the most popular. It is unclear whether smaller cars can be as profitable — or, for a few years, competitive with offerings from Toyota and Honda and a raft of inexpensive cars under development in China. David E. Sanger y Bill Vlasic “Chrysler’s Fall May Help Administration Reshape G.M.”, NYT, 3/05/09,: http://www.nytimes.com/2009/05/03/business/03auto.html?hp

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Opinion May 3, 2009 EDITORIAL The Swiss and Their Secrets Switzerland’s president has offered a deal. He said it would be easier to complete a new bilateral tax treaty if Washington dropped its legal action against UBS, the Swiss bank that tens of thousands of wealthy Americans have used to hide their money from the I.R.S. The offer looks tempting. Under international pressure, Switzerland has indicated a willingness to relax its bank secrecy rules and abide by new global guidelines. A new tax treaty, which Treasury officials were negotiating last week, would give the Internal Revenue Service access to information it needs to collect taxes from Americans with secret accounts. It is still a bad deal. It would let off the hook thousands of people who have used UBS to avoid billions in taxes. This money is owed. The Treasury certainly needs it. And it is doubtful that Switzerland, no matter what it claims, would jeopardize a treaty that all Swiss companies that do business in the United States need, for reasons including protecting themselves from possible double taxation. The Swiss government claims that the American demand that UBS hand over the names of 52,000 United States customers with secret accounts is not far from a fishing expedition, forbidden under international guidelines. But UBS has already been caught soliciting illicit business in the United States. It admitted in court that it sent dozens of bankers on thousands of trips with devious stratagems to hide money from tax authorities. According to court documents, by the middle of the decade these American accounts held about $15 billion in assets and generated revenues for UBS of more than $120 million a year. We understand that the Swiss government is worried about the future of its biggest bank, in which it recently sunk taxpayer money. We welcome its newfound openness — however reluctantly given. But the United States need not condone the illegal of the past for a shot at stopping illegal tax evasion in the future. The Obama administration should, politely, say no. http://www.nytimes.com/2009/05/03/opinion/03sun3.html?ref=opinion

409 Business May 3, 2009 How Lehman Brothers Got Its Real Estate Fix By DEVIN LEONARD BACK when he was a major Wall Street deal maker, Mark A. Walsh, the former head of the global real estate group at Lehman Brothers, had a running joke with Carmine Visone, one of his managing directors. Mr. Visone, 10 years older than his boss, would lecture Mr. Walsh about the importance of fundamentals: land values, construction cost and rents. As Mr. Visone remembers it, Mr. Walsh would wave his hand dismissively and would argue just as emphatically that the best way to make office buildings spew cash was through the magic of financial engineering. Typically, Mr. Visone gave in. “He was too smart for me,” Mr. Visone recalls. Many others were equally in awe of Mr. Walsh’s intellect. Until Lehman Brothers collapsed last September, Mr. Walsh was considered the most brilliant real estate financier on Wall Street. In the ’90s, he pioneered the art of lending to office building developers and then slicing up and repackaging the debt for investors. Less risky pieces went to institutional investors; the lower-rated chunks to hedge funds and others hungry for juicier returns. Lehman pocketed a fee every step of the way, and it often retained a risky piece or two to give its own earnings a kick. “That was one of Lehman’s strengths,” says Brad Hintz, a former chief financial officer at Lehman who is now an analyst at Sanford C. Bernstein. “In fact, a lot of Wall Street firms tried to duplicate Lehman’s commercial real estate strategy.” Mr. Walsh, who wore rumpled Brooks Brothers suits and could be painfully awkward in front of crowds, was one of Lehman’s biggest profit producers. Former Lehman executives say Richard S. Fuld Jr., the bank’s chief, relied on Mr. Walsh to bankroll the firm’s swanlike transformation from a second-tier bond trading shop into a full-service investment bank. Former members of his unit, who requested anonymity because they were concerned about being swept up in lawsuits and investigations surrounding Lehman’s collapse, say it generated more than 20 percent of Lehman’s $4 billion in profits at the peak of the real estate boom in 2006. Many factors, of course, contributed to Lehman’s demise last fall. Near the end, it carried $25 billion in toxic residential mortgages. It was wildly overleveraged. And the federal government made the fateful decision not to rescue Lehman from its mistakes. But when real estate overheated in the years before Lehman’s implosion, Mr. Walsh made billions of dollars in loans and equity investments that also ultimately helped bring down the bank. Lehman’s bankruptcy hasn’t quelled the controversy about Mr. Walsh’s activities. Last fall, the United States attorney’s office in Manhattan subpoenaed him and other former Lehman executives as part of an investigation into whether the firm improperly valued its commercial real estate holdings, among other things. In March in a civil complaint, Anne Milgram, the attorney general, accused Mr. Walsh and 17 other

410 former Lehman officials of defrauding the state’s pension funds by misrepresenting Lehman’s real estate exposure. Mr. Walsh, 49, declined to be interviewed for this article. His former co-workers and clients remain staunchly loyal. “I have the greatest respect for him personally and professionally,” says Richard S. Ziman, the former C.E.O. of Arden Realty, a company based in Los Angeles that Mr. Walsh helped take public in 1996 and sell in 2006. “I’d testify in court if that was necessary.” But even among Mr. Walsh’s supporters, a nagging question remains: How could a real estate wizard who built a thriving business by creating new ways of managing risk by sweeping loans off Lehman’s balance sheet end up doing deals that contradicted everything he seemed to stand for — and contribute to the collapse of one of Wall Street’s most venerable firms? MR. WALSH grew up in Yonkers, the son of a lawyer who once served as chairman of the New York City Housing Authority. He attended Iona Preparatory School in New Rochelle; the College of the Holy Cross, where he majored in economics; and, finally, the Fordham University School of Law. After receiving his law degree in 1984, he worked as a real estate lawyer in Miami and handled a lot of foreclosures. That came in handy when he took a job at Lehman in 1988, at the end of an earlier real estate boom that left banks and insurers saddled with mountains of bad loans. Mr. Walsh bought and sold loans on properties that were often in foreclosure. There were bargains galore. He generated hundreds of millions of profits for the firm and won the confidence of Mr. Fuld, who gave him the authority to make huge loans. Then, along with Ethan Penner of and Andrew D. Stone of Credit Suisse First Boston, Mr. Walsh discovered securitization. This created an entirely new market for commercial real estate debt. No longer would lenders have to shoulder all the risk from real estate lending. Wall Street could make the same loans and sell them off. The challenge then became lassoing the right kind of developers to back. The three men marketed their services very differently. Mr. Penner hired Bob Dylan, Stevie Nicks and the Eagles to serenade clients, while Mr. Stone jetted around the country with the likes of . The publicity-shy Mr. Walsh was more understated. Mr. Ziman says Mr. Walsh went fly-fishing with clients in Colorado and Montana. Developers also loved the fact that Mr. Walsh was willing to lend them enormous sums. In 1997, Barry Sternlicht, then the chief executive of Starwood Hotels and Resorts, needed $7 billion to buy ITT. “I called up Mark and Goldman Sachs and said, ‘Would you be interested?’ ” he recalls. “Goldman said they were. They came to see us. But we needed to get it done really quickly. Mark said, ‘Yeah, we’ll do it.’ I said, ‘Really? You are going to do it yourselves?’ He said, ‘Yup.’ ” Mr. Sternlicht says Mr. Walsh brought Mr. Fuld himself to a meeting at the hotelier’s home to assure him that Lehman would back his acquisition. “Dick Fuld sat there in my living room and said: ‘You have our word. We’ll get this done,’ ” Mr. Sternlicht recalls. “We paid a $20 million fee. I was never so happy paying a fee.” Mr. Fuld declined to be interviewed for this article.

411 During the late ’90s, Mr. Walsh forged close ties with many of the most prominent developers in New York. He bankrolled Tishman Speyer in its purchase of the Chrysler Building in 1997. He backed Steven C. Witkoff in his purchase of the Woolworth Building in 1998. And he financed the acquisitions by the German real estate developers Aby Rosen and Michael Fuchs of the landmark Lever House and Seagram Building. Mr. Rosen recalls that he and Mr. Walsh closed the $375 million Seagram Building deal in four weeks. “He was fast,” says Mr. Rosen. “He doesn’t try to kill you or retrade. To be honest, there are very few people in the industry you can say that about.” Mr. Walsh was also skilled at making all that debt vanish from Lehman’s balance sheet before the firm choked on it. On the eve of the financial crisis brought by the near collapse of Long Term Capital Management in 1998, Lehman flushed $3.6 billion in commercial real estate loans through its securitization machine, avoiding some of the losses that crippled other firms, including Nomura and Credit Suisse. Mr. Walsh was rewarded with more responsibility, and in 2000 was named co-head of a new private equity group dedicated to real estate investments. After raising $1.6 billion from pension funds and university endowments and delivering an internal rate of return of more than 30 percent, the equity franchise easily raised $2.4 billion for a second fund, which closed in 2005. While the market was heating up and low-priced deals were harder to find, the second fund still generated a 15 percent return. But the funds’ structure created perverse incentives within Mr. Walsh’s group, according to two former members of his team who requested anonymity because of confidentiality agreements they had signed with Lehman. Lehman owned 20 percent of the funds. Institutions and wealthy investors controlled the rest. Mr. Walsh, in order to raise money, promised to give the outsiders a first peek at deals. If institutional investors and others passed, Mr. Walsh’s bankers were free to make the same investments with the firm’s money — which was just fine with his troops: they received bigger bonuses on the riskier deals because Lehman didn’t have to share the profits. But it also meant that more deals that could go wrong ended up on Lehman’s balance sheet. And this is exactly what happened with a set of deals known as “bridge equity” financings. As real estate went into overdrive in 2003, Mr. Walsh, in order to help clients pump up their offers in heated bidding wars, started frequently putting Lehman’s own cash into deals — alongside the debt they raised. With its cash on the line, Lehman would be dangerously exposed in any downturn, so, once a deal closed, the firm would try to sell its equity stake as quickly as possible. Lehman made ripe 4 percent fees for its equity investments — twice the going rate for loan securitization. As long as the market was rising, Mr. Walsh’s group was fine. But if the bank couldn’t sell the bridge equity and if real estate prices fell, it could end up with nothing. “It was a classic assumption that values are going to be higher a year from now,” says Mike Kirby, chairman of Green Street Advisors, a research firm. “That was the mentality at the time.”

412 Bridge equity quickly became one of Lehman’s signature products, and Mr. Walsh’s group deployed it in dozens of deals, including Tishman Speyer’s $1.7 billion purchase of the MetLife Building on Park Avenue in 2005 and Beacon Capital Partners’ acquisition of the News Corporation’s headquarters on the Avenue of the Americas for more than $1.5 billion in 2006. “Guys like Tishman Speyer wanted as much of this product as they could get,” says a former real estate banker at a competing Wall Street firm, who requested anonymity because of confidentially agreements he had signed with the bank. “For them, it was a no-brainer. It was like, ‘Bring as much of this on as possible.’ ” By all accounts, Mr. Walsh made piles of money. He had perks like a corner office over Park Avenue with a private conference room. Yet his ego never matched the size of his deals. Friends say Mr. Walsh lived in a modest home in Rye, N.Y., with his wife, Lisa, and their three boys. His main interest outside of work and family was fishing. “At the end of the day, he is content to throw a line in the water and fish by himself,” says his friend Dan McNulty, co-chairman of DTZ Rockwood, a real estate investment bank in New York. “He’s a very reflective guy.” IF Lehman and Mr. Walsh were convinced about the virtues of bridge equity, outside investors weren’t. “It was a gray area,” says a former Lehman executive who asked not to be identified because of his confidentiality agreements with the firm. “It wasn’t the kind of risk that the investors had signed up for. The funds never participated in those deals.” One partnership pursued by Mr. Walsh exemplified his newfound appetite for ever riskier deals: transactions with the SunCal Companies of Irvine, Calif., an operation with an intriguing business model. It bought land, primarily in its home state, and sought government approval for residential development. If it got the green light, it sold the land to builders for an enormous profit. Mr. Walsh lent SunCal more than $2 billion and formed a close relationship with its founder, Boris Elieff. Mr. Elieff did not return calls seeking comment. “We had other Goldman Sachs and other people who were clamoring to do business with us,” says Louis Miller, a lawyer for SunCal. “Lehman said, ‘No, we want to you to be exclusive with us.’ They loved SunCal.” But because the cash flow from the SunCal deals was hard to predict, Lehman’s loans to the company were nearly impossible to syndicate. After all, how do you estimate income from raw land that may or may not be approved for development? After putting about $140 million from the funds into SunCal deals, Mr. Walsh discovered that the investors wanted out. In 2006, he cashed them out with a tidy profit in exchange for effectively transferring their ownership stake onto Lehman’s balance sheet. That left Lehman with even more SunCal exposure, just before the emergence of the subprime crisis that would pummel the Southern California real estate market. Others were already sensing danger, and some of Mr. Walsh’s longtime clients started to pull back. Mr. Ziman of Arden Realty sold his company to GE Capital in 2006. He said the real estate market — and, indeed, the entire financial system behind it — was becoming increasingly bizarre.

413 “Every Monday, I’d get these e-mails from all the investment banks about the deals of the week,” Mr. Ziman recalls. “I kept saying, ‘Where is all this money coming from?’ ” Lehman wasn’t the only bank throwing bridge equity into real estate. In October 2006, Wachovia and Merrill Lynch pledged $1.5 billion for Tishman Speyer’s $5.4 billion acquisition of Stuyvesant Town, the huge apartment complex in Manhattan. In February, Goldman Sachs, Morgan Stanley and Bear Stearns put up $3.5 billion into the Blackstone Group’s $32 billion deal to buy Equity Office Properties Trust. Missing out on the Stuyvesant Town deal stung Lehman, said one of the firm’s bankers who declined to be identified because he wasn’t authorized to speak publicly about his time at Lehman. It wasn’t just the lost fees. Mr. Walsh considered Tishman Speyer a core client. What’s more, Tishman Speyer’s chairman, Jerry Speyer, had a close relationship with Mr. Fuld. They were both board members of the Federal Reserve Bank of New York; Mr. Speyer and Mr. Fuld’s wife, Kathleen, were trustees of the Museum of Modern Art. And it wasn’t long before Mr. Walsh found a way to do an even bigger deal with Mr. Speyer’s company. In May 2007, Lehman and Tishman Speyer offered to buy Archstone-Smith Trust, a $22 billion deal struck at the peak of an already dangerously frothy market. Tishman Speyer put up a mere $250 million of its own equity. Lehman, in a 50-50 partnership with Bank of America, put up $17.1 billion of debt and $4.6 billion in bridge equity financing. As the credit crisis began to set in during the following summer, the financing for the Archstone deal appeared imperiled. With the markets spiraling downward, rumors were rife that Lehman was having problems and that it might walk away from the Archstone transaction. Mr. Speyer, who declined to comment for this article, phoned Mr. Fuld to make sure that he still had Lehman’s backing. “When I placed that call, I knew it was preposterous,” Mr. Speyer recalled in an interview with The New York Times in 2007. “I placed it because I had to. But I knew when I was dialing how the conversation would come out.” Lehman stuck by Mr. Speyer, and the deal was completed in October 2007. Had Lehman walked away, the partners would have absorbed a $1.5 billion breakup fee. In hindsight, it would have been smart to swallow that loss. But several people involved in the deal say the parties thought that the would actually help Archstone because people who could no longer afford houses would rent the company’s apartments. And for his part, Mr. Walsh was reluctant to jeopardize an important client relationship. A former Lehman executive, who declined to be identified because he wasn’t authorized to speak publicly about his time at the firm, said: “We were very loyal to our clients and had a culture of standing by our clients, even when the road got bumpy. We did not back away from commitments. We could not have built such a dominant franchise with any other approach. That culture, of course, has its risks and downside, including losing money on some transactions.” Mr. Walsh tried to limit Lehman’s risk. He sold $8.9 billion of the Archstone debt to Fannie Mae and Freddie Mac and persuaded Bank of America and Barclays to buy

414 $2.4 billion of the bridge equity. Even so, Lehman ended up with nearly 25 percent of a hugely overpriced deal just as real estate was imploding. This time, Lehman couldn’t sell its immense hunk of bridge equity, and it was stuck with a $2.2 billion ownership stake that nobody wanted. Still, there were no hard feelings between the partners. “Mark is an extremely talented investor and a great partner,” Mr. Speyer says. “We look forward to working with him in the future.” Of course, the most that Tishman Speyer could lose on Archstone was $250 million — a pittance next to Lehman’s total $5.4 billion exposure. Lehman soon had much bigger worries. In March 2008, Bear Stearns nearly collapsed and was sold to JPMorgan Chase in a government-supported deal. Wall Street wondered which bank might be next to fall. Short-sellers thought they knew: Lehman Brothers. Mr. Walsh and his crew rushed to sell their inventory. Between November 2007 and February 2008, Lehman shed $2.8 billion of its commercial real estate exposure. But that still left $36 billion of hard-to-value leftovers, including debt and equity from Archstone and SunCal. Last spring, the hedge fund investor David Einhorn, who was shorting Lehman’s stock, suggested that the bank’s positions in Archstone and SunCal might be worthless. Mr. Einhorn said share prices of Archstone’s competitors had tumbled as much as 30 percent since the acquisition was announced. As for SunCal, he pointed out that publicly traded home builders had written down their Southern California land holdings to “pennies on the dollar.” Mr. Einhorn called for Lehman to take a multibillion-dollar write-down on its Archstone holdings. Lehman said it was valuing its commercial real estate fairly, based on the prices that Mr. Walsh’s group had been getting on the open market as it struggled to free up the bank’s balance sheet. Lehman ended up with $29 billion in commercial mortgage exposure on its books in the second quarter of 2008 — 30 percent more than Deutsche Bank and Morgan Stanley and 70 percent more than Goldman Sachs. In early September, Lehman announced that it would stuff its toxic commercial mortgages into a new public company to be spun off to shareholders. The idea went nowhere. “They couldn’t get that commercial real estate off their books to save their lives,” says Mr. Hintz at Sanford C. Bernstein. In short order, Lehman collapsed. SOON after Lehman’s bankruptcy, a former executive who declined to be identified because he wasn’t authorized to speak publicly about his time at the firm went to Mr. Walsh’s office to talk. But they sat in silence. After two minutes, the executive left. “It became clear that neither one of us was going to say something that the other didn’t already know, or that we were going to actually have a new idea or bring greater clarity to the situation,” he recalls. Ultimately, Barclays scooped up part of Lehman’s operations. But it dismissed Mr. Walsh and most of his team. Now the United States attorney’s office and the New Jersey attorney general are trying to determine whether Mr. Walsh did anything wrong.

415 But according to former Lehman executives who requested anonymity because of confidentially agreements, the values of commercial real estate holdings were determined by an independent committee outside his division. Mr. Walsh has hired Patrick J. Smith, a former federal prosecutor who is now a partner at DLA Piper, to defend him in these investigations. Mr. Smith declined to comment for this article. In the meantime, Mr. Walsh is staying busy. He is helping the estate of his former employer dispose of its private equity holdings. His friends say they believe that Mr. Walsh will eventually emerge from the rubble of Lehman’s collapse and return to deal- making. “Guys like this are very rare,” says Mr. Rosen, the developer. “He’ll be back. He picked up the phone and people listen. Nobody can take that away from him.” Devin Leonard, “How Lehman Brothers Got Its Real Estate Fix”, NYT, 3/05/2009, en: http://www.nytimes.com/2009/05/03/business/03real.html?hp

416 Negocios REPORTAJE: Empresas & sectores Información privilegiada Tres mujeres sin piedad Tres directivas del Banco de España instruirán el expediente de CCM MIGUEL Á. NOCEDA 03/05/2009 Tres mujeres (Lucinda Claver Madurga, María Ortega Diego y Paloma García Galocha) de la Secretaría Técnica del Banco de España se han encargado de la instrucción del expediente abierto a Caja Castilla La Mancha (CCM) y los responsables de su gestión. Es decir, los miembros del consejo de administración durante 2007 y 2008 (incluidos los representantes del PP que dimitieron en febrero), con su presidente, Juan Pedro Hernández Moltó, y el director general, Ildefonso Ortega, a la cabeza. Los implicados pueden presentar alegaciones al pliego de cargos en un plazo de 20 días. Todo indica, a la vista del demoledor informe de los Servicios de Inspección del Banco de España, que los implicados tienen poca defensa. Los errores cometidos -como volcarse en el sector inmobiliario, no hacer caso a las exigencias del Banco de España, conceder créditos a personas ligadas a la entidad para otros proyectos, tener un 84% de los grandes créditos de dudoso cobro, entre otros pecados- no son desde luego la mejor tarjeta. Lo cierto es que el informe ha puesto patas arriba el sector, donde se comenta con avidez que las malas prácticas de CCM son moneda común en gran parte de las cajas de ahorros. Sin embargo, lo que ha ocurrido es que la que se ha intervenido es CCM y, a juzgar por lo que se sabe ahora, con mucho retraso. Lo que el banco central quiere es aprovechar el informe para dar el aviso a navegantes basándose en los requerimientos que hace a CCM tras desvelar su política de actuación, que llevó a unas pérdidas antes de impuestos de 1.102 millones de euros. El informe, en ese sentido, recomienda "establecer medidas gerenciales para reforzar el área de recuperaciones y extremar el seguimiento de los acreditados que presenten debilidades para evitar el menoscabo de valor de la cartera crediticia". Asimismo, exige "una profunda reflexión sobre los errores cometidos y un esfuerzo por encontrar las mejores soluciones que eviten que las inversiones continúen siendo una fuerte rémora para la institución". Y, sobre todo, destaca que la estructura organizativa no contaba con líneas de responsabilidad claras y definidas y que hicieron poco caso a anteriores inspecciones del Banco de España. Vale para todas, las que pueden estar en una situación delicada y las que no. El conocimiento del informe ha provocado gran revuelo político en Castilla-La Mancha, donde PP y PSOE se han estado echando los trastos a la cabeza en busca de réditos electorales. Pero tanto uno como otro saben que tienen muy difícil salida, porque los dos tienen personas implicadas en la gestión de la caja por mucho que el PP hubiera querido escurrir el bulto forzando la dimisión de sus consejeros de la caja y de la Corporación CCM, que no cumplieron todos. Seguramente por eso, desde el PSOE, que con José María Barreda gobierna en la región, se mandan mensajes de concordia y entendimiento al otro lado apelando a asegurar el futuro de la caja de ahorros. Las respuestas del PP, dirigido por María Dolores de Cospedal, no parecen que vayan encaminadas a acabar con el enfrentamiento.

417 El mismo mensaje se ha lanzado desde el Banco de España, que ha puesto al frente de la caja para reflotarla a un hombre del sector, Xabier Alkorta, recientemente jubilado como director general de la Kutxa. Alkorta tiene el reto de poner a CCM en órbita de nuevo y evitar que siga la sangría de retirada de depósitos, que para lo que está cayendo se considera que no ha sido muy grave. Y, mientras siguen los rumores de fusiones y de existencia de listas negras, en la institución que gobierna Miguel Ángel Fernández Ordóñez han respirado satisfechos al ver cómo en los resultados del primer trimestre se han cumplido, en la mayoría de los casos, los criterios de prudencia que recomienda en general y que en el caso de CCM han brillado por su ausencia, a juzgar por la Inspección. Es decir, dotar provisiones extraordinarias (llenar la hucha) por si los tiempos que vienen son todavía peores. La lectura de los resultados trimestrales ofrece otras conclusiones: el efecto de la crisis ha sido duro, pero no demasiado (los sindicatos reclamaron el viernes que no llenen sus resultados y hagan fluir el dinero a los ciudadanos); la morosidad se ha disparado de forma preocupante y sigue siendo un peligro, y el sistema financiero español es el que mejor ha capeado y capea el temporal. http://www.elpais.com/articulo/empresas/mujeres/piedad/elpepueconeg/20090503elpneg emp_2/Tes

El Banco de España desvela múltiples irregularidades en la gestión de CCM El supervisor aflora operaciones de "riesgo" con personas vinculadas a la caja MIGUEL ÁNGEL NOCEDA / ÍÑIGO DE BARRÓN - Madrid - 01/05/2009 El informe de la Inspección del Banco de España sobre Caja Castilla La Mancha (CCM) es demoledor. Pone al descubierto "graves errores y carencias" en la gestión desde 2007, como operaciones concedidas a personas vinculadas al grupo para otros proyectos y un excesivo riesgo en el sector inmobiliario. El informe de la Inspección del Banco de España sobre Caja Castilla La Mancha (CCM) es demoledor. Pone al descubierto "graves errores y carencias" en la gestión desde 2007, como operaciones concedidas a personas vinculadas al grupo para otros proyectos y un excesivo riesgo en el sector inmobiliario. Ello obligó a unos ajustes por valor de 1.102 millones de euros en la cuenta de resultados a 31 de diciembre de 2008. Asimismo, responsabiliza directamente al presidente, Juan Pedro Hernández Moltó, e incoa expediente a los consejeros de los ejercicios 2007 y 2008, incluidos, pues, los del PP, que dimitieron en febrero. En el informe, que entró en el registro del Banco de España el 29 de abril, la Inspección descarga toda una batería de irregularidades y vicios en la organización, el control interno y los excesos de concentración: "La estructura organizativa no contaba con líneas de responsabilidad clara y definida". Subraya que, aunque el presidente no tenía funciones ejecutivas, "en la práctica presidía la Comisión Ejecutiva, el Comité de Dirección y realizaba funciones de gestión de forma directa".

418 A la Comisión de Inversiones la desnuda: "No ha velado por el cumplimiento de los objetivos que su reglamento establece, no realizaba contraste con estrategia alguna, no tenía en cuenta la capacidad financiera de la caja, no informaba al Consejo de Administración o comunicaba las decisiones con posterioridad". Y al director general y el control de riesgos más de lo mismo: "No han limitado las demandas de financiación de las sociedades participadas y no se han apreciado en el entorno del control interno una segregación de funciones bien definida". - Enumera las siguientes prácticas: - La carencia de políticas de seguimiento de las inversiones se ha traducido en graves carencias de control y ha llevado a que se cometan graves errores de gestión, sobre todo en participaciones minoritarias en sociedades cotizadas, que suponen en torno al 50% del total de las inversiones. - Concentración en el sector inmobiliario, que, unido al crecimiento de la inversión crediticia, ha hecho que se supere el límite del 35% marcado por el propio Consejo en junio de 2005. - No se produce la necesaria independencia entre el análisis de riesgos y los intereses de la sociedad solicitante, destacando operaciones en las que se financia la práctica totalidad de la inversión para adquirir participaciones en sociedades relacionadas con la entidad y operaciones concedidas a personas vinculadas con la entidad en otros proyectos por un importe de riesgo elevado en relación con su capacidad de devolución. - Ausencia de un cuadro de mando adecuado para la toma de decisiones, lo que provocó que la financiación mayorista sobre el total fuera del 39%. - El seguimiento de la inversión crediticia se hacía con retraso y sin profundidad. - La auditoría interna no recibía la atención necesaria de los servicios centrales. Según la Inspección, "todos esos problemas hacen que la caja supere el límite de concentración de riesgos con empresas del propio grupo no consolidable y con otro grupo económico, ascendiendo el exceso a 168 millones". Asimismo, denuncia que no incluyó a las sociedades multigrupo, por lo que el exceso adicional se aproximaría a 290 millones, "alcanzando los riesgos con las sociedades del grupo no consolidado el 44% de los recursos propios de la entidad". - El informe desglosa las actuaciones de CCM: - Relativas a la contabilización y deterioro de las inversiones de CCM Corporación y otras participadas. La Inspección cuantifica en 309,8 millones de euros el ajuste. De ellos, 221,9 provienen del deterioro del valor de los activos en 35 de las participadas, especialmente en inversiones inmobiliarias. A esa cifra hay que añadir 14,5 millones de gastos financieros indebidamente activados; minusvalías por valor de 36,1 millones en una sociedad cotizada (presumiblemente Metrovacesa) y ajustes por 37,3 millones propuestos por Ernst & Young. - Relativos al deterioro de la inversión crediticia. Tras analizar los 125 clientes con créditos por más de 16 millones, una cartera de 4.011 millones, la conclusión es que nada menos que el 30% se consideran dudosos, el 34%, subestándar y otro 20% requiere seguimiento especial. De los 125 acreditados, 93 presentan "algún tipo de debilidad". El Banco de España pide reclasificar 902 millones como dudosos y ajustar la cuenta de resultados por 579,5 millones.

419 - Relativos al incumplimiento de los requerimientos de la anterior inspección. Con fecha 21 de octubre de 2008 se emitieron los requerimientos de una inspección sobre las cuentas de 2007 y se instaba a reconocer el deterioro de las participaciones en inmobiliarias a 30 de septiembre de 2008 por 196 millones, que se elevaron a 212 millones a final de año. El Consejo contestó el 15 de diciembre que se había acordado "encomendar a la dirección general la adecuada contabilización de las minusvalías". Pese a eso, la entidad las recogió como ajuste dentro del patrimonio neto, en lugar de la cuenta de resultados. - Los ajustes anteriores arrojan unas pérdidas después de impuestos de 740 millones y una reducción de recursos propios por valor de 598 millones, muy por debajo del mínimo exigido. http://www.elpais.com/articulo/economia/Banco/Espana/desvela/multiples/irregularidad es/gestion/CCM/elpepieco/20090501elpepieco_2/Tes

420 Opinion May 1, 2009 OP-ED COLUMNIST An Affordable Salvation By PAUL KRUGMAN The 2008 election ended the reign of junk science in our nation’s capital, and the chances of meaningful action on climate change, probably through a cap-and-trade system on emissions, have risen sharply. But the opponents of action claim that limiting emissions would have devastating effects on the U.S. economy. So it’s important to understand that just as denials that climate change is happening are junk science, predictions of economic disaster if we try to do anything about climate change are junk economics. Yes, limiting emissions would have its costs. As a card-carrying economist, I cringe when “green economy” enthusiasts insist that protecting the environment would be all gain, no pain. But the best available estimates suggest that the costs of an emissions-limitation program would be modest, as long as it’s implemented gradually. And committing ourselves now might actually help the economy recover from its current slump. Let’s talk first about those costs. A cap-and-trade system would raise the price of anything that, directly or indirectly, leads to the burning of fossil fuels. Electricity, in particular, would become more expensive, since so much generation takes place in coal-fired plants. Electric utilities could reduce their need to purchase permits by limiting their emissions of carbon dioxide — and the whole point of cap-and-trade is, of course, to give them an incentive to do just that. But the steps they would take to limit emissions, such as shifting to other energy sources or capturing and sequestering much of the carbon dioxide they emit, would without question raise their costs. If emission permits were auctioned off — as they should be — the revenue thus raised could be used to give consumers rebates or reduce other taxes, partially offsetting the higher prices. But the offset wouldn’t be complete. Consumers would end up poorer than they would have been without a climate-change policy. But how much poorer? Not much, say careful researchers, like those at the Environmental Protection Agency or the Emissions Prediction and Policy Analysis Group at the Massachusetts Institute of Technology. Even with stringent limits, says the M.I.T. group, Americans would consume only 2 percent less in 2050 than they would have in the absence of emission limits. That would still leave room for a large rise in the standard of living, shaving only one-twentieth of a percentage point off the average annual growth rate. To be sure, there are many who insist that the costs would be much higher. Strange to say, however, such assertions nearly always come from people who claim to believe that free-market economies are wonderfully flexible and innovative, that they can easily transcend any constraints imposed by the world’s limited resources of crude oil, arable land or fresh water.

421 So why don’t they think the economy can cope with limits on greenhouse gas emissions? Under cap-and-trade, emission rights would just be another scarce resource, no different in economic terms from the supply of arable land. Needless to say, people like Newt Gingrich, who says that cap-and-trade would “punish the American people,” aren’t thinking that way. They’re just thinking “capitalism good, government bad.” But if you really believe in the magic of the marketplace, you should also believe that the economy can handle emission limits just fine. So we can afford a strong climate change policy. And committing ourselves to such a policy might actually help us in our current economic predicament. Right now, the biggest problem facing our economy is plunging business investment. Businesses see no reason to invest, since they’re awash in excess capacity, thanks to the housing bust and weak consumer demand. But suppose that Congress were to mandate gradually tightening emission limits, starting two or three years from now. This would have no immediate effect on prices. It would, however, create major incentives for new investment — investment in low- emission power plants, in energy-efficient factories and more. To put it another way, a commitment to greenhouse gas reduction would, in the short- to-medium run, have the same economic effects as a major technological innovation: It would give businesses a reason to invest in new equipment and facilities even in the face of excess capacity. And given the current state of the economy, that’s just what the doctor ordered. This short-run economic boost isn’t the main reason to move on climate-change policy. The important thing is that the planet is in danger, and the longer we wait the worse it gets. But it is an extra reason to move quickly. So can we afford to save the planet? Yes, we can. And now would be a very good time to get started. Paul Krugman “An Affordable Salvation”, NYT, 1/05/09, http://www.nytimes.com/2009/05/01/opinion/01krugman.html?_r=1

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La banca ya no quiere más viviendas Para las entidades de crédito, los pisos son un quebradero de cabeza en su gestión del día a día YOLANDA DURÁN 01/05/2009 Las entidades financieras ya tienen bastante con su propia crisis. La recomposición de sus carteras, la morosidad y el reordenamiento del sector van a marcar las pautas de 2009 y 2010, y los bancos están informando de forma privada a las inmobiliarias de que no están dispuestos a asumir más carteras de inmuebles en pago de deuda, lo que significa vender como sea con descuentos reales. Y es que las entidades financieras prevén en los próximos meses un incremento de las suspensiones de pagos procedentes de otros sectores empresariales, que se traducirá en un crecimiento de impagados. El aumento del paro se va a sentir con más virulencia en los créditos dudosos, lo que repercutirá a su vez en la tasa de morosidad y en la solvencia, algo que la banca española teme por su repercusión internacional. El FMI declaró hace unos días que los bancos españoles necesitarían captar 3.200 millones de euros adicionales para fondos propios, y así sortear la crisis. El diagnóstico se hizo tras realizar un test de estrés a las 53 principales entidades financieras (ocho bancos, cuarenta cajas de ahorro y cinco cooperativas). Los cálculos se apoyaban en el análisis de los préstamos de dudoso cobro de los bancos y cajas y en cómo pueden verse afectados estos créditos -hipotecas, créditos a los promotores y otros préstamos- si se cumplen determinadas hipótesis como una caída nominal de los precios de la vivienda del 16% a finales de 2009, tasa de paro del 15%, inflación ligeramente por debajo del 2% y mismo volumen de deuda del sector privado en relación al PIB. Sobre Europa, sin contar la banca británica, el FMI asegura que las entidades necesitan entre 375.000 y 725.000 millones de euros de capital adicional "no sólo para compensar pérdidas, sino para lograr el índice más estricto de apalancamiento y el mayor nivel de capitalización que exigen en este momento los mercados en vista de la incertidumbre que rodea las valoraciones de activos y la calidad del capital". En España, la morosidad de los créditos concedidos a empresas y particulares alcanzó el 4,12% en febrero, su nivel máximo desde enero de 1997. El volumen total de créditos dudosos de cobro del sistema asciende a 77.653 millones de euros en febrero, lo que significa que se ha multiplicado por cuatro en apenas un año, tras pasar del 1,05% (20.116 millones de euros) al citado 4,12%, y eso que no recoge la morosidad de los establecimientos financieros de crédito (ECF), con tasa de impagos muy elevada. En este contexto, las entidades no creen que se pueda asumir más cartera de activos inmobiliarios para su venta, puesto que, aunque en menor medida que si estuviera en balance como deuda, no deja de suponer un quebradero de cabeza para la gestión del día a día. Los expertos del sector prevén que la morosidad continúe aumentando en 2009, un año en el que podría llegar hasta el 9%. Las advertencias no son oficiales, pero coinciden en el tiempo, y no es casualidad, con una reactivación de las campañas de comercialización con descuento por parte de diversas empresas, y con el mensaje insistente del sector de que los descuentos en las

423 ventas ya superan el 20%. A esto hay que sumar la sorprendente petición por parte de la patronal hacia el Ejecutivo. Su presidente, José Manuel Galindo, ha propuesto sin éxito la compra por parte del Gobierno de paquetes procedentes del stock de casas en venta, a las que el Estado daría "un uso social", vía alquiler, y subvencionadas, con el fin de hacerlo atractivo a la banca. Comercialización especializada Algunas empresas han intensificado su labor de comercialización, incluso con la búsqueda de nichos específicos. El grupo Ternum prevé lanzar una oferta de viviendas para separados y divorciados con descuentos de hasta el 40% y pago aplazado, denominada "Separadosincasa". Osuna va a ofrecer descuentos a todos los miembros de la comunidad universitaria de la Universidad de Jaén en el alquiler de apartamentos de su propiedad. Metrovacesa ha puesto en marcha una iniciativa comercial por la que ofrece descuentos desde el 15% y hasta el 55% en un total de 270 viviendas ubicadas en Alicante, Almería, Barcelona, Cádiz, Castellón, Madrid, Málaga, Murcia, Sevilla, Valencia y Valladolid, siempre que la compra se cierre antes del 30 de abril. El primer Rastrillo Inmobiliario Roan, que se celebró los pasados 23 y 26 de abril, ofreció más de 500 viviendas en la capital y en la costa mediterránea con descuentos de hasta el 50%, en parte procedentes de activos adjudicados. Atendió 5700 peticiones de información y cerró 184 ventas que podrían llegar 300, según el Grupo. En paralelo, Galindo se ha mostrado partidario de alcanzar acuerdos entre los promotores y las entidades similares al firmado con el Santander, por el que el banco se ha comprometido a apoyar con créditos las ventas de los promotores y éstos a rebajar el precio. El presidente de la Apce indicó que la patronal negocia con algunas entidades acuerdos parecidos, aunque no desveló de qué bancos y cajas se trata. El 'stock' no deja de crecer El stock o excedente de pisos sin vender en manos de promotores sigue creciendo; los empresarios calculan que tendrán cerca de 800.000 viviendas sin colocar en el mercado. Carlos Ferrer-Bonsoms, director de suelo y residencial de la consultora Jones LangLasalle, fue más allá al cuantificar en cerca de un millón el stock en venta. El directivo, que presentó esta semana el informe de inversión anual de la consultora, estimó que cerca de un 10% del producto existente de costa es "invendible", por ser proyectos de ubicación discutible o a precios disparatados. Además, y según sus cálculos, entre un 5% y un 7% más del stock disponible es de difícil venta. Unos argumentos que coinciden con la opinión expresada por la ministra de Vivienda hace unas semanas, en las que aseguraba que no todo el stock de casas promovidas hasta la fecha tiene encaje en el mercado, aunque hubiera demanda. El presidente de la patronal Apce, José Manuel Galindo, insistió en que un elevado stock de vivienda "es injusto" desde el punto de vista social, porque a pesar de la demanda son inmuebles inutilizados; y desde el punto de vista económico, dado que el coste de la deuda de estas viviendas paralizadas ascenderá a casi 4.600 millones de euros en 2009, según sus datos. Además, la caída en la construcción de nuevas casas en 2008 y 2009 supondrá la destrucción de casi un millón de puestos. Ante esta situación, el presidente de Apce planteó semanas atrás la posibilidad de que el Estado lance una oferta pública para comprar estas viviendas y dedicarlas a políticas sociales. El propio Galindo subrayó que esta propuesta "no ha encontrado receptividad

424 en el Ministerio", un hecho que fue ratificado el mismo día de la presentación. La directora general de Arquitectura y Política de Vivienda, Anunciación Romero, aseguró que "no se ha planteado en ningún momento la compra del stock existente".

http://www.elpais.com/articulo/economia/banca/quiere/viviendas/elpepueco/20090501 elpepueco_3/Tes

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May 1, 2009 The Lenders Obama Decided to Blame By ZACHERY KOUWE Peter A. Weinberg and Joseph R. Perella are part of a band of Wall Street renegades — “a small group of speculators,” President Obama called them Thursday — who helped bankrupt Chrysler. That, anyway, is the Washington line.

In fact, Mr. Weinberg and Mr. Perella, with sparkling Wall Street pedigrees, are the epitome of white-shoe investment bankers. And their boutique investment bank, a latecomer to Chrysler, played only a small role in the slow-motion wreck of the Detroit carmaker. But now the two men, along with a handful of other financiers, are being blamed for precipitating the bankruptcy of an American icon. As Chrysler’s fate hung in the balance Wednesday night, this group refused to bend to the Obama administration and accept steep losses on their investments while more junior investors, including the United Automobile Workers union, were offered favorable terms. In a rare flash of anger, the president scolded the group Thursday as Chrysler, its options exhausted, filed for bankruptcy protection. “I don’t stand with those who held out when everyone else is making sacrifices,” Mr. Obama said. Chastened, and under intense pressure from the White House, the investment firm run by Mr. Weinberg and Mr. Perella, Perella Weinberg Partners, abruptly reversed course. In a terse statement issued shortly before 6 p.m. Thursday, Perella Weinberg Partners announced it would accept the government’s terms. It was too late. Whether the other Chrysler holdouts will capitulate as well remained unclear. At least one, Oppenheimer Funds, insisted it would not back down. But whatever the outcome, this bit of brinkmanship — which many characterized as a game of chicken with Washington — has become yet another public relations disaster for Wall Street. Representatives for Perella Weinberg, which is advising the government on a wide range of banking issues, initially defended the firm’s decision to rebuff the government’s offer. They characterized the move as a principled stance against the administration’s growing intrusion into American business. Many in the financial and in the legal worlds said the investors were within their rights to challenge the proposal.

426 OppenheimerFunds, in a statement, said: “Our holdings in secured Chrysler debt are entitled to priority in long-established U.S. bankruptcy law, and we are obligated to our fund shareholders to support agreements that respect these laws.” But now that Chrysler has tipped into bankruptcy, some industry executives worry the administration will try to turn this episode to its political advantage. Washington, these people contend, needed some political cover for the mess in Detroit — and Wall Street provided a handy scapegoat. A move is already afoot to tighten oversight of hedge funds and end certain tax benefits for private investments funds. The Chrysler bankruptcy, and Wall Street’s role in it, will make resisting those efforts more difficult. What is striking to many in financial circles is how much Chrysler’s reluctant creditors gambled for what is, in the scheme of this bankruptcy, a relatively small amount of money. After weeks of increasingly rancorous negotiations, Perella Weinberg and 17 other financial firms — including OppenheimerFunds and Stairway Capital, a hedge fund that specializes in troubled companies — rejected the administration’s plan. It was, they argued, simply unfair. These investors together hold about $1 billion of Chrysler’s secured debt. The Treasury offered to pay all of Chrysler’s senior lenders $2.25 billion in cash if they forgave most of the company’s debts. Perella Weinberg and the others demanded more, arguing they would receive at least that much, and possibly more, under ordinary bankruptcy proceedings. But this is no ordinary bankruptcy. JPMorgan Chase and other large banks involved in the negotiations are, to greater and lesser degrees, beholden to Washington. Many have received billions of taxpayer dollars, as well as other generous subsidies. For the banks, defying the administration was never a serious option, according to people close to the talks with lenders, who asked not to be identified because they had signed confidentiality agreements. The other creditors, who sought to distinguish themselves from those who have received bailout money, believed they had a stronger hand. Many of them bought Chrysler debt for about 30 cents on the dollar, long after it became clear that the company was in trouble. Most of this debt is secured by Chrysler assets — factories, equipment, real estate and the like. The thinking was that in the worst case, these assets could be sold at a profit if Chrysler were liquidated. The dissident creditors said they had a fiduciary responsibility to seek the best possible returns for their own investors — which, the group said, include teachers’ unions, pension funds and endowments. “The government has risked overturning the rule of law and practices that have governed our world-leading bankruptcy code for decades,” the group said in a statement Thursday. The creditors suggested banks that had received bailout money were being strong-armed by the administration, a view some of the bankers privately said they shared. Now, however, Perella Weinberg and others will have to see what the bankruptcy court decides the creditors should get. If the other holdouts object to the reorganization plan — and it was unclear whether they would — they stand little chance of prevailing in court, bankruptcy lawyers said. The administration hopes to complete the proceedings within 60 days, and the political pressure to go along is unlikely to let up. “Saying they have an uphill battle is an understatement,” said John C. LaLiberte, a bankruptcy lawyer with the firm Sherin & Lodgen. Even those involved in the negotiations see little upside in fighting. “There’s zero chance this group will be able to get anything more in bankruptcy court given that 90 percent of the lenders are lined up against them,” said a hedge fund manager who owns about $10 million of Chrysler’s secured debt and voted for the government’s proposal.

427 Even before Chrysler filed for bankruptcy, another member of the group, Elliott Management, also accepted the government’s deal. In a six-line statement proclaiming its U-turn, Perella Weinberg said its Xerion Fund would do the same. “We believe that this is in the best interests of all Chrysler stakeholders, and our own investors and partners,” the firm said Thursday. http://www.nytimes.com/2009/05/01/business/01hedge.html?hp

May 1, 2009 WHITE HOUSE MEMO Obama Brings a Hands-On Style to Details, Big and Small By PETER BAKER AS he thrust Chrysler into bankruptcy on Thursday, President Obama stopped to make a commercial message to his national audience. “If you are considering buying a car,” he said as cameras carried his words live, “I hope it will be an American car.” No money down! Just drive it off the lot today! But he was not done yet. “I want to remind you that if you decide to buy a Chrysler,” he went on, “your warranty will be safe because it is backed by the United States government.” Free, no obligation quote for the extended warranty! He may not have set out to be a car salesman — or a banker for that matter, or an insurer. But suddenly Mr. Obama is all of those. And more. In the midst of a health scare, he is Dr. Obama telling Americans to wash their hands. In an energy crisis, he is a utility engineer telling them to turn down their thermostats. By dint of circumstance, ideology or nature, or some blend of the three, this is a president, and by extension a government, that is increasingly involved in many corners of society. The president’s announcement on Chrysler made abundantly clear that his team effectively controls a onetime American industrial giant, down to determining which executives are out, which brands die and how much aggrieved creditors will get. Standing behind Mr. Obama during Thursday’s announcement was essentially the new management team for American industry, the collection of cabinet secretaries, economists and policy makers who make up the president’s auto team. It will be up to these government jockeys to help build a new-generation Chrysler that can retool its products, scale back its work force and find its niche in the modern marketplace. All of which has many free-market libertarians worried about the expanding presence of the state and its leader. Even many conservatives grant the logic behind government intervention during times of economic crisis — after all, it was President George W. Bush who started putting taxpayers into the banking business — but they want to see an exit strategy.

428 The administration’s resistance to taking back bailout money from some financial institutions only reinforced the fear that state involvement may not be temporary. “You can make a reasonable case that the circumstances required them to” dive deeply into the financial sector, said Irwin M. Stelzer, director of the Center for Economic Policy Studies at the Hudson Institute. “What is scary is they don’t want to give it up: ‘Here’s your money back.’ ‘Uh-uh, we don’t want you to give the money back. We want control.’ ” Mr. Obama insists he has no interest in “meddling in the private sector,” as he put it at his news conference Wednesday. “I don’t want to run auto companies,” he said. “I don’t want to run banks. I’ve got two wars I’ve got to run already. I’ve got more than enough to do. So the sooner we can get out of that business, the better off we’re going to be.” And yet there does seem to be a part of Mr. Obama that has him in other people’s business beyond business itself. He seems prone to giving advice for everyday lives. During the campaign last year, he told Americans to properly inflate their tires and get their cars tuned up to save on energy use. Republicans mocked him, with Gov. Sarah Palin of Alaska, the party’s vice presidential nominee, complaining that his approach would lead to the “government moving into the role of taking care of you.” More recently, Mr. Obama advised Americans not to “stuff money in their mattresses” out of fear of bank failures. Last month, he held a roundtable discussion to urge Americans to refinance their houses, complete with a Web address. And on Wednesday night, he counseled those worried about a flu outbreak to “wash your hands” and “cover your mouth when you cough.” Such entreaties do not always work out so well for presidents. Mr. Bush was ridiculed for telling Americans after Sept. 11, 2001, that the most important thing they could do was to go shopping. Jody Powell, a former press secretary for President Jimmy Carter, said that the president has a responsibility to speak out. “I think Americans are kind of looking for some leadership here,” he said. “Maybe we’re getting past the point of, ‘Hey, if it feels good do it; don’t worry, it’ll all work out.’ ” Even some critics said Mr. Obama’s popularity might make it easier for him to play the outsize role in American society he is assuming, at least for now. “He is, I hate to say this, the father of the country,” Mr. Stelzer said. “There’s a kind of egomania behind that. But it works.” http://www.nytimes.com/yr/mo/day/index.html

429 Opinion EDITORIAL: The Chrysler Bankruptcy EDITORIAL: “The Chrysler Bankruptcy”, April 30, 2009 http://www.nytimes.com/2009/05/01/opinion/01fri1.html/?pagewanted=print

When President Obama outlined his plan to restructure Chrysler under bankruptcy-court protection, we shared his view that keeping a company “afloat on an endless supply of tax dollars” was no solution to the cratering of even iconic American companies. We also admired his supreme confidence that the Chrysler bankruptcy will be a quick, official and controlled process. We just wished we were as confident as the president. If the process is prolonged, the costs and complexity would likely ensure that the company would never emerge from bankruptcy proceedings, with dire implications for employment and economic recovery. For the administration, the Chrysler bankruptcy filing became inevitable when a holdout group of the carmaker’s lenders rejected the government’s final offer to settle their debts, for about 33 cents on the dollar. The United Auto Workers union had already agreed to concessions to help keep the company afloat, as had large banks that hold most all of the company’s debt. Chrysler and the Italian carmaker, Fiat, had also agreed to a partnership that would enable Chrysler to tap into Fiat’s technology, designs and management. By pushing the matter into bankruptcy court, the administration is assuming that the judge will also reject the holdouts’ demands. That would allow for a quick restructuring while keeping intact the previous agreements with the union, the big bank lenders and Fiat. In short order — 30 to 60 days by the administration’s estimate — Chrysler would emerge from bankruptcy with all the pieces in place to become in Mr. Obama’s words, “stronger” and “more competitive.” There are reasons to hope it will work out that way. In particular, a judge may be unwilling to favor the dissident bondholders when other significant stakeholders have been able to come to agreement outside of court. But short “prepackaged” bankruptcies generally succeed when all of the difficult issues are resolved ahead of time, requiring only a judge’s official approval. The judge in the Chrysler case may not see the remaining issues in the same cut-and-dried way that the administration does. Quickie bankruptcies like the one the administration envisions for Chrysler have also never been attempted for a company as big and multifaceted as a carmaker. If the Chrysler bankruptcy case does not proceed apace, the administration will need a new plan — and fast — to avoid pouring taxpayer money into a restructuring that may never yield the desired result. If the bankruptcy succeeds, there is no guarantee that the Chrysler and Fiat partnership will succeed. A recent report by Fortune magazine detailed the likelihood of culture clash in a Chrysler-Fiat combination, given the companies’ complexity and different national identities. Remember the disastrous Daimler-Chrysler marriage? It will also take some time, probably at least a couple of years, before the Chrysler and Fiat partnership yields any new cars. In the meantime, Chrysler’s own brands like Dodge and Jeep have been badly damaged by the company’s failing fortunes. The Chrysler bankruptcy filing is a bold move for the administration, a refusal to blink when confronted with what it perceived as unreasonable demands. The object of the game — a strong and competitive Chrysler — is far from achieved. http://www.nytimes.com/2009/05/01/opinion/01fri1.html/?pagewanted=print

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Economics and Finance soufflé Chrysler to File Bankruptcy, Obama Unhappy with “Money People” April 30, 2009 – 10:33 am

In an odd twist, enough of Chrysler’s creditors voted against the administration’s reorganization & recapitalization plan to force the automaker into bankruptcy. The filing is expected today. Credit default swaps may be playing a supporting role in this drama, as I’ll get to at the bottom… Yesterday, the reorganization plan seemed close to completion. Four big banks controlling 70% of Chrysler’s debt had signed off on the deal. This isn’t surprising. The four banks in question are Chase, Citi, Morgan Stanley and Goldman Sachs. All are current (and likely future) recipients of bailout money and favorable Fed/FDIC lending facilities so they are willing to do the administration’s bidding on the $5 billion or so worth of principal exposure they have to Chrysler paper. But other investors in Chrysler debt, including smaller banks and hedge funds, didn’t want to go along. There may be a few reasons for this. The first, is that the government is running roughshod over creditor interests. A Chrysler creditor profiled in a WSJ article points out that secured creditors have a senior claim over others in a bankruptcy process. They are supposed to recover value for their assets before unsecured creditors, including employees and their pension funds: “We did not contemplate having our first liens invalidated by a sitting president…” The way this deal (and GM’s) are structured, the UAW and its health care trusts walk away with far more in cash and equity than if they were forced to enter a non-gov’t-sponsored bankruptcy reorganization. Debt investors are rightly unhappy about this, as their claims rank senior. But pious arguments with respect to the rule of law may be masking other incentives the creditors have to force Chrylser into bankruptcy… (WSJ) Bank-debt holders, many of them hedge funds or distressed debt funds, voted against the latest deal for various reasons, ranging from financial interests to philosophical ones. Some said their funds had bigger positions in Ford Motor Co. or General Motors Corp. and could benefit by a Chrysler bankruptcy and the production capacity that may eliminate. Some funds may also have credit- default swaps on Chrysler bank debt that pay out in the event of a bankruptcy. Credit default swaps may be playing a particularly sinister role in bankruptcy filings. As reported earlier in FT, this WSJ op-ed, and a year ago on OA, CDS give their holders a perverse incentive to root for bankruptcy. Where this gets tricky is if the holders of CDS are themselves bondholders in a distressed company. Since there’s not much limit to the amount of exposure one can take in CDS contracts referencing a particular credit, it can be profitable to load up on CDS and then buy just enough of the actual bonds so that you can force a

431 bankruptcy. You lose on the bonds you own, but gain far more on the CDS that pay out as a result… At the same time, comments like this from the administration and from Obama are not helpful. First, this from the Prez: “We don’t know yet whether the deal is going to get done,” he said. “I will tell you that the workers at Chrysler have made enormous sacrifices - enormous sacrifices - to try to keep the company going. One of the key questions now is, are the bond holders, the lenders, the money people, are they willing to make sacrifices, as well?” First off, the employees have NOT made “enormous sacrifices,” not relative to the millions of other workers who’ve lost jobs recently and not benefited from government aid. And the unions played a starring role bankrupting American automakers with pay and benefit schemes that made their employers totally uncompetitive. An enormous sacrifice would be to repudiate benefits and take a pay cut in order to make Chrysler viable. But unions are a chief Democrat constituency and have to be placated. What bothers OA is Obama’s totally loaded way of describing Chrysler investors….”The bond holders, the lenders, the money people”……Why not go all-in and call them “Shylocks?” Maligning investors is not smart. Those with capital to put at risk are the ones that are going to rescue the American economy, not the government. Then there was this comment from an unnamed administration official: “[Bondholders] failure to act in either their own economic interest or the national interest does not diminish the accomplishments” by Chrysler, its planned alliance partner Fiat SpA and other stakeholders in the company, the official said, “nor will it impede the new opportunity Chrysler now has to restructure and emerge stronger going forward.” Since when are investors charged with acting in the “national interest?” As to their economic interest, that is for them to decide. If CDS are perverting their interests, well that’s one thing. But guess who helped lead the charge to keep them from being properly regulated? Obama’s top economic adviser Larry Summers. Who’s going to want to go near distressed companies if the administration continues to add insult to economic injury? http://optionarmageddon.ml-implode.com/2009/04/30/chrysler-to-file-bankruptcy- obama-unhappy-with-money-people/ Chrysler Bankruptcy: Were CDSs the culprit? Posted Apr 30th 2009 5:45PM by Alex Salkever Filed under: General Motors (GM) No one likes a bankruptcy -- unless you have a massive insurance policy that will pay you more than debts owed. It's akin to taking out an insurance policy on your house that will pay you back three times what its worth. But that's the contention of Rolfe Winkler, a blogger and CFA who publishes the often astute OptionArmageddon site. Winkler contends that, even though the big banks that were the primary creditors of Chrysler had signed off, the smaller guys likely had Credit Default Swaps betting against Chrysler.

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These swaps would likely only pay out if Chrysler went down. These are the same Credit Default Swaps that decimated insurance giant AIG after a rogue office in London wrote hundreds of billions of ill-advised CDS to the likes of Goldman Sachs and UBS, among others. If this is true, then it's entirely possible that other bond holders with General Motors might be more interested in tipping the biggest carmaker into bankruptcy, as well. The administration's hands might be tied. Alex Salkever is the Director of Research at Piqqem.com, a stock community powered by crowd wisdom. http://www.bloggingstocks.com/2009/04/30/chrysler-bankruptcy-were-cds-the-culprit/

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April 30, 2009, 2:09 pm Does the U.S. Need an Auto Industry? By The Editors (Photo: Jeff Haynes/Agence France-Presse — Getty Images) Updated, Apr. 30, 6:20 p.m. | Deborah Swenson, an economist at U.C. Davis, joins our discussion. With Chrysler filing for bankruptcy today, President Obama expressed confidence that the automaker will emerge stronger. But, of course, it will be vastly changed, as will General Motors, which may face the same difficult decision come June 1, when it must complete its own restructuring. Under the administration’s plan, Chrysler will receive upward of $8 billion in government support to get it through bankruptcy and to restart its operations. With its survival, at least in the short term, so dependent on public assistance, it seems fair to ask, do we need a domestic auto industry? Many American manufacturing industries, like textiles and electronics, long ago moved to other producing countries. Why is the auto industry different? Robert Reich, former secretary of labor Robert Lawrence, economist, Harvard University Tyler Cowen, economist, George Mason University Mark Thoma, economist, University of Oregon Deborah Swenson, economist, U.C. Davis The Jobs Come First Robert Reich, a professor at the Goldman School of Public Policy at the University of California at Berkeley, was secretary of labor in the Clinton administration. He is the author, most recently, of “Supercapitalism,” and he blogs at Robert Reich’s Blog. The United States needs an auto industry because automobile jobs are good ones. They pay higher than average and provide good benefits. But that doesn’t necessarily mean we need General Motors, Ford and Chrysler. The American auto industry is not the Big Three. It’s Americans who make automobiles. Foreign-owned automakers, producing cars here in the United States, now employ — directly or indirectly — hundreds of thousands of Americans. And at the rate the Big Three are shrinking, even as they’re bailed out, foreign automakers may soon employ more Americans than the Big Three do. Meanwhile, the Big Three have gone global. A Pontiac G8 shipped by G.M. from Australia contains far less American labor than a BMW X5 assembled in the United States. General Motors’ European subsidiaries include Opel and Saab. Ford also has operations around the world. It even owns Volvo.

434 We’re paying G.M. and Chrysler billions of taxpayer dollars to keep them afloat, while they cut tens of thousands of American jobs and slash wages. I’m not arguing against an auto bailout. But its purpose ought to be to help American auto workers keep their jobs, regardless of whether they work for G.M. or Toyota or anyone else. Or if they lose their jobs, help them get new ones that pay almost as well. Yet we’re doing exactly the opposite: paying G.M. and Chrysler billions of taxpayer dollars to keep them afloat, while they cut tens of thousands of American jobs and slash wages. We’re transferring money from taxpayers to Big Three shareholders for no apparent reason other than the Big Three are headquartered in America. Why should taxpayers foot any of this bill unless the Big Three agree to keep their workers employed while they try to turn themselves around? It’s Not Competitiveness, It’s Management Robert Lawrence is the Albert L. Williams Professor of International Trade and Investment at Harvard Kennedy School of Government and a senior fellow at the Peterson Institute for International Economics. We ignore market signals at our peril. We should only produce domestically those goods and services that are globally competitive and import the goods and services that foreigners can produce better and more cheaply. The U.S. has lost its comparative advantage in large segments of electronics, apparel and footwear, and we are better off buying such products from foreigners rather than producing them at home at higher cost. This frees up domestic labor and capital to be put to more productive uses. Foreign firms have shown that cars can be built profitably in the United States. But this is not actually the case with automobiles. Foreign firms have shown that cars can actually be built profitably in the United States. So the key problem is not the competitiveness of the American economy in autos but rather the competitiveness of the Big Three. Poor management is the core weakness. The policy question is not whether to have domestic auto production but rather whether our policies should ensure that we have a certain amount of that production undertaken by automakers with U.S. headquarters. To be sure, everything else being equal, we would be better off if the firms can be restructured and reoriented with minimum dislocation. Having U.S.-owned automakers is beneficial because the profits stay here and because headquartered firms confer additional benefits to their communities. But the policy cannot be to preserve domestic firms no matter what the costs. Such an approach could be costly to taxpayers and counterproductive by providing the Big Three with incentives to continue to look to Washington to solve their problems rather than changing their behavior. In the current crisis, given the costs of dislocation for which the government is already committed to pay (unemployment insurance, pension guarantees, local government support) there may be a case for providing the automakers some transitory financial adjustment assistance. But over the long run, we should allow our production structure to respond to international market signals. We Don’t Care Tyler Cowen is a professor of economics at George Mason University. His blog, Marginal Revolution, covers economic affairs.

435 I’m an economist, not a business forecaster, so I don’t have any particular predictions about Chrysler and G.M. We do know that Ford is likely to survive. More important, there are some very efficient Toyota plants in the United States. That too is part of our domestic automobile industry and those plants employ a large number of American workers. You might think that Toyota is different because it is a Japanese company rather than an American one. But in fact Toyota is a publicly traded company, as are most of the other major automobile makers. That means any American can, any time he or she wants, buy some Toyota shares and make Toyota more of an “American company” and less of a “Japanese company.” Have you gone out and bought those shares? Maybe not. Maybe that means you don’t really care about whether Toyota is a Japanese or an American company. If you have bought Toyota shares, maybe it is simply because you thought that the company was a good investment. That’s O.K., there is nothing wrong with those attitudes. In fact those attitudes are a sign of your rationality. Our automobile industry could be much more “American” if we really cared to make it so. But we don’t. Our behavior as investors and consumers is usually more rational than the claims we offer up in politics and in public discourse. National Defense Interests Mark Thoma is an economics professor at the University of Oregon and blogs at Economist’s View. Does America need an auto industry? I believe that specialization and trade generally makes us all better off, so there is no reason to oppose industry moving outside our borders. But the costs and benefits of specialization sometimes hit different groups of people, so there can be winners and losers. People losing jobs in the auto industry generally do worse when they find new jobs, and that has been a big reason for the opposition to letting manufacturing of autos and other goods go into decline. But there is another rationale for policies preserving certain kinds of production: protecting industries vital to national defense. If you are an island nation vulnerable to blockades or trade embargoes intended to prevent food and other goods from being imported, it may be in your interest to protect domestic agriculture, for example. Automobile assembly lines cannot be constructed in an instant, so losing this industry would make us more vulnerable. The question is the degree to which a country can outsource the manufacturing of goods needed for national defense. If we do not have the capacity to produce engines, cars, tractors, and other goods that can be quickly converted to building military vehicles and aircraft, and war breaks out and those supplies are cut off, where does that leave us? Some goods can be safely outsourced since they aren’t vital to national defense, or because the barriers to restarting production are small. But assembly lines used to produce automobiles cannot be constructed in an instant, so losing this industry would make us more vulnerable. (Foreign ownership of factories located here is not a problem, since we could easily take those over if necessary, so we should be happy with the announcement of the alliance of Chrysler with Fiat.) Of course, a counterargument is that “vital for national defense” can be used as a cover for broad protectionist policies. Every supplier to the auto industry, for example, could

436 claim that they are just as essential as the factory itself. Still, I think it’s important to ask if eliminating domestic auto production crosses the safety line, and I worry that it would. Going Against the Protectionist Impulse Deborah Swenson is a professor of economics at the University of California, Davis. The economy’s long-term growth is best served when firms and workers are able to reallocate their activities in ways that respond to market demands. But in the short term, the decline of Chrysler and General Motors will cause severe dislocations in places like Detroit, which have depended on those companies for jobs and taxes. Even in normal economic times, a large number of workers who lose manufacturing jobs may only find lower-paying jobs. High unemployment combined with the housing slump, which will impede worker mobility, will only increase this problem. Aside from the regional effects, one might ask how a retrenchment of the U.S. auto industry affects global production. Globally integrated firms coordinate a large number of tasks that include R&D, market research, design, parts production, assembly, logistics, marketing and sales. With some luck, a restructured and leaner auto industry might just benefit from future opportunities abroad. While the location of these tasks is generally influenced by comparative advantage and trade costs, multinational firms usually retain a greater share of their more complex, and highly-compensated tasks, such as design or R&D, in the country where they are headquartered. For this reason, a decline in U.S. car production by Chrysler and G.M. implies that a greater share of design, marketing and logistics jobs which support sales of cars in the U.S. will be done by workers abroad in the headquarters of foreign suppliers. Nonetheless, it would be wrong-headed to push for policies that protect and promote American-based multinational firms. First, the industry’s restructuring is necessary because it has been building products that didn’t meet consumer demand. Second, to the extent that those companies have been burdened by legacy health care and retirement costs, it would be better to deal directly with the health care problem through reform rather than through industry protections. Finally, it is important to look beyond this downturn. G.M. has been highly successful, relative to many other automakers, in entering the Chinese market. Any policy based on the promotion of U.S.-based sales for American multinational firms would ignore the fact that these firms also benefit from access to overseas markets. With some luck, a newly structured and leaner auto industry might just benefit from future opportunities abroad.

437 Apr 30, 2009 Banks Exposure to the Declining Commercial Real Estate: Who Holds Toxic CMBSs? Overview: The balance sheets of many American banks are highly affected by the Commercial Real Estate crisis. Transaction sale prices of US commercial property sold by major institutional investors fell by more than 10 percent in the fourth quarter of 2008. "Citigroup is less exposed to commercial mortgages than its biggest competitors. The bank has $6.6 billion, or 0.9 percent of its loans, in real estate, compared with 12 percent at Wells Fargo, 7.5 percent at JPMorgan Chase and 6.9 percent at Bank of America, according to company reports." (Bloomberg) Mar 23, Bloomberg: 10 of the biggest U.S. banks have $327.6 billion in commercial mortgages, which face a wave of defaults as office vacancies grow and retailers and casinos go bankrupt. Wells Fargo and Bank of America account for about half of commercial mortgages owned by the 10 largest banks, company reports show. Feb. 10, Research Recap: According to the MIT Center for Real Estate, the transaction-based index for commercial property has fallen steadily for all of the past six quarters and is down 23 percent for the year and 31 percent since its mid-2007 peak Apr 15, Jeffrey DeBoer: The head of a national real estate trade association said: "we don't expect the CMBS market to come back in its old ways any time soon. So we said we need a credit facility; in effect, a gigantic credit card that would help finance new loans, new originations" Apr 06, Property Wire: Delinquent loans climbed 43% (to $65.9 billion) in the first quarter of 2009. Now, a total of 3,678 US properties are in distress and commercial real estate values have fallen at least 30% since their 2007 peak and "may decline another 11% this year, increasing the number of properties that may be repossessed" according to Deutsche Bank AG's real estate unit. Apr 03, NREI: Unemployment is highly and positively correlated to vacancies in office buildings. The national unemployment rate reached 8.5% in March and now stands at a 26-year high. Contemporarily, the national office vacancy rose by 70 basis points from 14.5% to 15.2% in the first quarter of 2009. Mar 26, Bloomberg: On George Soros' opinion, the U.S. commercial real estate will most probably drop another 30 percent in value, causing further strains on banks. The delinquency rate on about $700 billion in securitized loans backed by office buildings, hotels, stores and other investment property has more than doubled since September to 1.8% in March.

438 Feb. 05, Bloomberg: "The U.S. recession is crimping consumer spending and hurting business growth, making it harder for commercial property owners to make their payments. Should Moody’s decide to cut the ratings, investors including banks and insurers may need to sell CMBS holdings to maintain required levels of capital." and "The gap, or spread, on commercial mortgage-backed bonds relative to benchmark interest rates has soared in the past year on concern that defaults will rise." Dec. 2008, Bloomberg: Unfounded Optimism. From 2005 to 2008, lenders raised income projections for commercial properties by as much as 15 percent more than those properties’ historical performance. The lending institution assumed strong growth in the rents of office buildings and warehouses as the U.S. economy was rapidly increasing Policy Option. Start Of The $1 Trillion TALF For Consumer Asset-Backed Securities (ABS): Eligible Collateral Includes Legacy RMBS and CMBS April 23, Richard Parkus, of Deutsche Bank:"Commercial-property prices have fallen by 35% or so in America... I thinks that 70% of all CMBS issued recently in America will not be able to refinance without a big increase in the capital that borrowers stump up." “Banks Exposure to the Declining Commercial Real Estate: Who Holds Toxic CMBSs?”, RGE Monitor, 30/04/2009, disponible en: http://www.rgemonitor.com/687

439 30.04.2009 Chrysler headed for bankruptcy

The New York Times reports that Chrysler Corporation is headed for chapter 11 bankryptcy filing later today, after the collapse of an agreement to win over bondholders. To win over those bond holders, which include hedge funds, the US Treasury had improved its cash offers, but the paper reports that some of the hedge funds were still refusing the terms. The paper suggested that Chrysler would first file for bankruptcy, and then present an agreement with Fiat to the court for approval, possibly on Monday. Fortis shareholders approved sale to BNP Paribas The sale of the Belgian Fortis Bank to the French BNP Paribas was approved by shareholders despite a a first turbulent meeting on Tuesday with shoes thrown towards management, reports the FT. The vote seals the sale of 75% of Fortis Bank to BNP, which would make it the largest bank in Europe by deposits and marks the end of seven months of uncertainty. The Belgian state keeps the remaining 25%. It had paid €9.4bn for a 100% stake in Fortis Bank and will now get a 11.6% stake in BNP Paribas, which are currently worth €4.4bn, writes De Tijd (hat tip Flanders Today). In addition, the federal government has also helped out through guarantees for financing the vehicle for junk bonds. But many market-watchers still believe the greatest loss is the fact that the sale will mean Belgium's biggest bank's decision-making centre will move from Brussels to Paris. The Irish expect to be bailed out Karl Whelan of the Irish Economy blog dug up an outrageous comment by Irish finance minister Brian Lenihan. He claims that Ireland’s blanket bank guarantee has zero costs, because the ECB will bail them out should the guarantee ever be called. Here is the quote in full. In the beginning he was referring to criticism from the IMF about the lack of provisions for those guarantees. "We don’t accept their estimate because, like many commentators from the US and American world, they do not take into account our Euro membership. Those kind of figures can be made available to us and are being made available to us through the European Central Bank system. It’s based on a presumption that the state

440 guarantee will be called in and that the guarantee on deposits will have to be funded by the taxpayer. And the President of the European Central Bank, Mr Trichet, has made it clear that the European Central Bank will not permit any bank in the eurozone to fail. That has been spelt out very very clearly." Whelan makes the correct point that Lenihan mixes up solvency and liquidity. The ECB only ever said it will not allow a bank to fail due to lack of liquidity. Insolvency is a matter for governments. The Irish Economy Lenihan on the ECB and the Guarantee This post was written by Karl Whelan In my earlier post on the government’s criticisms of the IMF, I left out what was probably the most interesting argument because it raised a number of other issues. Speaking on This Week on Sunday, the Minister for Finance criticised the IMF’s assessment of the cost of the liability guarantee on the grounds that the guarantee would not be called on. I’ve already noted that this is a somewhat spurious way to look at the cost of the guarantee. However, what was particularly odd about the Minister’s comments was his particular explanation of why the guarantee would not be called upon. About four minutes in, the Minister said the following: We don’t accept their estimate because, like many commentators from the US and American world, they do not take into account our Euro membership. Those kind of figures can be made available to us and are being made available to us through the European Central Bank system. It’s based on a presumption that the state guarantee will be called in and that the guarantee on deposits will have to be funded by the taxpayer. And the President of the European Central Bank, Mr Trichet, has made it clear that the European Central Bank will not permit any bank in the eurozone to fail. That has been spelt out very very clearly. These comments appear to confuse the issues of bank solvency and liquidity. As described in a speech by M. Trichet on Monday, the ECB has extended its already-broad definition of eligible collateral for obtaining funds from the ECB, switched from rationed auctions to unrationed fixed rates for its refinancing operations, and provided more and longer-maturity financing than before (see here.) As Trichet put it on Monday: We have been determining the lending rate – at a very low level – and we stand ready to fill any shortage of liquidity that might occur at that interest rate for maturities of up to six months. This means that we currently act as a surrogate for the market in terms of both liquidity allocation and price-setting. The ECB’s policies deal with problems banks may have in getting short-term liquidity, provided they have enough eligible collateral (which, for instance, Anglo did not have on September 29). This is in no way a commitment by the ECB to bail out insolvent banks. If a bank has sustained substantial losses and thus becomes insolvent, the ECB will not move in to help. Instead, regulators need to move in to shut it down or ensure that some outside investor provides new equity capital. The ECB’s policies would not in any way prevent the Irish government from having to provide funds to re-capitalise insolvent banks so that the guarantee is not called on. At this well-advanced stage of the banking crisis, I find the continuing confusion between liquidity and solvency to be disturbing.

441 Shifting ownership of Irish banks This post was written by Patrick Honohan Given the current interest in ownership of the Irish banks, I thought readers might be interested to read about the size distribution of shareholders. AIB provides the most interesting data, reported in their recently published Annual Report and relating to end-December 2008. There have been some interesting shifts in the past year. First of all, shareholders in the Republic (including pension funds etc.) now hold 41 per cent of the shares, up from 37 per cent last year. Second, in the face of dramatic declines in price and increase in volatility, the number of AIB shareholders has increased by over 10 per cent or 10,000 persons. Almost all of the increase relates to the Republic, and almost all hold less than 5000 shares. (Today, the shares closed at €0.81). This confirms what was known anecdotally, namely that lots of middle income people thought it worth taking a flutter on bank shares given the novelty that they were only worth cents. They have bought these shares from foreign institutions. For, although there over 90,000 AIB shareholders in total, of whom 76,000 in the Republic, fewer than 5000 shareholders hold more than 10,000 shares, and just 384 hold more than 100,000 shares. Bank of Ireland had about 80,000 shareholders when it last reported the number, about a year ago. (We’ll likely see a similar pattern to the changes when the March 2009 figures are published.) A look at Irish Life and Permanent’s reports (giving shareholders at end March 2009) shows a similar, though smaller trend: they now have over 135,000 shareholders up about 1%. All but 10,000 of them have fewer than 1000 shares each, but most of the newcomers seem to have between 1000 and 10000). Anglo Irish Bank had far fewer shareholders — fewer than 20,000; just over 100 of them held 85% of the total shares between them.

Euro area economic optimism on the rise There is some good news at last. The European Commission’s economic sentiment index for April increased marginally from 67.2 to 64.7 (having peaked at 112 in May 2007), which may indicate that the worst is over for the euro area, Germany’s gloomy predictions Not too long ago, the German government criticised forecasters who dared to predict that the economy would fall by 5% this year. Now the economics ministry is predicting 6%. And for next year, the prediction is for unemployment to rise to 4.7m by the end of the year. This is a similar level which prevailed before Gerhard Schroder’s labour market reforms. This implies that involuntary unemployment is forecast to reach the highest level in post-war German history. Germany’s economic institutes have forecast a rise in unemployment to 5m. For those who can read German, here is the summary of the forecasts. This is from FT Deutschland:

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European banks are tightening the noose FT Deutschland has the story that European bank have cut lending by €15bn during March, and that they are planning to tighten credit conditions further during the next few months. The only upshot from the latest ECB data is the banking survey, which showed that the gap between banks that are tightening credit provisions, and those that are loosing them, has been getting a little smaller. Some economists, including the ECB itself, appear to interpret this as a sign that the worst is over. The European Commission soft approach on hedge fonds FT Deutschland has an article that the Commission regulation of hedge fonds and private equity is coming under increasing opposition, especially the hasty change in thresholds. In the original draft the Commission had proposed a €250bn ceiling, above which the regulation requirement kicks in, this was now increase to €500bn for private equity groups, and lowered to €100bn for hedge funds. After France, Germany has now said it finds this proposal too soft. Barry Eichengreen on risk "...the problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists whose scholarship provided intellectual justification for the financial institutions’ decisions. The consequence was that scholarship that warned of potential disaster was ignored. And the result was global economic calamity on a scale not seen for four generations."

443 Stephanie Flanders on China In her BBC blog, Stephanie Flanders discusses the most important piece of good news currently around – the apparent economic recovery of China. Growth expectations are rising, and so are credit volumes, as the Chinese government’s large stimulus package is kicking in – which includes spending on welfare and infrastructure. Her conclusions, however, are more cautious. China will remain a country with extreme levels of excess savings due to distorted financial and welfare systems. It is too soon to judge whether China can manage the long-term turnaround the global economy needs.

Brad DeLong on Sweden Brad DeLong discusses what he sees as confusion among US commentators in respect of the Swedish model of bank nationalisation. The misunderstanding concerns the treatment of bondholders. The Swedes nationalised the banks, but they guarantee all debt. DeLong says some advocates of the Swedish model in the US miss that detail. So if you want to wipe out the bondholders, Sweden is not for you.

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April 30, 2009 Chrysler Bankruptcy Looms as Deal on Debt Falters By ZACHERY KOUWE and MICHELINE MAYNARD DETROIT — Last-minute efforts by the Treasury Department to win over recalcitrant Chrysler debtholders failed Wednesday night, setting up a near-certain bankruptcy filing by the American automaker, according to people briefed on the talks. Barring an agreement, which looked increasingly difficult, Chrysler was expected to seek Chapter 11 protection on Thursday, most likely in New York, these people said. The automaker, which is in talks with the Italian automaker Fiat, would file for bankruptcy first. It subsequently would present an agreement with Fiat to the court for approval, possibly on Monday, these people said. They requested anonymity because they were not authorized to speak for the government. A bankruptcy filing by Chrysler would be the first by one of Detroit’s three auto companies amid a devastating slump, and could serve as a preview of what a filing by General Motors might look like. G.M., which like Chrysler received federal assistance last year, faces a June 1 deadline for its own restructuring. To win over several hedge funds, which have been holding out for better terms, the Treasury increased its cash offer to holders of Chrysler’s secured debt by $250 million, to $2.25 billion, these people said. If all of the secured holders would agree to the new deal, which would give them the cash in exchange for retiring about $6.9 billion of debt, Chrysler would still have a chance of restructuring out of bankruptcy court. Several investment funds, however, continued to reject the Treasury’s sweetened offer at a vote of the lenders on Wednesday evening, people familiar with the talks said. During a prime-time press briefing at the White House on Wednesday, President Obama appeared to lay groundwork for a Chrysler bankruptcy filing, although he said it was “not yet clear” Chrysler would have to move forward with one. “I am actually very hopeful, more hopeful than I was 30 days ago, that we can see a resolution that maintains a viable Chrysler automobile company out there.” He added: “The fact that the major debtholders appear ready to make concessions means that even if they ended up having to go through some sort of bankruptcy, it would be a very quick type of bankruptcy.” The four big banks that own 70 percent of Chrysler’s secured debt have already signed on to the Treasury’s plan and are trying to line up the other lenders in favor of the new terms. If all 46 lenders do not agree to the new offer, and a bankruptcy filing occurs, the lenders will be forced to accept the $2 billion they were originally offered or fight in court for a higher amount.

445 The Obama administration is adamant that every lender participate in the debt swap, according to people close to the talks. One reason is that the deal would face legal challenges. People briefed on the negotiations said that while it seemed certain Chrysler would survive and avoid liquidation, it was not yet clear whether it would have to be placed into bankruptcy to sort through any unresolved issues with creditors. Administration officials said late Wednesday that while bankruptcy remained a possibility, talks with all of the stakeholders in Chrysler still could continue right up to an administration-imposed deadline at 11:59 p.m. Thursday. The administration gave Chrysler until Thursday to complete an agreement with Fiat, and avoid court protection. But it became clear in the last week that bankruptcy might be needed to allow Chrysler to shed debt, close dealerships and rid itself of other liabilities, in order to make itself a more attractive partner for the Italian auto company. A bankruptcy filing could lead to a prolonged battle in court with the company’s lenders, dealers and parts suppliers across the country. In bankruptcy, the government would also have to provide financing for the company to operate. Two people close to Michigan’s Congressional delegation said Wednesday that Mr. Obama would probably opt for a bankruptcy filing, which would be intended to be executed in as little as 60 days. Publicly, Chrysler officials remained hopeful Wednesday that the company could avoid bankruptcy. In a letter to employees, Chrysler’s chairman, Robert L. Nardelli, said the company was making progress with Fiat and hoped to have a deal in hand by Thursday. “I’m encouraged by this progress and I want you to know I deeply appreciate the sacrifices made by so many constituents to help us reach the restructuring targets established by the government,” Mr. Nardelli said. There was no immediate comment from Fiat. Any deal with Fiat would involve management changes, including the departure of Mr. Nardelli, who joined the company in August 2007. Mr. Nardelli told employees this month that he was likely to leave Chrysler. The new management is likely to take charge of Chrysler as soon as agreements with the Treasury Department are completed, people briefed on the situation said. If there is a bankruptcy filing, the new management team will lead the company until it has finished restructuring. It was not clear whether one of Chrysler’s executives or a Fiat executive would head the company. Chrysler, subsisting on $4 billion in federal loans, has asked for another $7 billion in government aid to carry it through the worst automotive market in the United States in 25 years. But members of the president’s special auto task force are unsure the company can be viable for the long term without the use of what has been called a “surgical bankruptcy.” As the talks with Fiat and the lenders entered the final hours, members of the United Automobile Workers union approved a historic deal in which the union would take a 55 percent stake in Chrysler. The stake would finance half of a new trust to administer retiree health care costs. Nick Bunkley, Jim Rutenberg and Bill Vlasic contributed reporting.

446 Business

April 30, 2009 Shareholders Oust Bank of America Chief as Chairman By LOUISE STORY CHARLOTTE, N.C. — The applause thundered inside the Belk Theater on Wednesday for a fading star of American finance: Kenneth D. Lewis, the beleaguered head of Bank of America. But all those huzzahs, offered up by loyal employees and steadfast believers, did not sway Mr. Lewis’s shareholders. Mr. Lewis, who helped build Bank of America into the nation’s largest bank, was stripped of his chairman’s title — a stinging blow that leaves his stewardship and legacy in doubt. At a contentious annual general meeting, angry investors held him accountable for what they view as a series of missteps that forced the once-mighty bank to accept not one but two government bailouts. For Mr. Lewis, the bad news arrived shortly before 6 p.m., after a gathering that seemed to captivate much of Charlotte, where Bank of America’s soaring headquarters punctuates the skyline. While Mr. Lewis remains chief executive — the board expressed its unanimous support for him — many inside and outside the bank wonder if he can hang on. Mr. Lewis confronts daunting challenges, and many of his investors are losing patience. Even after receiving billions of taxpayer dollars, some analysts say, the bank may still need to raise more to shore up its weakened finances. “Ken Lewis has now become the lightning rod of controversy, and that is highly distracting,” said Jeffrey A. Sonnenfeld, a professor at the Yale School of Management, who believes Mr. Lewis should resign. “Even if everything he did was appropriate, it has hampered his legitimacy to lead.” It was not long ago that Mr. Lewis was celebrated for his vision. His daring takeover of Merrill Lynch was the latest in a series of high-profile acquisitions that helped transform Bank of America into a national powerhouse. His conquests included the Countrywide Financial Group, the giant mortgage lender which, for many, came to symbolize the excesses of the subprime era. In December, the American Banker, the daily chronicle of the banking industry, named him 2008 Banker of the Year. But that was then. Now Mr. Lewis is drawing fire for overpaying for Merrill, whose gaping losses prompted Bank of America to seek a second rescue from Washington. The attorney general of New York is examining whether Mr. Lewis adequately disclosed the risks of the takeover to his shareholders, drawing headlines — and more ire. The timing could hardly be worse. Bank of America is bracing for another wave of loans to go bad as the recession drags on. Walter E. Massey, the president emeritus of Morehouse College in Atlanta, will replace Mr. Lewis as chairman. On Tuesday night, before the shareholder gathering, Mr. Lewis seemed chipper as he chatted with colleagues over drinks at Sonoma, a swanky restaurant at the base of the bank’s headquarters. As usual, he and his executives wore red, white and blue Bank of America pins on their lapels.

447 But by 7 a.m. Wednesday, news crews were setting up outside the bank, expecting a showdown. Employees made their way through the growing crowd. Jonathan Finger, a prominent bank shareholder and a vocal critic of Mr. Lewis, strode from camera to camera. A few protestors turned up with signs. One of them, Judy Koenick, wore a T- shirt emblazoned with a phrase that summed up the view of Mr. Lewis’s most ardent detractors: “Fire!!! Kenneth Lewis Fire!!!” Soon the Belk Theater was packed. The throng overflowed into the lobby, where a crowd watched on video monitors. Some 2,200 people turned up, a bank spokeswoman said.Many of them welcomed Mr. Lewis, a man who helped put Charlotte on the world’s financial map. The applause rang out for more than half a minute. Shareholders took turns at the microphone to offer testimonials. “If we don’t have Ken, who do we have?” one asked. Even Evelyn Davis, the corporate gadfly who calls herself “Queen of the Corporate Jungle,” defended Mr. Lewis. At one point, she ran up and kissed him on the cheek. The president of the city’s Chamber of Commerce spoke in support of Mr. Lewis, as did representatives from Habitat for Humanity and several environmental groups. One shareholder suggested Mr. Lewis donate his $1.5 million salary to charity. Someone in the audience yelled: “Oh, stop!” Mr. Lewis, who has worked for the bank for 40 years, replied: “Unfortunately, because of my pledges, I actually did give away more than I make." Again, applause. Mr. Lewis shed little light on the Merrill transaction, though he did say in his prepared remarks that both Merrill and Countrywide helped the bank’s first-quarter results. “These acquisitions are not mistakes to be regretted. Both are looking more like successes to be celebrated,” Mr. Lewis said. “We are building this company for the long run.” Gradually, the crowd thinned and, after four hours, the meeting broke up, with Mr. Lewis’s fate still unknown. So many shareholders cast votes that it took the bank longer than expected to count them all. Robert Stickler, a bank spokesman, said some large shareholders had told the bank they voted to remove the chairman title from Mr. Lewis because of corporate governance concerns, not because they did not support him. In the end, it was close: 50.34 percent of shareholders — 25 million votes — opted to remove Mr. Lewis as chairman. A third voted to remove him from the board altogether. Even before the vote count was final, the bank’s directors were considering replacing Mr. Lewis as chairman because it was clear he had lost the support of so many shareholders. Carl Wagle, a retired machinist from nearby Greensboro who said he had lost most of his $65,000 life savings on Bank of America stock, left the meeting shaking his head. He said he had come to suggest that Bank of America pay higher interest rates on savings accounts. “They need to understand what the average American person thinks of banks,” Mr. Wagle said. “They see banks as a place where fat cats live. Americans are not going to start having confidence in their banks until they see the bankers changing.” Mr. Lewis, hewing to his routine, stopped in at Sonoma. Several executives hugged him. Then he emerged, waved and smiled at people gathered in the courtyard, and disappeared into Bank of America’s headquarters.

448 Business

April 30, 2009 As Detroit Is Remade, the U.A.W. Stands to Gain By MICHELINE MAYNARD and NICK BUNKLEY DETROIT — In the devastating slump that has forced two of Detroit’s automakers to the brink of bankruptcy, the United Automobile Workers union stands to become one of the industry’s few winners. According to restructuring plans proposed this week, the union will have more than half the stock in Chrysler and a third of General Motors, meaning it will have tremendous influence, with the government, in determining the future of the companies. The United Automobile Workers union said Wednesday that its members ratified a cost- cutting deal with Chrysler by a 4-to-1 margin. “Our members have responded by accepting an agreement that is painful for our active and retired workers, but which helps preserve U.S. manufacturing jobs and gives Chrysler a chance to survive,” Ron Gettelfinger, the union’s president, said in a statement. The prospect of a big ownership stake for the U.A.W. in G.M. has angered holders of billions of dollars in bonds, who stand to get only a fraction of the restructured company. As for Chrysler, the banks, hedge funds and others that lent it money have been promised only cash, not stock. “We believe the offer to be a blatant disregard of fairness for the bondholders who have funded this company and amounts to using taxpayer money to show political favoritism of one creditor over another,” a group of G.M. bondholders said in a statement this week. The U.A.W. members at both automakers stand to lose some of their pay and benefits, but the cuts are not as deep as those faced by airline and steel workers when their companies went bankrupt. Under proposed deals devised by the Treasury Department, U.A.W. pensions and retiree health care benefits would largely be protected. The U.A.W. has derived its leverage in part from the support of a Democratic president and Congress. But it also results from a long-term strategy to build support in Washington that stretches back more than 60 years. “We have to fight both in the economic and political fields, because what you win on the picket lines, they take away in Washington if you don’t fight on that front,” Walter P. Reuther, the union’s best known president, said in 1947. Mr. Reuther and every succeeding U.A.W. president invested significant amounts of time and money to pursue that goal. In the last 20 years, the U.A.W. has donated more than $25.4 million to federal candidates, 99 percent of it to Democrats, according to OpenSecrets.org, a site that tracks campaign contributions.

449 The union ranks No. 16 on the group’s list of top 100 political donors, known as “heavy hitters.” The U.A.W. was well ahead of G.M., which gave $10 million in that period, ranking it 73rd. Chrysler and Ford Motor did not make the list. Mr. Gettelfinger, the current president, has also been an effective, steel-nerved leader, and has managed to maintain the union’s importance in recent negotiations, even though the U.A.W. has lost nearly 200,000 members since he took office in 2003. Mr. Gettelfinger’s influence stems in part from the fact that the U.A.W. represents nearly all the auto workers at the Detroit companies. (Workers at a few plants are represented by the I.U.E.) By contrast, airline workers are represented by multiple unions. “The U.A.W. is so overwhelmingly dominant,” said Duane Woerth, former president of the Air Line Pilots Association. “You’re only talking to one union and that gives them more power.” Mr. Woerth, whose union was involved in 22 bankruptcy cases involving big and small airlines during his tenure as its president, said the pressure that bondholders and other investors might put on the U.A.W. has been mitigated by Democrats’ support. For example, the union has yet to complete a deal with G.M., which laid out an offer to its bondholders this week that would pay them about 41 cents on the dollar. In order for the deal to succeed, 90 percent must accept it, which analysts say is unlikely given bondholders’ criticism of the offer. Only this week did the U.A.W. come to terms at Chrysler, facing a Thursday deadline set by the administration. The tactics have won admiration from others in the labor movement, even those forced to grant concessions to bankrupt companies. Robert Roach Jr., a general vice president of the International Association of Machinists and Aerospace Workers, said a successful outcome for the U.A.W. and the auto companies would benefit the economy, and in the process help his 650,000 members at major airlines, aircraft makers and other companies. “We’re all in this,” Mr. Roach said. “The corporations, the federal government, the taxpayer, the cities and the states. If we are able to save these auto companies, that will be good for everybody.” But many of the U.A.W. members who voted Wednesday on the Chrysler proposal were struggling to see the benefits of the cuts they were agreeing to. The deal suspends cost-of-living pay increases, limits overtime pay and reduces paid time off. It also eliminates dental and vision benefits for retirees.It also provides for Fiat to begin building cars in at least one Chrysler plant. “Either you vote for it or it’s bankruptcy,” said Bruce Clary, 58, who was an electrician at a Detroit engine plant until being laid off in January. “And it may be bankruptcy anyway.” At Chrysler’s Jefferson North assembly plant nearby, the oldest auto plant still operating in Detroit, workers said the consequences of rejecting the deal would be far worse than the concessions that it would force.“This was the best deal we could get,” said John Davis, who has worked at Chrysler for 33 years. “We did our part, and now the banks need to do their part.”

450

Press Release

Release Date: April 29, 2009 For immediate release Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower. Household spending has shown signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit. Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing. Although the economic outlook has improved modestly since the March meeting, partly reflecting some easing of financial market conditions, economic activity is likely to remain weak for a time. Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability. In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term. In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of financial and economic developments. Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

451

29.04.2009 The credit crunch is coming

Germany’s CSU, the sister party of Angela Merkel’s Christian Democrats, is seriously concerned about a credit crunch for SME’s, and wants banks to be able to drop the obligatory ratings process under Basle II, according to FT Deutschland. Otherwise, there might be a serious problem for the corporate sector. The Ifo institute’s latest business survey suggests that 42% of German companies are reporting that banks have tightened their credit policies. Ackermann warns of difficult year for banks FT Deutschland reports that Josef Ackermann of Deutsche Bank warns of another difficult year for the banks. While last year banks were mostly in trouble that owned large amounts of structured products, this year the troubles will be extended to the entire banking sector, as the recession reduces the quality of loans, forcing the banks to make further write-offs. Money market rates keep on falling The FT has the story that money market rates are been falling steadily throughout the western world. Three-month Libo rates were: Euro area: 1.378% (1.498% six months ago) US: 1.039% (1.176%) UK:1.378%( 1.625%) The article quoted a number of analysts saying that conditions in the credit market had improved a little bit, but while banks are start to lend again, activity is still not nearly as pronounced as it is in normal times. Working time directive fails FT and other newspapers cover the final failure of the reform to the EU’s working time directive, which will now remain in its old form, limiting working time to 48 hours per week, but with specific opt-outs , which a majority of EU have applied. One of the criticism of the opt-outs is that they have led to excessively long working hours in the health care sector. FT Deutschland writes that the reform failed as Germany and the UK were inflexible in their negotiating position.

452 France to benefit from other countries’ stimulus The French government encouraged French companies to look for opportunities that result from stimulus plans of other countries, Germany in particular, reports Les Echos. French trade secretary Ann Marie Idrac said that “the German stimulus plan is the one from which we expect most hope”. The automobile sector already benefited from the car wreckage subsidy, now the energy sector is encouraged to look into the opportunities from energy saving renovation schemes. Sarkozy to unveil €35bn transport investments Nicolas Sarkozy will unveil today his plans to invest €35bn in transport for Paris, according to Les Echos. The work is expected to start in 2012 (taking the risk of being pro-cyclical) and to last for 12 years. While the financing is not yet secured, there are several proposals on the table including higher taxes on business or property or public subsidies. Sarkozy named other objectives for Paris such as the doubling of housing and the creation of 1m employment in the region. ESRI warns of a peak-to-trough fall in Irish GDP of 14% Ireland is suffering the worst recession of any advanced country since the 1930s, the research institute ESRI warns in its latest report. GNP is forecast to fall by 14% over three years for 2008-2010, unemployment is expected to reach 15% this year and 17% next year. The Irish Independent writes that the only positive message of the report is that the government begins to get a grip on public finance, even though it still has to borrow 22bn this year and 20bn next. There is more to be done, as public sector jobs pay 20% more than private ones.

Garibaldi on the euro In a comment in La Stampa, Pietro Garibaldi argues this crisis offers a huge, unique opportunity for the euro to reinforce its position as a global currency. One reason is the likely scenario of higher inflation in the US, post-recovery, as the Fed is unlikely to role back its monetary easing sufficiently fast, and since inflation is highly effective at reduce the real value of debt. Another reason is the European Central Bank’s relative conservativism, in particular its reluctance to cut interest rates to zero. As China begins to demand an alternative reserve currency to the dollar, the euro seems to be in a good position to benefit. Munchau on Germany’s parallel universe In his FT Deutschland column, Wolfgang Munchau says that the apparent lack of interest in, and knowledge about financial crisis is deceptive. The crisis seems to be hardly an issue in Berlin in particular, but this is very likely to change as the economic problems translate into the labour market, and as bank rescues will end up costing the government a lot more than it currently admits. He says part of the problem is the failure of the government to prepare the population for what the cyclical and structural impact ahead. US house prices go down and down We are still in an extreme downward movement of US house prices, but the end of the adjustment is getting a little closer. The following two graphs show the February Case Shiller House Price index, which is slowly approaching its trend, and the price to rent ratio, which has done most of the adjustment (though this series is likely to overshoot). The two are consistent with the view that the decline in US house prices has further to go, but that it may

453 stop in 2010. The following charts are from Calculated Risk.

454

04/29/2009 04:28 PM IS 2009 THE NEW 1929? Current Crisis Shows Uncanny Parallels to Great Depression By SPIEGEL Staff Is history repeating itself? The current global downturn has many parallels to the Great Depression. And if the current massive bailout packages fail, the effect on the world's economies could be similarly drastic. The Germans have always had a penchant for looking to America to gain a glimpse into the future. They marveled at the Apollo 11 mission to the moon. They admired the gray but affordable Commodore personal computer. And they succumbed to the spell of an Internet company with the odd name of Google.

DPA Will the current crisis be as bad as the Great Depression? Now the Germans are looking across the Atlantic once again, but this time they see images that remind them of their own past, images of sad-looking people standing in long lines, hoping for work. One of them is Michael Sheehan, who worked as an engineer with a large company until February. Not too long ago, Sheehan was the one doing the hiring. Today he is only one of 900 other job-seekers attending a job fair in a depressing hotel ballroom in Philadelphia. One of the flyers arranged on the tables exhorts the attendees to "Stay Positive." But Sheehan feels more outraged than positive. Someone at the fair asks him for his resume. "I don't have a resume," he says. "I worked at one company for more than 30 years." Natalie Ingelido, 21, is standing nearby, trying to calm down her bawling two-year-old son, who clearly doesn't like it here. "I'm looking for a job, any job, in a restaurant, a bar, cleaning, whatever," she says. In the past, says Ingelido, "Help Wanted" signs were plastered on the doors of shops and bars. The past she refers to is last summer, when Natalie and her husband still lived in their own apartment. Now they live with his parents.

455 Across America, people like Sheehan and Ingelido are standing in lines, waiting and hoping. At one job fair in New York, the line stretched for several city blocks. Many would turn away, embarrassed to be seen there, whenever TV reporters attempted to document their fates. More than 5 million people in the United States have lost their jobs since the crisis began. As if the country were undergoing fever convulsions, more than 650,000 were catapulted into the streets in the last month alone. Most experts are now convinced that Germany will follow the United States along this downward trajectory. And those who, like many a politician, had refused to believe it until now were disabused of that notion last week. Wednesday was a dark day for the leaders of Berlin's grand coalition government, which comprises the center-left Social Democratic Party (SPD) and the conservative Christian Democratic Union (CDU). All their hopes that the skies over Germany could quickly brighten -- just in time for September's national election -- were suddenly dashed when leading economic institutes released their annual forecasts, which turned out to be even gloomier than expected: a 6 percent shrinkage in the German economy this year, followed by another year with no economic growth. Unemployment will rise sharply. It is expected to exceed 4 million by this fall and hit 5 million by next year. By then, at the latest, the crisis will have become reality for millions of people, as it reaches private households, forces more companies into bankruptcy and pushes countless loans into default, only making things worse for the country's already ailing banks. Politicians around the world are forced to look on as the economic crisis jumps from one industrial sector to the next and spreads to more and more social groups. They are the witnesses of a reality that repeatedly debunks their worst prognoses as being all too optimistic. They are approving billions in government spending for economic stimulus programs and bank bailout packages, and pumping more and more money into the economy to rejuvenate the economic cycle. But no one knows whether this medicine actually works -- and if it does, when it will take effect. DER SPIEGEL Graphic: Parallels between current crisis and Great Depression Politicians, in their desperation, are clinging to even the tiniest glimmer of hope. At the opening ceremony of the Hanover Trade Fair early last week, where the number of exhibitors had just about remained stable, Chancellor Angela Merkel announced that the worst appeared to be over. At an economic summit at the Chancellery a few days later, none of the 31 invited representatives of industry was willing to share this optimism. Instead, the meeting was marked by pessimism and a deep sense of helplessness. The mood reminded one of the attendees of a "funeral wake." It appears that the German federal government, labor unions and employers have exhausted their options. As a result, the course of the meeting was predictable. The assembled representatives of industry groups used the opportunity to present the government with their familiar demands. The invited economists argued over terminology and forecasts, and the members of the government snubbed those officials who had expressed their opinions somewhat too loudly of late. The mood at the Chancellery only worsened in response to the grim forecast for growth presented by Hans-Werner Sinn, the president of the Munich-based Ifo Institute for Economic Research, who predicted that the worst is yet to come. According to Sinn, German banks will have to make write-downs equivalent to up to 90 percent of their capital, while most businesses

456 hold a pessimistic view of the future. Sinn even believes that deflation is possible, a situation in which demand would continue to decline despite falling prices. But not all of the economics professors in attendance agreed with the Munich economist's theories. Wolfgang Franz, an economist from the southwestern German city of Mannheim, said that he believed that the economy could fall back into step more quickly than others predicted. Axel Weber, the head of Germany's central bank, the Bundesbank, made it clear that he sees possible inflation as a much greater threat. By the end of the economists' presentations, the attendees were no longer sure which danger they were supposed to combat. Deflation, inflation, mass unemployment -- these are words reminiscent of the darkest chapter in economic history. Thus, it comes as no surprise that experts are mentioning with growing frequency a term that was believed to have been relegated to the history books: Great Depression. 'The Consequences Are Real' In the United States, the term "depression" has already crept into daily usage. Christina Romer, the chair of the Council of Economic Advisers appointed by US President Barack Obama, doesn't like to hear the comparison with the past. The Great Depression was Romer's field of expertise as an economic historian at the University of California, Berkeley, before she came to the White House under the new administration. Now Romer has the feeling that history moved to Washington with her, that the past is alive once again and, on some days, is already beginning to look like the present. "In the last few months, I have found myself uttering the words 'worst since the Great Depression" far too often,'" she said in a recent speech at the Brookings Institution in Washington. She went on to repeat all of the depressing references to the past: "The worst 12 month job loss since the Great Depression; the worst financial crisis since the Great Depression; the worst rise in home foreclosures since the Great Depression." Even Ben Bernanke, the chairman of the US Federal Reserve, whose job requires him to be a professional optimist, finds it difficult to dispel the current melancholy. As a professor at Princeton, Bernanke wrote a substantial book on the world economic crisis. "I've always been more skeptical than others when it comes to predicting the potential effects of this crisis," he says. "Some people thought that we would get over this easily." He chuckles, but it sounds more like a groan. "I hope that no one subscribes to that view any more. The consequences of this crisis are very real, and they are extremely serious."

DER SPIEGEL: Graphic: Economic forecasts for Germany But how serious? That's what everyone wants to know, and yet no one is able to predict how the crisis will continue -- not Romer, not Bernanke and not German Finance Minister Peer Steinbrück. Last week, Steinbrück admitted, openly and helplessly: "I don't know." That's what makes this crisis so uncanny. It's clear where it comes from, but no one knows where it is going. Will it continue to rage on at the same pace? Or will it subside, even just for a few months? Or is the worst already behind us, as some market players seem to believe? They pushed Germany's DAX stock index up by 24 percent and the US's Dow Jones Industrial Average up by 22 percent in the last seven weeks. Is the market smarter than all of the experts, who were denying the possibility of a deep recession as recently as last year? Or is the market blind to the major fault lines in the world economy? The mood on Wall Street remained positive for a long time after real estate prices began tumbling in the fall of 2007.

457 Every small sign of hope is eagerly interpreted as a turn for the better. When the Ifo Business Climate Index, an early indicator for economic development in Germany, rose last Friday, the DAX promptly added 3 percent -- even though a majority of the firms polled by Ifo Institute expect the situation to worsen even further. The crisis is currently putting an excessive burden on everyone. It behaves like an aggressive, previously unknown virus, changing its appearance and speed from week to week. At first, it looked like an American real estate crisis, then a banking crisis, a market crisis and a financial crisis. But the virus was consistently worse than the words that were being used to describe it. At the beginning of the crisis, everyone felt that it was someone else's problem. Carmakers thought that it was a crisis for banks. The Europeans thought that it was an American problem. The rich believed that it would only affect the poor. The opposition felt that it was the government's crisis. Today, everyone knows that these notions were too short-sighted. The virus is raging in all parts of the world, and striking at all levels of society. The pathogen has spread more quickly than all other pathogens in the past. It is invisible, but the trail it leaves behind is not pretty. 'No Land in Sight' At the container terminal in the northern German port city of Hamburg, only 12 of 100 parking spots for trucks that transport containers to and from the docks are occupied. "Only a year ago, they had to wait in line for a spot," says dockworker Gerhard Hamann. Things are even worse in Bremerhaven, another northern German port city, where German cars are shipped to destinations around the world. The automobile shipping industry has lost almost half of its business, and the company that provides harbor services has plans to lay off more than 1,000 of its 2,700 employees. In the boom days of globalization, German cars were hot items, status symbols for the nouveau riche in China, Russia and India. German machinery was in high demand when large sums of money were being invested in emerging economies. As a result, Germany, the world's leading exporter, benefited the most from globalization. Conversely, the effects of a shrinking global economy are felt all the more acutely in Germany. As the virus rages, it is already claiming its first victims. German industrialist Adolf Merckle threw himself in front of a moving train because his life's work, which includes the companies Ratiopharm, a pharmaceutical company, and HeidelbergCement, was threatened. David B. Kellermann, the chief financial official of the US's second-largest mortgage lender, Freddie Mac, hung himself at his home in a Washington suburb last week. "It is plain that at Freddie Mac, as at many of the companies in the center of this economic storm, there are forces so strong they can overwhelm almost anyone," wrote the New York Times. No part of the world is currently unaffected by the crisis. From the United States to China to Germany, the pictures of devastation are the same. Poor countries, especially in Africa, are even worse off. According to a report by the World Bank and the IMF, the global recession will plunge up to 90 million into extreme poverty and drive up the number of chronically hungry people to more than 1 billion. Emerging economies are also getting nowhere fast. In fact, they have been brought to their knees. As Western consumers cut back on spending, much of their export industry is at a standstill. In March alone, Taiwanese exports dropped by 30 percent over the previous month. Hundreds of empty freighters are at anchor off Singapore's port, while Japanese Prime Minister Taro Aso sees "no land in sight" for his country. In Latin America, Western companies are pulling out their investments en masse. In Brazil, half of the 35 modern ethanol plants planned for 2009 and 2010 will not be put into service. Western capital is flowing back into the country that triggered the crisis in the first place. US treasury bonds are now considered a safer investment than the biofuel business.

458 At the same time, prices for many crops have dropped sharply -- the price of soybeans, for example, has declined by 40 percent -- meaning the Brazilian economy is caught in a dangerous pincer movement. The country's traditional sectors are no longer viable while new businesses are not yet fully developed. Even export giant China is losing steam. Chinese exports fell by 25 percent in February, a number Bank of America calls "ugly." Donating Sperm to Beat the Crisis All eyes are on the US, the country where the disaster began. American consumers have lost their erstwhile reputation as the engine of worldwide growth. Instead, they are now seen as reserved and uncertain, potential consumers who need strong persuasion before they buy anything. Chains like Pizza Hut are offering customers who buy a pizza a second one for a penny, while car dealers are trying to entice customers by offering a second vehicle for $1 -- if only the consumers would buy the first one. New business ideas are cropping up, providing ways for budget-conscious Americans to earn a quick buck. Phil Maher, who runs the Web sites bloodbanker.com and spermbanker.com, which feature information on how people can earn extra income by donating blood and sperm, says that traffic to his sites has grown by 50 percent and 80 percent respectively in recent months. Men, he says, are mainly donating sperm. "You can donate every two to three days, twice to three times a week if you're lucky," Maher told the news agency AFP. "Three times a week, $100 per donation -- with a year's commitment it can get really interesting." Germany hasn't reached this stage yet. Many Germans are nervously awaiting whatever comes next. They still have their jobs and are still collecting their salaries, and yet the uneasy feeling that things could take a turn for the worse is difficult to dispel. In fact, many are now wary of the reality they see around them, a reality imbued with ominous words like "still" and "until now," words that rob one's feeling of security. Many can take comfort in the fact that their favorite stores are still open, and that their own employers have not resorted to layoffs -- yet. Most Germans are doing well, but how much longer can it last? A classic German company like Porsche is still a strong carmaker -- or is it? Humanity has yet to find cures for diseases like AIDS, Alzheimer's and Parkinson's, even though all the relevant data for these illnesses can be found inside a single body. But the economic crisis is taking place in 6.5 billion minds at the same time, making it the biggest psychodrama in world history. Experiences and television images become condensed into expectations, expectations turn into fears, and fears shape what is happening in every market today. These fears exert a stronger impact on markets than politicians and central bankers, with their speeches and their programs. The virus has eluded the powerful. The entire world is now on edge, causing large numbers of people and businesses -- from housewives to CEOs to bankers -- to hesitate and take a wait-and-see approach to things. This partly explains why the World Bank and the IMF predict a decline in global economic activity in 2009 -- for the first time since World War II. In its most recent report, the Organization for Economic Cooperation and Development (OECD) writes: "The world economy is in the midst of its deepest and most synchronized recession in our lifetimes, caused by a global financial crisis and deepened by a collapse in world trade." According to the OECD, by 2010, the gap between our current economic potential and the current output of goods and services will be twice as large as in the early 1980s, when many countries faced their most severe recession since World War II. One has to go back even further in time to find anything comparable -- to a time when photographs were still in black and white and life was grim.

459 The Great Depression was the primal event of the last century, the root of all evil in the 20th century, including poverty, mass unemployment, Hitler and total war. It is a painful comparison to make, because it presupposes an inevitability that, of course, doesn't exist. Drawing this historical analogy is dangerous, Frank Schirrmacher, a co-publisher of the heavyweight German newspaper Frankfurter Allgemeine Zeitung, warned last fall. According to Schirrmacher, it creates precisely the reality that it warns against, conjuring up "a social type -- that of our grandparents or great-grandparents -- with which an insecure and outclassed society can, at the very least, identify." Comparing is not the same as equating, but it improves our understanding. The past illuminates the present, the German philosopher Karl Jaspers once said. But perhaps the comparison will also show that the differences are greater than the similarities. Is 2009 a new 1929? "I believe and hope it is not, but I wouldn't be surprised if I were wrong," says Robert Samuelson, a leading US commentator on economic issues. When Nobel laureate Paul Krugman was asked the same question recently, he reflected for a moment before responding. Finally, he said, with his trademark thoughtfulness: "It's impossible to rule out anything at this point." Today's data are still a long way from the dramatic -- and, for many, traumatic -- economic statistics of the Great Depression. In the United States, the epicenter of the current crisis, a quarter of all citizens available to work were unemployed at the height of the Great Depression. Today, only 8.5 percent of Americans who are available to work are unemployed. Between September 1929 and June 1932, stock markets lost up to 85 percent of their value, representing a massive destruction of wealth. By comparison, today's Dow Jones index has lost only about 40 percent of its value. But the total value wiped out by the crisis exceeds the destruction of wealth in the Great Depression several times over, even when adjusted for inflation. This is because there is simply more money invested in stocks today than there was 80 years ago. At the time, the entire US economy shrank by almost a third, as tens of thousands of factories, stores and banks went out of business. Between 1929 and 1932, 5,000 banks filed for bankruptcy, and another 4,000 financial institutions went under in 1933, at the height of the financial crisis. These bankruptcies meant that roughly one-fifth of American banks disappeared. In the current crisis, only a few dozen financial institutions have declared bankruptcy. Nevertheless, today's banks are not in a significantly better position than banks were during the Great Depression. Their balance sheets remain burdened by toxic assets. The government continues to inject new, clean money into the economic system. Although this doesn't make banks healthy, it at least prevents their demise. Nevertheless, many institutions are now known in the industry as "zombie banks" -- banks that continue to exist like the undead. During the Great Depression, governments, especially in the United States, stood by and watched as the crisis deepened. The economy stumbled -- and the government allowed it to fall, leaving citizens, banks and companies to their own devices. Governments today, however, are coming to the rescue with billions in bailout funds. This is an important difference, as Obama's adviser Christina Romer is quick to point out. Unfettered Capitalism In 1930, the first year of the crisis, the German economy was caught in a downward spiral, as the population became more and more impoverished each day. Unlike today, very few citizens could claim significant benefits under unemployment insurance, and many were dependent on meager local assistance programs. The victims of the crisis included people who, as the then-mayor of Cologne, Konrad Adenauer -- who would later become the first chancellor of West Germany -- once said, "would never have

460 had to rely on public assistance in normal economic times: pensioners, independent craftsmen and tradesmen." Germans did their best to limit their consumption. One Berlin newspaper, the Berliner Lokalanzeiger, reported that people would drive to restaurants on the outskirts of the city catering to day-trippers, and would often "order only a bottle of mineral water and eat cake they brought along from home." Foreclosure auctions were announced in the newspapers on a daily basis. Bakers decorated cakes with sayings like: "This cake is small, because I too am out of work!" Cafés saved costs by eliminating live bands, playing music from the radio instead, and by serving glasses of milk for 10 pfennigs instead of sparkling wine. In our day, there is more fear than suffering. Germany now boasts a relatively sizeable and stable social welfare state, and even the United States of today cannot be compared with the America of the 1930s. Capitalism was primitive and unfettered at the time. In the United States, government spending as a percentage of gross domestic product was barely 10 percent at the end of the 1920s. Today, the same ratio amounts to around 40 percent in the United States and 44 percent in Germany. As a result, governments have economic forces at their disposable that they can now put into action. During the Great Depression, workers who lost their jobs usually ended up directly on the street. Unemployment meant poverty, while prolonged unemployment led to a slide into economic misery. Both the German and the American welfare states are much stronger today. The United States has unemployment insurance benefits (albeit relatively small), a mandatory social security system and health insurance for retirees and children. In addition, 32 million Americans, or more than 10 percent of the population, receive government food stamps. The greatest similarities between 2009 and 1929 have to do with the causes of the crisis. The history leading up to the Great Depression reads like a review of the last decade. In both eras, people were enamored of the present. They celebrated themselves, and they consumed and invested -- doing both with money they didn't have. They failed to notice growing economic imbalances, and they ignored the trouble brewing in the global economy. People in the 1920s were fascinated by progress and the fashionable new products it spawned, including cars, airplanes, radios and telephones. They were finally able to take part in the latest technical achievements. For only two months' worth of wages, a worker at Ford could buy himself the first affordable automobile, the Model T, popularly known as the "Tin Lizzy." The stock markets also came under the spell of modernity, as more and more citizens became fascinated by stocks and invested their savings in the market. People at all levels of society were suddenly overtaken by a new stock market fever. Unbelievable stories made the rounds, like the tale of a New York valet who made a quarter of a million dollars in the stock market, or the nurse who became $30,000 richer on the basis of a stock tip she had received, or the shoeshine boy who bought stocks worth $50,000 for $500 in cash. Many investors speculated with borrowed money, convinced that they would be able to pay off their debts when their shares appreciated. The American fondness for buying things on credit was already very pronounced at the time. More than half of all cars and three-quarters of all furniture bought in the 1920s were financed on credit.

461 John Kenneth Galbraith, the great student of the world economic crisis, wrote that a "mass escape from reality" had brought movement into the markets -- not in slow, sedate steps, but by leaps and bounds. According to Galbraith, a mass exodus into an economic world of make- believe had begun. Everyone was convinced that the stock market boom in God's own country could only continue, perhaps not indefinitely, but certainly for several more years. Homebuyers in the United States felt the same way until recently. They too were living in an illusory world, except that this time it consisted of their own homes. Politicians played a less than admirable role in both eras, encouraging people to do the wrong things. President George W. Bush told Americans to "go shopping" after the terrorist attacks of Sept. 11, 2001 had shaken the country to its core. The Federal Reserve, America's central bank, provided low interest rates. As a result, economic growth in the United States was driven, not by rising exports or groundbreaking inventions, but by consumption paid for with credit. The US had "the best recovery that money can buy," says Kenneth Rogoff, a former chief economist at the IMF. A similarly unshakable belief in the future prevailed in the 1920s. In the 1928 election campaign, President Herbert Hoover crowed: "We in America today are nearer to the final triumph over poverty than ever before in the history of any land." As late as November 1929, the Harvard Economic Society was still declaring that "a serious depression seems improbable." In both eras, the drama began with a crash. "Despite many differences in terms of detail, the market crash of 1929 and the banking crisis of 1931 closely resemble the problems of today," says economic historian Werner Abelshauser. The bankruptcy of US investment firm Lehman Brothers, for example, bears a fatal resemblance to the events that led to the demise of Germany's Danat Bank. The Danat Bank drama ran its course on the evening of May 11, 1931, when the bank's chairman, Jakob Goldschmidt, was informed during a dinner that his most important client, the Bremen-based textile giant Nordwolle, had falsified its accounts and was hopelessly insolvent. "Nordwolle is finished, Danat Bank is finished, is finished, and I am finished," he said frantically. Goldschmidt was not wrong in his assessment. Danat Bank was indeed finished, and every major Berlin bank was in trouble. The debacle was followed by a crisis meeting of politicians and bankers on the weekend of July 11 and 12. Underestimating the Crash The large conference room at the Reich Chancellery at Wilhelmstrasse 77 in Berlin was filled with dignitaries from the world of politics and money. Contemporary observers reported that the mood in the room was extremely tense. As Hjalmar Schacht, the then president of the central bank, the Reichsbank, recalled, the bank directors were hurling "accusations at each other concerning their financial condition and business practices." But the bankers downplayed the gravity of the situation in their discussions with politicians. Then-Deutsche Bank Chairman Oskar Wassermann even insisted that the situation among Germany's major banks was "no worse than anywhere else in the world." The bankers sought to portray the Danat failure as an isolated case and treated Goldschmidt "like someone with the plague," as then-Chancellor Heinrich Brüning wrote in his memoirs. When Brüning asked the bankers about the condition of Dresdner Bank, "the question alone was perceived as an insult," as he wrote. Three days later, Dresdner was ready to be bailed out. The events in Germany were mirrored in the United States. First the banks came down, followed by their customers -- manufacturers, department store barons and small businesses. After that, all

462 economic activity went into a tailspin, something the modern world had never quite experienced before. Global trade volume fell by 30 percent in three years, while industrial production shrank by 37 percent. It was a shocking experience for everyone involved, from beggars to businessmen. The official unemployment figure in Germany rose to 6.1 million by February 1932, but real unemployment was in fact much higher. Today's contractions in the overall economy and the labor market are relatively modest by comparison. The US economy is expected to shrink by 3 percent in 2009, while Germany will experience a significantly greater decline. The comparisons between the current crisis and the Great Depression are indeed problematic. What exactly is being compared? One set of statistics represents the ultimate outcome of the Great Depression, but what do today's statistics signify? Perhaps merely the beginning of the current crisis? In the late 1920s, the crisis began when it was underestimated. No one recognized the events of the day as the turning point they would eventually become. So much was whitewashed and so many people were placated. If speculation was the mother of the crisis, its father was naïveté. The players, says the economic historian Werner Abelshauser, lacked an "awareness of disaster." At one point, on October 24, 1929, the Dow Jones index fell from 305 to 272 points. The next day, the headline in the New York Daily Investment News declared: "Stock Market Crisis Over." The chairman of the New York Stock Exchange continued his honeymoon in Honolulu. The stock market would not hit bottom until three years later when, in July 1932, the index fell to 41 points. It would take the market another 22 years to reach its pre-crisis level. Politicians at the time, not unlike politicians today, were notoriously optimistic at first. President Hoover heralded a recovery, but the real downturn was yet to come. When his successor, Franklin D. Roosevelt, came into office in 1933, he too believed that the worst was over -- and he too would be proven wrong. President Obama, also unable to resist temptation, used the first halfway positive economic data to instill confidence in the public. In mid-April, he said the economy was showing "glimmers of hope," while his chief economic advisor, Lawrence Summers, said that the sense of "unremitting freefall" in the US economy had disappeared. But that was before the IMF revised its forecasts drastically downward. By that point, there could be no question of an end to the crisis or even a reversal of the current trend. When Obama gave a speech to workers in Iowa last Wednesday, the talk of glimmers of hope had already evaporated. This time, the president told his audience to be patient and bold, not to give up hope, and to believe in America's future. He looked tired. His staff said that he was still exhausted from his European trip. In the decade following 1929, there were repeated signs of a recovery, and politicians were not the only ones to eagerly grasp at every hopeful opportunity. People believed that they had put the worst behind them, and yet their hopes were deceptive. An even bleaker future lay ahead. Even John D. Rockefeller, the richest man of his day, was mistaken in his assessment of the markets. At the end of the week of the 1929 crash, he returned to the market and bought stocks, "believing that fundamental conditions of the country are sound." Last September, Warren Buffett, one of the world's richest men today, made a similarly hasty decision when he invested $5 billion (€3.8 billion) in the firm Goldman Sachs a little more than a week after the Lehman bankruptcy. He would have turned a decent profit if he had waited a while longer. More than anyone else, President Herbert Hoover would go down in history for downplaying the Great Depression. In December 1929, he said that it was "the strong position of the banks" that

463 had "carried the whole credit system through the crisis without impairment." But the real banking crisis was yet to come. In May 1930, the president boldly announced that he was "convinced we have now passed the worst and with continued unity of effort we shall rapidly recover." German Chancellor Angela Merkel seems to be doing her best to imitate Hoover. In the spring of 2008, she believed that the crisis would "perhaps not affect Germany." She was quickly proven wrong. A short time later, Merkel said that German banks were in good shape, and yet the first of those banks had to be rescued soon afterwards. Perhaps the most astute contemporaries are those who withhold judgment. When asked the question: "Can you explain what has happened?" Robert Solow, a winner of the Nobel Prize in Economics, simply shakes his head and says: "No, I don't think that normal economic thinking can help explain this crisis." In light of the difficulties in comparing a past depression with a depression in its embryonic stages, it is worth taking a look at the speed of the respective processes of disintegration. It is an exercise that exposes the raw forces that prevail. The current downward spiral exceeds all previous downturns when it comes to its intensity and speed. The United States has experienced seven recessions since 1947, which lasted 10 months on average. It was only in 1982 and 1983 that the unemployment rate climbed to around the 10 percent mark. But this time jobs are being destroyed at a rate that suggests the outbreak of an epidemic in factories and office buildings. Last August saw 640,000 people being added to the unemployment rolls, followed by 629,000 in October, 255,000 in November and 632,000 in December, and the rate of new unemployment has continued unabated ever since. The US economy is currently losing about 700,000 jobs a month. At this rate, the 10 percent threshold will likely be exceeded at a gallop. The Rise of Hitler A similar decline in economic activity is also unprecedented in Germany. Most German economic research institutes now predict a 6 percent decline in growth for this year, and although the decline is not expected to be as severe in 2010, forecasts do not foresee growth. These assumptions are not based on the opinions of business owners and consumers. Instead, they reflect the decline in orders for goods and services. Both the machine-building and steel industries report a 50 percent drop in orders. Indeed, it is hard to find an industry that is not shrinking dramatically. Germany's postwar society has never experienced turmoil of similar proportions. The major economic tremors have always been felt in neighboring countries, brought on by France's nationalization policies in the 1980s, the withdrawal of the British pound sterling from the European Monetary System, and the conditions in Italy that led to the rise of current Prime Minister Silvio Berlusconi. "This is the first postwar crisis that we are not experiencing as someone else's crisis," says Wolfgang Nowak, the director of Deutsche Bank's Alfred Herrhausen Society. One can only guess at the long-term political impact of today's crisis. The reason the comparison with the Great Depression is so horrifying is that the world economic crisis led not only to the impoverishment of large segments of the population in Germany and elsewhere, but also to a political catastrophe. In the wake of the economic crisis, Germany fell into the hands of the Nazis. The slogan, "Hitler - Our Last Hope," was plastered on campaign posters in the 1930s. Many agreed with the sentiment at the time. A bizarre political group that had formed around Adolf Hitler, a former vagrant and veteran of World War I, was suddenly catapulted to the center of the public eye. On May 2, 1930, Hitler, a

464 man who had been ridiculed until then, was suddenly speaking to a packed house at Berlin's Sportpalast hall. Now the people, or at least a significant portion of the people, were eager to hear Hitler speak. After the Reichstag election in the late summer of 1930, a splinter group had suddenly become a force to be reckoned with. The Nazi Party won 18.3 percent of the vote and 107 seats in the Reichstag, making it the country's second-most powerful party. The economic crisis had catapulted the party to power within just a short space of time. Berlin is not Weimar. And the current economic crisis has not produced any noticeable political changes -- at least not yet. Demonstrations and protests by those affected by the crisis have attracted moderate crowds at best, as was the case at last week's demonstration outside the annual meeting of the Continental automotive parts company's annual meeting in Hanover. This could change if the crisis worsens and unemployment rises significantly. But will that lead to "social unrest," as Michael Sommer, the head of the DGB federation of German trade unions warns? Could the situation in Germany become explosive, posing a threat to democracy, as Gesine Schwan, the SPD's presidential candidate, cautions? Nothing so far suggests that this is the case. Both Sommer and Schwan have already been reproached for engaging in scare tactics, even by fellow party members like Frank-Walter Steinmeier, the SPD's chancellor candidate. But what is realistic? How will the crisis change the country and the rest of the world? When experts don't know what will happen next, they develop scenarios. And because future economic developments are so politically explosive, Germany's foreign intelligence agency, the Bundesnachrichtendienst (BND), has decided to address the issue. In mid-April, BND President Ernst Uhrlau presented German President Horst Köhler with his analysis of the repercussions of the current situation. During the meeting at Berlin's Bellevue Palace, the president's official residence, the two men discussed a "metamorphosis in geopolitics" and the future political make-up of a world that will never be the same again. The core message for the German government is that Europe and the United States will come under growing political pressure, and will face growing competition from China. Beijing will be one of the likely beneficiaries of future shifts on the political map. Uhrlau believes that there are three possible scenarios. The first scenario, the most optimistic of the three, assumes that the current economic stimulus programs will work, leading to a rapid shift in trends in the stock and credit markets, and that confidence will return and the economy will pick up speed soon. Under this scenario, the United States will remain the dominant superpower, but it will emerge from the crisis economically weakened and with less available capital to fund its military activities. The People's Republic of China would benefit from this development as the strongest exporting nation. The Chinese will benefit even more if scenario two, which the BND calls the "China scenario," becomes reality. It describes what will happen if the billions from the West's economic stimulus programs end up primarily in Asian countries. The foreign capital would reinvigorate Asian domestic markets, allowing Beijing to invest even more heavily in advanced technology and take over the prime assets of Western industry, thereby accelerating its modernization process. This, in turn, would speed up China's process of catching up with the West. For Beijing, the crisis would serve as the catalyst for a development that has already been underway for several years. "China would develop even more strongly into a superpower in Asia and a reference point for countries like the Arab Gulf states and other raw materials producers," says Uhrlau. "The United States, on the other hand, could forfeit some of its dominant status."

465 India would also grow in the slipstream of the Chinese, though not as dynamically. The BND believes that under this scenario, competitors to central institutions like the IMF would take shape, such as an Asian Monetary Fund. The third scenario is the most dismal. It describes the consequences if the economic stimulus programs are ineffective, which will become all the more likely the longer it takes for the recovery to emerge. It is a catastrophic scenario for large parts of Africa, as well as for countries like Argentina, Venezuela, Iran, Kazakhstan and parts of the European Union, which would come under massive pressure. Countries like Yemen could turn into "failing" states, with central governments losing much of their authority, while the loss of aid payments from other countries would push countries like Jordan to the brink of insolvency. The flow of refugees to Europe would surge, benefiting Islamists worldwide. In this scenario, the BND predicts mass unemployment for China, internal unrest and a loss of its monopoly on power for the Communist Party. This would constitute virtually a revolutionary development with grave risks to global stability, because it would prompt the government in Beijing to become more aggressive abroad to compensate for internal tensions. The BND expects to see a blend of the first two scenarios emerge -- not exactly a soft landing, but not an all-out catastrophe, either. What all three scenarios have in common is the theory that, after this crisis, the world will likely not be as dependent on the United States and Asia will play a greater role than in the past. "There will be a development in the direction of regionalization," says Uhrlau, "and we will have to get used to a more self-confident China in the future." But is the third scenario truly out of the question? Isn't it possible that the billions now being pumped into the economy could seep away without producing the desired effect, because the foundation of the economy has become so porous after years of being fueled by debt? The End of American Hegemony There are, at the very least, signs that this scenario is not quite as unlikely as some would like to claim. The severe crisis is affecting the United States, which is already in a weakened position, and it could accelerate the country's relative demise as a superpower which already began a long time ago. American industry, or what is left of it, is already in a deplorable condition today. Detroit's Big Three carmakers, General Motors, Ford and Chrysler, have been ailing for a long time and are now on their last legs. In the last three years alone, the three companies have lost a combined $110 billion (€83 billion). The history of the US auto industry -- and this is what makes the current situation so dramatic -- is the history of America as an economic superpower, from its brilliant ascent to its agonizingly slow demise. The GM model, characterized by massive marketing, little substance and an excessive policy of debt financing, has also become the country's model. Never before has a country lived at the expense of the future with such reckless abandon. The United States today is an economy that sucks in the savings of other nations. America currently needs more than half of worldwide savings merely to avoid falling below the levels of previous years. The government and private households borrow roughly $1 billion (€760 million) on each business day. Three years ago, the country was only borrowing two-thirds of this amount. Even when adjusted for the size of today's economy, the US's current debts significantly exceed debt levels during the Great Depression. The superpower has become an empire of debt. The most dangerous element of President Obama's crisis management program is that this debt is not being reduced, but expanded. The US's national deficit will reach an estimated $1.8 trillion (€1.36 trillion) in 2009 and will only continue to grow after that, perhaps even doubling. About 40 percent of the national budget is already not being covered by revenues.

466 If only the problem were limited to the United States. But the situation that has been brewing on the periphery of the crisis is far more dramatic than it was in 1929. This is mainly attributable to the fact that modern globalization had only begun at the time. Many of today's industrialized nations were agricultural economies, and were not linked to the global economic system. Countries like Romania, Hungary, Russia, Latvia and Ukraine did not play a significant role at the time of the Great Depression. Today, they are either on the brink of bankruptcy or, like Russia, they are in serious trouble because the price of oil has declined dramatically and Western investors are pulling out their money. The Institute of International Finance expects the flow of capital into the emerging economies of Eastern Europe, Latin America and Asia to fall to only $165 billion (€125 billion) this year, or one-sixth of the level of foreign investment in these countries only two years ago. Eastern Europe, in particular, is suffering from a massive exodus of capital. The Hungarian forint has lost more than 20 percent of its value since last July, while the Ukrainian hryvna has declined by a third. The tailspin affects banks in Austria, Germany and Italy that had heavily invested in the region. In some countries, more than half of all loans were denominated in foreign currencies. Experts like economics Nobel Prize winner Krugman believe that, barring a noticeable improvement in Eastern Europe, Austria could face national bankruptcy. Austria's wellbeing depends on the wellbeing of the Eastern Europeans. This, in turn, is closely tied to the influx of foreign investment capital. There would be serious political consequences if any Eastern European countries became failed states. One would be a threat to the goal of European unification. A divided Europe would not be a peaceful Europe, as radical influences would quickly begin flowing from the edges of the continent towards its center, which is precisely where Germany is located. The IMF is currently doing its utmost to prevent the collapse of these countries. Special task forces are being established, Hungary and Latvia are being supported and rescue programs for other countries have already been approved. At its recent summit in London, the G-20 group of major industrialized nations voted to provide the IMF with an additional $500 billion (€380 billion) in lending capital. Germany is also preparing itself for tougher times, at least in theory. As unemployment rises, tax and social security revenues will naturally decline. As a result, Germany will sink further into the red. The Nuremberg-based Federal Labor Agency has already sounded the alarm, noting that its reserves will be depleted by this fall. Some €2.1 billion ($2.8 billion) have already been set aside for 2009 to pay for the large numbers of workers that are on short-time schemes, where the shortfall in their wages is partly made up by the government. The government's reserves for social security benefits are likely to be tapped even further, partly to prevent the development of a politically explosive atmosphere. The "Agenda 2010" labor market and social system reforms adopted under former Chancellor Gerhard Schröder have helped to reduce the costs to the government of welfare programs. But in a crisis of the current dimensions, these laws could also lead to the rapid impoverishment of people who are still part of the middle class today. Anyone who is unable to find a new job within a few months automatically becomes a welfare case in Germany. In the past, if a 57-year-old worker became unemployed, he would continue to receive 60 percent of his last net salary for 32 months. Only then would he qualify for unemployment assistance. Under the old system, he was able to keep his home and his life insurance policies. This helped to slow the descent into poverty.

467 Today, the same worker would lose his unemployment benefits after 18 months. If he fails to find a job after that, he stands to descend quickly into poverty. A person who is classified as long-term unemployed receives €351 ($463) a month in government assistance, as well as the cost of rent for "suitable" housing, which, for a single person, is generally restricted to an apartment no larger than 45 square meters (484 square feet). And he only qualifies for this assistance if his savings are minimal. Germany could soon face a debate over the future of the social welfare state. "We must take an offensive approach to discussing the threat of impoverishment," says one SPD cabinet member. The cabinet member insists that an amendment to the Hartz IV reforms is at the top of the political agenda, and that the Social Democrats cannot allow their political base to fall into the poverty trap. Nevertheless, no one in Berlin is currently interested in actively discussing the issue. No one wants to be suspected of fueling public anxiety even further. Politicians are still holding onto the hope that things will not turn out to be as bad as expected after all. Everyone, in fact, still hopes that the differences between today's crisis and the Great Depression will be greater than the parallels. Unlike 1929, the governments of the major industrialized nations today are generally in agreement and are combating the crisis together, a commitment they agreed upon at the London G-20 summit in early April. Unlike 1929, the social welfare network, especially in Germany, provides citizens with a cushion against the most acute hardships. Under the Obama administration, America's social safety net is also being improved. Unlike 1929, the world's major countries are flooding the economy with money to prevent deflation and, with it, a downward spiral of declining prices and income. But no one knows whether this will suffice, or whether all the money being thrown at the aggressive virus fueling this crisis will only make it worse. Debts are being fought with debts, meaning that not only banks but entire countries could end up bankrupt. Perhaps the efforts to combat the current crisis are merely laying the foundations for the next crisis, which will be bigger still. Economic historian Werner Abelshauser is among those who refuse to rule out anything. "History doesn't repeat itself," he says. But then he quickly adds: "Or does it?" MARKUS DETTMER, RÜDIGER FALKSOHN, ALEXANDER JUNG, ALEXANDER NEUBACHER, GREGOR PETER SCHMITZ, HOLGER STARK, GABOR STEINGART Translated from the German by Christopher Sultan

URL: http://www.spiegel.de/international/world/0,1518,621979,00.html

468 RELATED SPIEGEL ONLINE LINKS: Photo Gallery: 2009 and 1929: History Repeating? http://www.spiegel.de/fotostrecke/fotostrecke-42025.html Germany's Recession Blues: Berlin Predicts Sharp GDP Contraction for 2009 (04/29/2009) http://www.spiegel.de/international/business/0,1518,621896,00.html Taking the Downturn on the Chin: Why Is Germany So Calm? (04/28/2009) http://www.spiegel.de/international/germany/0,1518,621680,00.html The Ailing Celtic Tiger: Dell Departure Threatens to Cripple Limerick (04/24/2009) http://www.spiegel.de/international/business/0,1518,621002,00.html Opinion: The New Angst at the Heart of Germany (04/24/2009) http://www.spiegel.de/international/germany/0,1518,620976,00.html Soup Kitchens and Tent Cities: Crisis Plunges US Middle Class into Poverty (04/23/2009) http://www.spiegel.de/international/world/0,1518,620754,00.html 'Worst Depression' Since 1930s: Optimism Dips As Economic Downward Spiral Continues (04/23/2009) http://www.spiegel.de/international/germany/0,1518,620779,00.html Not Out of the Woods Yet: Experts Warn that Banking Euphoria Is Premature (04/23/2009) http://www.spiegel.de/international/business/0,1518,620590,00.html Spreading Hope: Merkel Says German Economy May Be Bottoming Out (04/20/2009) http://www.spiegel.de/international/germany/0,1518,620050,00.html New Idea to Keep Unemployment Down: Germany Mulls 'Parking' Unwanted Labor in New State-Funded Firms (04/14/2009) http://www.spiegel.de/international/germany/0,1518,618887,00.html Swimming Naked: The Worst Financial Predictions, One Year On (04/10/2009) http://www.spiegel.de/international/business/0,1518,618580,00.html 'I Take Responsibility': Obama's G-20 Confession (04/06/2009) http://www.spiegel.de/international/world/0,1518,617639,00.html Opinion: The West's Fatal Overdose (04/03/2009) http://www.spiegel.de/international/world/0,1518,617224,00.html SPIEGEL Interview with Economist Joseph Stiglitz: Government Stimulus Plans are 'Not Enough' (04/01/2009) http://www.spiegel.de/international/world/0,1518,616743,00.html The Hangover after the Party: Eastern Europe's Economic Crash (03/23/2009) http://www.spiegel.de/international/europe/0,1518,614960,00.html SPIEGEL 360: Our Full Coverage of the Global Economic Downturn http://www.spiegel.de/international/business/0,1518,k-7312,00.html

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04/28/2009 04:11 PM TAKING THE DOWNTURN ON THE CHIN Why Is Germany So Calm? By Juan Moreno and Stefan Simons The French are kidnapping managers and taking to the streets in protest against the global downturn. But their neighbors in Germany seem curiously unmoved by the economic nosedive -- at least for now. Arne Brecht has a problem, the kind of problem only a radical leftist in Berlin's bohemian Friedrichshain district can have. In one of the hippest neighborhoods in the German capital, where there is a bar or restaurant on every corner, Brecht is having trouble finding a café where he can give an interview. Brecht, 21, is in his fourth semester of his history degree at Berlin's Humboldt University. He has been a member of a group called the Berlin Antifascist Revolutionary Campaign (ARAB) for some time. He rejects capitalism, welcomes radical action like the torching of vehicles belonging to the German military (currently something of a trend in Berlin) and is looking forward to "Revolutionary May 1," traditionally a day of riots in the German capital and elsewhere. He has also spent a lot of time studying Marx and Engels. A man like Brecht refuses to meet in just any café. But "Liberación" and "Zielona Góra," two leftist establishments, both happen to be closed on this particular day. The only remaining alternative is a place called "Kuchenrausch" ("Cake Bliss") -- a name that doesn't exactly appeal to a revolutionary. Brecht insists on sitting at a table where there is no waiter service. Brecht is probably one of the most radical history students registered at Humboldt University. As an adolescent, he spent a lot of time reading about the low wages of workers in Asia, the destruction of the environment and how corporations rake in billions in profits. Brecht has a low opinion of demonstrations, which he regards as mere requests to the government. If they were effective, they would be banned, he reasons. He also rejects the government -- all governments, in fact. And he is opposed to capital. As far as Arne Brecht is concerned, the time is ripe for radical change. He shares at least some of his views with Oskar Lafontaine, the fiery chairman of Germany's far-left Left Party. "When French workers are angry, they lock up their managers," Lafontaine told WDR public radio last Friday. "I would like to see that happen here, too, so that they notice there is anger out there and that people are worried about their livelihoods." Lafontaine's words marked the climax of a week of irresponsible rhetoric in Germany. Michael Sommer, the chairman of the German Confederation of Trade Unions (DGB), had earlier warned of the possibility of "social unrest" if the crisis worsens. Gesine

470 Schwan, who is the center-left Social Democratic Party's candidate for German president, even went so far as to characterize the crisis as a "threat to democracy." Despite such comments, things have been relatively quiet on German streets until now. The only significant protests were expressed at two larger rallies leading up to the London G-20 summit. About 20,000 people attended a rally in Berlin, while an event in Frankfurt attracted a somewhat smaller crowd. The people who took to the streets in Frankfurt and Berlin included men carrying red flags, jokesters carrying signs intended for the bankers in their office towers that read "Jump you fuckers," labor union members, opponents of globalization and critics of capitalism. In other words, the usual suspects. Despite the crisis, the masses stayed home. 'A Mixture of Fear and Anger' Bernd Riexinger wants that to change, and he has big plans to make it happen. He is interested in getting the masses involved and he wants to see a general strike. Riexinger, the district head of German service workers union Ver.di in Stuttgart, has always been a leftist crusader. In late March, he was standing in front of Frankfurt's landmark Bockenheimer Warte tower, wearing a black leather jacket, to launch a demonstration against the crisis. Microphone in hand, Riexinger tried to make his point as concisely as possible: "We will not pay for your crisis." It was time for those who had profited from 20 years of neoliberal policies to pay for their mistakes. It sounded straightforward enough. There was a crisis, there were those who had brought it about, and there were ways for people to stand up for themselves. Riexinger, a member of the Left Party's regional organization in the state of Baden- Württemberg, is part of the left wing of his union. He has been trying for years to disabuse Ver.di members in the Stuttgart area of what he calls their "resignation mentality." But confrontation does not come easily to people. Germans like harmony. They may not like their bosses, but the standard approach is to keep quiet about it. Although the German penchant for consensus makes for reasonably pleasant interpersonal relationships, it is of little use to a true labor activist. "I'm beginning to sense a diffuse mixture of fear and anger, but the situation isn't clear yet," says Riexinger. Germany, it seems, is not easily aroused. But Riexinger is a persistent man, and he does what he has always done: fight. It doesn't seem to bother him that general strikes are banned in Germany, where the traditional role of labor unions is to negotiate labor contracts, not become involved in politics. "We should get rid of the taboo in this country," says Riexinger, who publicly called for a general strike at the Frankfurt demonstration. He says that he wants to prepare for the strike "in stages," which means convincing Ver.di first, then the DGB confederation, followed by other left-leaning groups. "Once we have reached critical mass, no one will take legal steps against the strikers." The country's trade unions have a combined membership of 6.5 million people. If they all took to the streets, Germany would be brought to a standstill. Riexinger has many supporters, including political celebrities like Lafontaine, who spoke out in favor of lifting the ban on general strikes on Friday, and activists such as Christina Kaindl, one of the organizers of the Berlin demonstration against the economic

471 crisis. Kaindl believes that Riexinger's plan for a general strike this fall could come to fruition. Riexinger says that he often hears other Ver.di members say that German unions ought to follow the French example. France is to labor organizers what the UK was to investment bankers: a land of unlimited possibilities. Experts with the International Monetary Fund (IMF) estimate that the French economy will shrink by 3 percent this year, or about half as much as the projection for Germany. Nevertheless, the French weekly newspaper Courrier International writes that a "touch of revolt" is taking hold throughout the country. Former Prime Minister Dominique de Villepin even believes that France is on the eve of a "revolution." The signs include plant occupations, wildcat strikes and workers taking managers hostage. In early March, the manager of a Sony plant was held against his will, and 10 days later workers held an executive of the pharmaceutical company 3M hostage. Workers occupied a plant owned by US construction equipment manufacturer Caterpillar in the western city of Grenoble and detained the entire management team, while directors at chemical producer Scapa, transportation company FM Logistic and Peugeot-Citroën supplier Faurecia were subjected to similar treatment. The management of automotive supplier Molex were held hostage in their offices for about 26 hours. "The conflicts in France are undoubtedly more frequent and intense," says Claude- Emmanuel Triomphe, who studies trends in working conditions and employment for the industry association ASTREES. According to Triomphe, it is precisely because French unions are more poorly represented in the private sector than in most other industrialized countries that worker frustration is manifesting itself in spontaneous radicalization at the lowest levels of society. "Violence is, to a certain extent, the weapon of the weak," says Triomphe. But why are the weak in Germany so silent? Jörg Schindler, the owner of a law firm with offices in Berlin and the eastern German city of Wittenberg, is opposed to violence, and yet he understands the rage of the underprivileged. He often represents the recipients of benefits under the controversial welfare program known as Hartz IV, which has long been the target of criticism by the German left. About a year ago, Schindler co-founded the leftist magazine "Prager Frühling" ("Prague Spring") in Berlin. It was intended as a forum for the proponents of leftist ideas, the logic being that the best ideas would eventually prevail. Those ideas would then be proposed to the general public. In other words, competition, a capitalist method, would be used to seek an alternative to capitalism. "We were taken by surprise," says Schindler. "Our aim was to criticize neoliberalism, but then, suddenly, everything fell apart. Now we are lacking a theoretical framework." Schindler believes that the left needs more time to come up with ideas, before it can tell citizens what to write on their protest banners. Another reason for the relative calm in Germany could be the fact that the weak are not as weak as some might assume. The country has a strong social safety net, so that the impact of the crisis has not been as severe for many. Companies have been able to keep their employees by reducing their working hours, while retirees will receive bigger pension supplements this year than they have received in a long time. In other words, citizens still have money -- but how long can it last?

472 "One reason that we are only seeing small protests is that politicians will not reveal the true cost of the crisis until after the parliamentary elections," says Elmar Altvater, a former professor of political economics at the Otto Suhr Institute at the Free University of Berlin. Altvater spent much of his career writing leftist books, and in 2005 he published a book titled: "The End of Capitalism as We Know It. A Radical Critique of Capitalism." According to Altvater, Germans are in for a rude awakening shortly after September's national election. Perhaps there will be a new wave of cost-cutting welfare reforms, like those which spawned the unpopular Hartz IV scheme. After all, the money the government is spending today will eventually have to come from somewhere, says Altvater. Will the post-election revelations trigger major protests or even violence? It will partly depend whether even more politicians or trade unions threaten to stir up the masses. Translated from the German by Christopher Sultan http://www.spiegel.de/international/germany/0,1518,druck-621680,00.html URL:

• http://www.spiegel.de/international/germany/0,1518,621680,00.html

RELATED SPIEGEL ONLINE LINKS:

• Photo Gallery: Taking to the Streets http://www.spiegel.de/fotostrecke/fotostrecke-41955.html

• Burned by Lehman Securities: German Bank Admits Giving Wrong Advice to Investors (04/28/2009) http://www.spiegel.de/international/business/0,1518,621599,00.html

• Opinion: The New Angst at the Heart of Germany (04/24/2009) http://www.spiegel.de/international/germany/0,1518,620976,00.html

• 'Worst Depression' Since 1930s: Optimism Dips As Economic Downward Spiral Continues (04/23/2009) http://www.spiegel.de/international/germany/0,1518,620779,00.html

• Attack from the Left?: Automobile Arson a Trend in Berlin (04/09/2009) http://www.spiegel.de/international/germany/0,1518,618443,00.html

• SPIEGEL 360: Our Full Coverage of the Global Economic Downturn http://www.spiegel.de/international/business/0,1518,k-7312,00.html

473

RGE Monitor's Newsletter 29/04/2009 8:00

Navigating Towards Bretton Woods 3? Greetings from RGE Monitor! A few years back, before this crisis erupted, several economists were concerned about the sustainability of the large global imbalances fueled by the so-called Bretton Woods 2 (BW2) system. These economists recognized in the tendency of emerging (export-led) economies to manage their exchange rate systems the origin of large trade and current account surpluses that, via large foreign reserve accumulation, were financing the mirror of those surpluses, namely the large U.S. trade and current account deficits. These surpluses, primarily in several exports-led Asian economies, and also in oil producing countries, ballooned to extensive proportions in 2007 and 2008. The purchases of U.S. government bonds by these investors helped keep long-term interest rates low and led many investors to seek out high-yielding investments especially in some emerging markets. Although we are not (yet) witnessing a U.S. dollar crisis, the Bretton Woods 2 system is still at the center of the debates on the origins of this crisis. Understanding the nature of this crisis is fundamental in order to understand what reforms need to be undertaken for this not to happen again, and to understand what the global economy will look like after this crisis. Although other factors played a part, it is hard to argue that the large global imbalances that arose in a few years ago had no role whatsoever in the current global synchronized recession. However, so far, global imbalances do not seem to be on even the long-term agenda of most of those trying to remake the global financial system. Global imbalances are now starting to narrow though – and the current crisis is likely playing a role – as saving rates rise in the U.S. trade volumes fall on lower demand, expensive credit and weak commodity prices. The U.S. current account deficit has fallen from 6.6% at the end of 2005 to 3.7% at the end of 2008 and the IMF estimates that it will fall further to 2.8% of GDP in 2009. Many of the emerging economies that easily financed wide deficits are now being forced into consuming less given the lack of credit and in some cases currency devaluation that boosts the costs of imports. Meanwhile the fall in the price of oil and other commodities is shifting many oil exporters, some of the larger surplus nations, into deficit territory. Is this the death of BW2? Can export-led growth countries increase consumption? Or are we going to see large imbalances in the global economy come back when the recovery will be in full swing? And would a permanent correction of global imbalances be contractionary? If surplus economies continue along a business as usual path, trying to stoke export demand rather than increasing domestic spending to boost consumption, it could increase deflationary pressures. Fiscal and current account surpluses and foreign exchange reserves can be used to increase

474 investment, which might help unwind the global imbalances. In fact, fiscal stimulus spending being undertaken during the current downturn by surplus countries like China and the Middle- East will help increase their own domestic demand and also boost the exports of deficit countries. Governments with comfortable fiscal/external surpluses, commodity revenues or foreign exchange reserves, such the Asia-Pacific, GCC< /a> and Latam economies, Canada, Norway, Germany and Russia, have rightly increased stimulus spending in spite of easing exports and commodity prices recently. However, there are criticisms that such spending still fall short and are rather steered towards export firms than domestic demand which will only exacerbate global deflationary pressures. On the other hand, stimulus spending by deficit countries such as the U.S. and UK will only accentuate pressure on global fiscal deficits and global imbalances. Some are still concerned that the unwinding of imbalances might be disorderly leading to swift exchange rate moves. However, it is also possible that this might be a gradual process, aided by a beefed-up IMF and other multilateral institutions which will avert balance of pay ments crises if not sharp contractions in many emerging economies especially in Eastern Europe. Some imbalances seem to be persistent though. China’s surplus does not seem to be shrinking very much, largely because the import contraction including goods for re-export and cheaper commodities is more severe than that of exports. And those of Germany and Japan are expected to continue to be quite large also. The consumption share of China’s GDP has fallen since the year 2000 although Chinese government investment could provide a boost in 2009. The IMF suggests that China’s current account surplus will continue to rise- albeit at a slower pace – in 2009, nearing $500 billion from almost $430 billion in 2008. Such a large current account surplus implies still large reciprocal deficits in some of China’s trading partners, likely the U.S. and several European countries. As we noted in our recently released outlook, there is a risk that China’s fiscal stimulus might exacerbate production overcapacities, creating further deflationary pressures unless China is able to stimulate domestic demand, especially private consumption. Moreover, there is related risk that China's extension of investment and credit expansion could defer China's transition to a global economy in which the U.S. consumer consumes less. As it currently stands, China’s almost $600 billion fiscal stimulus has less than 10% dedicated to social welfare programs. Expanding this expenditure through increasing government expenditure on health care, increasing pension payments and unemployment benefits, could have a significant effect on boosting consumption particularly as it could reduce some of the households’ structural pressures to save. In the longer term, some tax policy changes, including the requirement of state owned enterprises to pay dividends and introduction of a value added tax, might also be supportive of consumption based growth. As detailed in Nouriel Roubini’s account of his trip to China, Chinese leaders are cognizant of the need to rebalance growth, meaning China may be better placed to do so than some of the export and investment-led advanced economies or the Asian tigers whose growth models are in question in the midst of the global export collapse. So far, despite several months of hot money capital outflows, China seems to have increased its share of the safest U.S. assets especially treasury bills. Given the global export weakness, China may be forced to maintain its quasi dollar peg, which will likely involve a resumption of U.S. dollar asset purchases. Yet, Chinese concerns about the long-term value of its U.S. assets have increased. China has been diversifying its assets on the margins, increasing the

475 resource exporters. The Chinese central bank governor has suggested that over time the IMF's SDR has a certain attraction as a reserve currency given the instabilities that have stemmed from the U.S. dollar's reserve currency role. Take a look at: Will China Keep Buying U.S. Assets? Shifting to Short-term Liquid Assets and Can Chinese Growth Really Be Driven By Consumption? The severe impact of the global recession and export contraction on Asia’s growth and manufacturing output and employment loss might pave way for Asia to re-think its export-led growth model and change its source of growth away from exports towards domestic consumption. However, this might require a lot more political will since this growth model has nevertheless helped Asia attain higher per capita income, stronger economic growth and significant poverty reduction. Moreover, the structural changes required to change the growth model (move production from low-end manufacturing to high-end labor-intensive manufacturing and services to boost employment and incomes, improve social safety net, pension and health care systems, invest in skill training and R&D, and enhance intermediation of savings and credit access for firms by developing financial markets) all involve short-term costs with results only in the long-term, something that political leaders might be unwilling to trade. [See Box1 – Can Asia Move From an Export-Led to Domest ic Demand-Led Growth Model? in RGE Monitor’s Q1 Update to the 2009 Global Economic Outlook.] On the other hand, it might be argued that Asia might continue to follow an export-led model even in the future to sustain growth and poverty reduction and at the same time use the presently available vast resources to boost safety net and cushion the economy and workers from any future global export downturn. While policies to increase domestic demand might boost Asian imports and reduce current account surpluses, shrinking exports recently have in fact led imports to shrink at a faster pace than exports (given high import content of exports) thus keeping up the trade and curren t account surpluses in many Asian countries. Letting the exchange rate appreciate will also be challenging for Asia and will largely depend on China’s currency stance. In fact, many Asian countries started favoring an undervalued currency or at least stopped allowing appreciation recently as exports weakened and to maintain competitiveness vis-a-vis China. Asia' stance will also be governed by the losses that the central banks will have to realize on their U.S. treasury holdings by letting their currencies appreciate. Moreover, any change in Asia’s growth model will be governed by the medium to long-term factors such as the pace of rise in the U.S. savings rate and whether it’s structural or cyclical in nature, and also the trends in global commodity, shipping and Asian labor costs going forward. It is a different story with commodity exporters who as a whole are set to shift from surplus to deficit territory in 2009 given robust spending and much lower revenues. Unlike China, oil exporters were already contributing more to rebalancing in the last few years, with much of the incremental increase in revenues being spent or rather absorbed at home by massive projects and increased consumption. In fact, rather than generating surpluses, the current risks are that the economies of many oil exporters in the CIS, Africa and even some in the GCC could contract in 2009 on given the weaker hydrocarbon and non-hydrocarbon sector outlook. Facilitated by past savings, many of these countries including Saudi Arabia, the UAE and Russia are conducting expansionary fiscal policies this year and will run significant fiscal deficits at an oil price below $50 a barrel. Moreover countries like the UAE, Saudi Arabia and others are expected to run current account deficits, financed by the sale of past savings. Meanwhile with many sovereign wealth funds and other government capital been deployed at

476 Spending Sprees? The eurozone’s largely balanced external position covers ample intra-EMU imbalances among eurozone countries. Current account dispers ion reached from +8.4% in the Netherlands and 7% in Germany to –13.4% in Cyprus as of 2008. The European Commission notes that while large current account balances by themselves could merely be the expression of rational private sector choices, a comparison of real exchange rates (REER) with their benchmark “equilibrium” current accounts shows the existence of sizable real exchange rate misalignments. See Adjustment in EMU: Are Stabilizing or Diverging Forces At Work? Decompositions of this kind gave rise to claims that Germany, in particular in its role as EMU’s ‘center’ economy, is engaging in beggar-thy-neighbor behavior by setting in motion a real competitive devaluation of its currency through falling unit labor costs. This makes a rebalancing of high deficit countries all the more challenging. Since a nominal devaluation is not an option within the EMU, high-deficit countries have no option but to deflate in real terms either through relatively higher productivity or consumption restraint against an already ambitious German benchmark. Take a look at: Spain Running A Current Account Deficit of 10% of GDP: Is a Sudden Stop A Real Possibility? And The Credit Crunch In the Eurozone: Is The Corporate Sector The Eurozone's Weak Spot? As reported in RGE’s Global Economic Outlook (January 2009), Germany is not exposed to over-indebted households and non-financial corporates to the sam e extent as Spain, Ireland or even France. However, as the current downturn makes painfully clear, balanced financial accounts provide no shield against an over-reliance on external conditions or undiversified specialization patterns. Bundesbank president Axel Weber recently made clear that Germany should try to break its dependence on exports as the mainstay of its economic growth, whereas Chancellor Angela Merkel argues that a strong industrial base and external competitiveness are valuable assets, especially for an ageing and shrinking population. In fact, “[export- reliance] is not something we even want to change.” Check out: Germany As Export Champion: Sign of Strength or Sign of Weakness? Ultimately, the BW2 system of global imbalances has had far-reaching effects beyond the U.S. and Asia. Like the U.S., emerging markets in Eastern Europe were able to fund large current- account deficits in the recent era of cheap financing. In May 2007, Nouriel Roubini wrote: “The currency and economic policies of China and East Asia have contributed – among many other factors – to unsustainable global current account imbalances whose rebalancing now risks becoming disorderly rather than orderly.” This is certainly the case in Central and Eastern Europe (CEE), where current account deficits have been the norm and where the unwinding of such imbalances is raising concern that it could contribute to a regional financial crisis along the lines of 1997 in Asia. The drying-up of capital inflows, amid the global financial turmoil, is necessitating a sharp adjustment in Eastern Europe’s external imbalances. These imbalances rival, and in some cases exceed, those in pre-crisis Asia - i.e. current account deficits in Southeast Asia from 1995-97 fell within the 3.0-8.5% of GDP range, while those in CEE were well over 10% of GDP in Romania, Bulgaria and the Baltics in 2008. A correction in the region’s imbalances is already underway via currency depreciation (in countries with flexible exchange rates) and via a sharp drop in domestic demand. Thus far, the IMF has stepped in with financial assistance in three EU newcomers - Hungary, Latvia and Romania – to smooth out the sharp drop-off in capital inflows and to avert a disorderly unwinding of external imbalances. These countries are unlikely to be the last to knock on the IMF’s door.

477

Apr 28, 2009 Spain Running A Current Account Deficit of 10% of GDP: Is a Sudden Stop A Real Possibility?

Overview: Peltonen/Sagen (ECB): We find evidence of significant correlation between real exchange rates and productivity differentials in both the traded and the non-traded sectors. But our finding of a significant role for the non-traded sector in exchange rate determination, and of a relatively larger correlation between exchange rates and productivity shocks of a given size emanating from this sector, represent clear contradictions of the widely cited Balassa-Samuelson hypothesis. o March 2009 EU Commission quarterly report: Greece, Spain, and Portugal are estimated to be overvalued by about 12-13% and France by about 7%. On the other hand, Germany’s REER is estimated to run at 13% below its equilibrium level, whereas the Netherlands, Austria, and Finland are undervalued by about 6-7%.--> as the German benchmark is itself constantly improving, any adjustment of imbalances will occur via real adjustments ie. import and consumption retrenchment rather than via improved export comtetitiveness. o Feb 5 Evans-Pritchard: A €7bn treasury auction of 10-year Spanish bond saw yields jump to 137 basis points above German Bunds, a post-EMU high. Foreign investors were conspicuously absent, leaving Spanish banks to soak up the debt. o ECFIN Country Focus, BNP: The external net borrowing requirement of the Spanish economy was almost 8% of GDP in 2006, after having been in balance between 1993 and 1998--> The main financial instrument is portfolio investment, rather than FDI, while the financial system - and not the corporate sector or general government - has become the main channel between domestic borrowers and private foreign lenders. o Calvo et al.: Conditions for systemic sudden stops (3S) in developed and developing countries: 1) large potential real exchange rate changes (i.e. small supply of tradable goods relative to their domestic absorption); and 2) large foreign-exchange denominated debts towards the domestic banking system. o (con.t) Moreover: the larger the degree of financial integration, the larger becomes the probability of Sudden Stop (relationship reversed after critical threshold.) o Evans-Pritchard: Spain's foreign reserves have plummeted to wafer-thin levels (€13.2bn equivalent to 12 days of imports), Greece and Portugal have seen a similar drop: It appears the bank has been draining the reserves to help finance the current account deficit at 9.5% of GDP o Both Spain and Ireland experienced strong catching-up with other EMU countries. However: Ireland's output and price growth underpinned by productivity performance, Spain's productivity declined steadily thus undermining external competitiveness --> high current account deficit in Spain (10% of GDP), less in Ireland (4%)

478

Apr 27, 2009 Intra-EMU Spreads: Will There Be a Sovereign Default in Europe?

Overview o Ratings: S&P downgraded Greece to A-, Spain to AA+, Portugal to A+. Ireland on downgrade watch o Yield Spreads: Sovereign risk repricing sends investors dumping bonds most from countries with weaker PMIs and public finances - Italy, Greece, Spain. Since EU formed, 10yr european govt bond yields converged towards Germany's, but yield spreads have been widening against German Bunds since Nov 2007 despite lower Bund yields. In January, the yield premiums on 10yr Portuguese, French, Belgian, Greek, Spanish, Italian, Irish and Dutch bonds offered over benchmark German Bunds reached the highest level since 1999 o CDS Spreads: Jan 20, average sovereign CDS spread to Bunds widened to record high 157bp, ranging between 281 for Ireland and 55.8 for Germany. Meanwhile, Scandinavian bonds undeservedly suffer from the indiscriminate flight-to-bunds o Public Finance: Fiscal costs of financial sector support measures against credit crisis are large by the standards of past financial crises in advanced economies and range from 6% 7% of GDP in the UK, Germany, Belgium and Netherlands up to 13% in Switzerland. Fiscal deficit in 2009 is expected in Ireland at 11% of GDP, UK at 8.8%, Spain at 6.2%, and France at 5.4%. Impact of international risk factors is higher in countries with a higher government debt (Pozzi/Wolswijk) o Issuance: Spain, France and Ireland will register the highest bond supply increase in 2009 o Impact of Lack of Common Bond Market: The separate markets for sovereign debt paper of unequal quality issued by European governments cannot compete with the US market for financial flows in search of a safe harbor; and they will not be able to compete in times of turbulence until the European Union develops a unified market for bonds denominated in euros (CEPS) o Intervention possible: To halt widening of EMU bond spreads, Eurozone finance ministers may 'bail out' member countries buying bonds of those whose bond yields are rising the most Individual EGBs o Norway: The long yield spread between Norway and its peers is abnormally wide and not warranted by differences in fiscal or monetary policy. Norway will not finance fiscal expansion through debt issuance and the policy mix is less inflationary than elsewhere (SEB) o Sweden: CDS spreads driven not by gov't debt but by stop-losses and perceived risk of bank sector exposure to Baltics. Swedish long bond yields lower than Germany's (SEB)

479 the days of lira, raising concerns over Rome's ability to finance its budget deficit as repayment falls due next year. 10-year Italian BTP yielded 113bps more than German Bunds. Italian bond issuance could rise to EUR 220bn in 2009 o Greece: Jan 21, 10-year Greek/Bund yield spreads blew out to 280bp, highest since 1999. Greece plans to issue EUR 43bn of bonds in 2009. Budget deficit will widen to 3.7% of GDP in 2009 from 3.4% in 2008, exceeding the EU's 3% ceiling for a 2nd year o Austria: Mar 3, Austrian CDS traded at 253bp, surpassing Italy, Portugal and Spain after trading at only 17.5bp a year earlier. The Austrian bond yield spread over German bunds rose to an all-time high 137bp on Feb 18, the widest on record. Austria's lower debt (62.3% of GDP) than the EU average of 67.4% and EUR9bn current account surplus have been overshadowed by Austrian bank exposure to CEE, loans to whom equal 71% of Austrian GDP o Switzerland will see the biggest shock to its government debt ratio but the country's high saving rate, persistently large current account surpluses and large net external creditor position enhance debt tolerance o Germany and France have the least headroom in terms of their debt ratios, but the fiscal prudence of the German government in recent years generates a high degree of confidence that policy adjustments will prevent ongoing increases in public debt ratios. French fiscal policy has been less impressive, but the size of the bailout is small. Jan 13, yield spread between French and German bonds - which had been wiped out a few years ago - widened to near 60bp o Belgium is likely to see a sizeable interruption to the steady debt reduction it has enjoyed in recent years — a trend that has helped its ratings converge towards the AAA level. Jan 13, Belgian/Bund spread widened to 98bp, highest since 1999 o Spain and Ireland have small bailout costs, both are set to suffer particularly sharp recessions driven by housing cycles. Ireland's latest budget reveals a huge deterioration in the budget to a deficit of 5.5% of GDP from a surplus in 2007. Fortunately both start with government debt levels which are well below the AAA median o Portugal: Jan 21, 10-year Portuguese/Bund yield spread hit 146bp, highest since 1997, after S&P downgraded Portugal to A+. European Commission sees budget deficit more than doubling to 4.6% of GDP in 2009, well above the EU's ceiling of 3% o Netherlands: Jan 13, Dutch/Bund yield spread hit 70bp - widest since 1999 - just before the Netherlands sold 3.275 billion euros of new 2.5% January 2012 bonds at a heavy discount http://www.rgemonitor.com/458?cluster_id=3041

480

The Last Temptation of Risk by Barry Eichengreen 04.28.2009

THE GREAT Credit Crisis has cast into doubt much of what we thought we knew about economics. We thought that monetary policy had tamed the business cycle. We thought that because changes in central-bank policies had delivered low and stable inflation, the volatility of the pre-1985 years had been consigned to the dustbin of history; they had given way to the quaintly dubbed “Great Moderation.” We thought that financial institutions and markets had come to be self-regulating—that investors could be left largely if not wholly to their own devices. Above all we thought that we had learned how to prevent the kind of financial calamity that struck the world in 1929. We now know that much of what we thought was true was not. The Great Moderation was an illusion. Monetary policies focusing on low inflation to the exclusion of other considerations (not least excesses in financial markets) can allow dangerous vulnerabilities to build up. Relying on institutional investors to self-regulate is the economic equivalent of letting children decide their own diets. As a result we are now in for an economic and financial downturn that will rival the Great Depression before it is over. The question is how we could have been so misguided. One interpretation, understandably popular given our current plight, is that the basic economic theory informing the actions of central bankers and regulators was fatally flawed. The only course left is to throw it out and start over. But another view, considerably closer to the truth, is that the problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists whose scholarship provided intellectual justification for the financial institutions’ decisions. The consequence was that scholarship that warned of potential disaster was ignored. And the result was global economic calamity on a scale not seen for four generations.

SO WHERE were the intellectual agenda setters when the crisis was building? Why did they fail to see this train wreck coming? More than that, why did they consort actively with the financial sector in setting the stage for the collapse? For economists in business schools the answer is straightforward. Business schools see themselves as suppliers of inputs to business. Just as General Motors provides its suppliers with specifications for the cold-rolled sheet it needs for fabricating auto bodies, J. P. Morgan makes clear the kind of financial engineers it requires, and business schools deem to provide. In the wake of the 1987 stock-market crash, Morgan’s chairman, Dennis Weatherstone, started calling for a daily “4:15 Report” summarizing how much his firm would lose if tomorrow turned out to be a bad day. His counterparts at other firms then adopted the practice. Soon after, business schools jumped to supply graduates to write those reports.

481 Value at Risk, as that number and the process for calculating it came to be known, quickly gained a place in the business-school curriculum. The desire for up-to-date information on the risks of doing business was admirable. Less admirable was the belief that those risks could be reduced to a single number which could then be estimated on the basis of a set of mathematical equations fitted to a few data points. Much as former–GM CEO Alfred Sloan once sought to transform automobile production from a craft to an engineering problem, Weatherstone and his colleagues encouraged the belief that risk and return could be reduced to a set of equations specified by an MBA and solved by a machine. Getting the machine to spit out a headline number for Value at Risk was straightforward. But deciding what to put into the model was another matter. The art of gauging Value at Risk required imagining the severity of the shocks to which the portfolio might be subjected. It required knowing what new variables to add in response to financial innovation and unfolding events. Doing this right required a thoughtful and creative practitioner. Value at Risk, like dynamite, can be a powerful tool when in the right hands. Placed in the wrong hands—well, you know. These simple models should have been regarded as no more than starting points for serious thinking. Instead, those responsible for making key decisions, institutional investors and their regulators alike, took them literally. This reflected the seductive appeal of elegant theory. Reducing risk to a single number encouraged the belief that it could be mastered. It also made it easier to leave early for that weekend in the Hamptons. Now, of course, we know that the gulf between assumption and reality was too wide to be bridged. These models were worse than unrealistic. They were weapons of economic mass destruction. For some years those who relied on these artificial constructs were not caught out. Episodes of high volatility, like the 1987 stock-market crash, still loomed large in the data set to which the model was fit. They served to highlight the potential for big shocks and cautioned against aggressive investment strategies. Since financial innovation was gradual, models estimated on historical data remained reasonable representations of the balance of risks.

WITH TIME, however, memories of the 1987 crash faded. In the data used by the financial engineers, the crash became only one observation among many generated in the course of the Great Moderation. There were echoes, like the all-but-failure of the hedge fund Long-Term Capital Management in 1998. (Over four months the company lost $4.6 billion and had to be saved through a bailout orchestrated by the Federal Reserve Bank of New York.) But these warning signs were muffled by comparison. This encouraged the misplaced belief that the same central-bank policies that had reduced the volatility of inflation had magically, perhaps through transference, also reduced the volatility of financial markets. It encouraged the belief that mastery of the remaining risk made more aggressive investment strategies permissible. It made it possible, for example, to employ more leverage—to make use of more borrowed money—without putting more value at risk. Meanwhile, deregulation was on the march. Memories of the 1930s disaster that had prompted the adoption of restrictions like the Glass-Steagall Act, which separated commercial and investment banking, faded with the passage of time. This tilted the political balance toward those who, for ideological reasons, favored permissive regulation. Meanwhile, financial institutions, in principle prohibited from pursuing certain lines of business, found ways around those restrictions, encouraging the view that strict regulation was futile. With the elimination of regulatory ceilings on the interest rates that could be paid to depositors, commercial banks had to compete for funding by offering higher rates, which

482 in turn pressured them to adopt riskier lending and investment policies in order to pay the bill. With the entry of low-cost brokerages and the elimination of fixed commissions on stock trades, broker-dealers like Bear Stearns, which had previously earned a comfy living off of such commissions, now felt compelled to enter riskier lines of business. But where the accelerating pace of change should have prompted more caution, the routinization of risk management encouraged precisely the opposite. The idea that risk management had been reduced to a mere engineering problem seduced business in general, and financial businesses in particular, into believing that it was safe to use more leverage and to invest in more volatile assets. Of course, risk officers could have pointed out that the models had been fit to data for a period of unprecedented low volatility. They could have pointed out that models designed to predict losses on securities backed by residential mortgages were estimated on data only for years when housing prices were rising and foreclosures were essentially unknown. They could have emphasized the high degree of uncertainty surrounding their estimates. But they knew on which side their bread was buttered. Senior management strongly preferred to take on additional risk, since if the dice came up seven they stood to receive megabonuses, whereas if they rolled snake eyes the worst they could expect was a golden parachute. If an investment strategy that promised high returns today threatened to jeopardize the viability of the enterprise tomorrow, then this was someone else’s problem. For a junior risk officer to warn the members of the investment committee that they were taking undue risk would have dimmed his chances of promotion. And so on up the ladder.

WHY CORPORATE risk officers did not sound the alarm bells is thus clear enough. But where were the business-school professors while these events were unfolding? Answer: they were writing textbooks about Value at Risk. (Truth in advertising requires me to acknowledge that the leading such book is by a professor at the University of California.) Business schools are rated by business publications and compete for students on the basis of their record of placing graduates. With banks hiring graduates educated in Value at Risk, business schools had an obvious incentive to supply the same. But what of doctoral programs in economics (like the one in which I teach)? The top PhD- granting departments only rarely send their graduates to positions in banking or business— most go on to other universities. But their faculties do not object to the occasional high- paying consulting gig. They don’t mind serving as the entertainment at beachside and ski- slope retreats hosted by investment banks for their important clients. Generous speaker’s fees were thus available to those prepared to drink the Kool-Aid. Not everyone indulged. But there was nonetheless a subconscious tendency to embrace the arguments of one’s more “successful” colleagues in a discipline where money, in this case earned through speaking engagements and consultancies, is the common denominator of success. Those who predicted the housing slump eventually became famous, of course. Press now takes out space ads in general-interest publications prominently displaying the sober visage of Yale University economics professor Robert Shiller, the maven of the housing crash. Not every academic scribbler can expect this kind of attention from his publisher. But such fame comes only after the fact. The more housing prices rose and the longer predictions of their decline looked to be wrong, the lonelier the intellectual nonconformists became. Sociologists may be more familiar than economists with the psychic costs of nonconformity. But because there is a strong external demand for economists’ services, they may experience even-stronger economic incentives than their colleagues in

483 other disciplines to conform to the industry-held view. They can thus incur even-greater costs—economic and also psychic—from falling out of step.

WHY BELABOR these points? Because it was not that economic theory had nothing to say about the kinds of structural weaknesses and conflicts of interest that paved the way to our current catastrophe. In fact, large swaths of modern economic theory focus squarely on the kind of generic problems that created our current mess. The problem was not an inability to imagine that conflicts of interest, self-dealing and herd behavior could arise, but a peculiar failure to apply those insights to the real world. Take for example agency theory, whose point of departure is the observation that shareholders find it difficult to monitor managers, who have an incentive to make decisions that translate into large end-of-current-year bonuses but not necessarily into the long-term health of the enterprise. Risk taking that produces handsome returns today but ends in bankruptcy tomorrow may be perfectly congenial to CEOs who receive generous bonuses and severance packages but not to shareholders who end up holding worthless paper. This work had long pointed to compensation practices in the financial sector as encouraging short- termism and excessive risk taking and heightening conflicts of interest. The failure to heed such warnings is all the more striking given that agency theory is hardly an obscure corner of economics. A Nobel Prize for work on this topic was awarded to Leonid Hurwicz, Eric Maskin and Roger Myerson in 2007. (So much for the idea that it is only the financial engineers who are recognized by the Nobel Committee.) Then there is information economics. It is a fact of life that borrowers know more than lenders about their willingness and capacity to repay. Who could know better what motivation lurks in the mind of the borrower and what opportunities he truly possesses? Taking this observation as its starting point, research in information economics has long emphasized the existence of adverse selection in financial markets—when interest rates rise, only borrowers with high-risk projects offering some chance of generating the high returns needed to service and repay loans will be willing to borrow. Indeed, if higher interest rates mean riskier borrowers, there may be no interest rate high enough to compensate the lender for the risk that the borrower may default. In that case lending and borrowing may collapse. These models also show how borrowers have an incentive to take on more risk when using other people’s money or if they expect to be bailed out when things go wrong. In the wake of recent financial rescues, the name for this problem, “moral hazard,” will be familiar to even the casual newspaper reader. Again this is hardly an obscure corner of economics: George Akerlof, Michael Spence and Joseph Stiglitz were awarded the Nobel Prize for their work on it in 2001. Here again the potential problems of an inadequately regulated financial system would have been quite clear had anyone bothered to look. Finally there is behavioral economics and its applications, including behavioral finance. Behavioral economics focuses on how cognition, emotion, and other psychological and social factors affect economic and financial decision making. Behavioral economists depart from the simpleminded benchmark that all investors take optimal decisions on the basis of all available information. Instead they acknowledge that decision making is not easy. They acknowledge that many decisions are taken using rules of thumb, which are often formed on the basis of social convention. They analyze how, to pick an example not entirely at random, decision making can be affected by the psychic costs of nonconformity. It is easy to see how this small step in the direction of realism can transform one’s view of financial markets. It can explain herd behavior, where everyone follows the crowd, giving rise to bubbles, panics and crashes. Economists have succeeded in building elegant mathematical models of decision making under these conditions and in showing how such

484 behavior can give rise to extreme instability. It should not be a surprise that people like the aforementioned George Akerlof and Robert Shiller are among the leaders in this field. Moreover, what is true of investors can also be true of regulators, for whom information is similarly costly to acquire and who will similarly be tempted to follow convention—even when that convention allows excessive risk taking by the regulated. Indeed, these theories suggest that the attitudes of regulators may be infected not merely by the practices and attitudes of their fellow regulators, but also by those of the regulated. Economists now even have a name for this particular version of the intellectual fox-in-the-henhouse syndrome: cognitive regulatory capture. And what is true of investors and regulators, introspection suggests, can also be true of academics. When it is costly to acquire and assimilate information about how reality diverges from the assumptions underlying popular economic models, it will be tempting to ignore those divergences. When convention within the discipline is to assume efficient markets, there will be psychic costs if one attempts to buck the trend. Scholars, in other words, are no more immune than regulators to the problem of cognitive capture. What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises. It was not that economists failed to recognize the role of social and psychological factors in decision making or that they lacked the tools needed to draw out the implications. In fact, these observations and others had been imaginatively elaborated by contributors to the literatures on agency theory, information economics and behavioral finance. Rather, the problem was a partial and blinkered reading of that literature. The consumers of economic theory, not surprisingly, tended to pick and choose those elements of that rich literature that best supported their self-serving actions. Equally reprehensibly, the producers of that theory, benefiting in ways both pecuniary and psychic, showed disturbingly little tendency to object. It is in this light that we must understand how it was that the vast majority of the economics profession remained so blissfully silent and indeed unaware of the risk of financial disaster.

WITH THE pressure of social conformity being so powerful, are we economists doomed to repeat past mistakes? Will we forever follow the latest intellectual fad and fashion, swinging wildly—much like investors whose behavior we seek to model—from irrational exuberance to excessive despair about the operation of markets? Isn’t our outlook simply too erratic and advice therefore too unreliable to be trusted as a guide for policy? Maybe so. But amid the pervading sense of gloom and doom, there is at least one reason for hope. The last ten years have seen a quiet revolution in the practice of economics. For years theorists held the intellectual high ground. With their mastery of sophisticated mathematics, they were the high-prestige members of the profession. The methods of empirical economists seeking to analyze real data were rudimentary by comparison. As recently as the 1970s, doing a statistical analysis meant entering data on punch cards, submitting them at the university computing center, going out for dinner and returning some hours later to see if the program had successfully run. (I speak from experience.) The typical empirical analysis in economics utilized a few dozen, or at most a few hundred, observations transcribed by hand. It is not surprising that the theoretically inclined looked down, fondly if a bit condescendingly, on their more empirically oriented colleagues or that the theorists ruled the intellectual roost. But the IT revolution has altered the lay of the intellectual land. Now every graduate student has a laptop computer with more memory than that decades-old university computing center. And she knows what to do with it. Just like the typical twelve-year-old knows more than her

485 parents about how to download data from the internet, for graduate students in economics, unlike their instructors, importing data from cyberspace is second nature. They can grab data on grocery-store spending generated by the club cards issued by supermarket chains and combine it with information on temperature by zip code to see how the weather affects sales of beer. Their next step, of course, is to download securities prices from Bloomberg and see how blue skies and rain affect the behavior of financial markets. Finding that stock markets are more likely to rise on sunny days is not exactly reassuring for believers in the efficient- markets hypothesis. The data sets used in empirical economics today are enormous, with observations running into the millions. Some of this work is admittedly self-indulgent, with researchers seeking to top one another in applying the largest data set to the smallest problem. But now it is on the empirical side where the capacity to do high-quality research is expanding most dramatically, be the topic beer sales or asset pricing. And, revealingly, it is now empirically oriented graduate students who are the hot property when top doctoral programs seek to hire new faculty. Not surprisingly, the best students have responded. The top young economists are, increasingly, empirically oriented. They are concerned not with theoretical flights of fancy but with the facts on the ground. To the extent that their work is rooted concretely in observation of the real world, it is less likely to sway with the latest fad and fashion. Or so one hopes. The late twentieth century was the heyday of deductive economics. Talented and facile theorists set the intellectual agenda. Their very facility enabled them to build models with virtually any implication, which meant that policy makers could pick and choose at their convenience. Theory turned out to be too malleable, in other words, to provide reliable guidance for policy. In contrast, the twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants. Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. It is about time. Should this reassure us that we can avoid another crisis? Alas, there is no such certainty. The only way of being certain that one will not fall down the stairs is to not get out of bed. But at least economists, having observed the history of accidents, will no longer recommend removing the handrail. Barry Eichengreen is the George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley. http://www.nationalinterest.org/Article.aspx?id=21274

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28.04.2009 European Socialists: Barroso will stay on even if we win

The lack of ambition among European Socialists is breathtaking. Socialist group leader Martin Schulz said that even if the Socialists were to win the European elections, there would be no Socialist or Social Democrat Commission president, Financial Times Deutschland reports. (In other words: he defends the status quo that a democratic election can have no effect on the political leadership). Schulz, who hopes to be a member of the European Commission after the election, says the position would have been different if the Lisbon Treaty had been in force, but for the time being, the majority of heads of state and government is conservative. The paper says Schulz’ statement was unusual since in the past the Commission president was politically from the block of the largest faction in the European Parliament. But it now appears that Barroso is almost unstoppable.

German union chief says country must reduce export dependence This is interesting coming from the head of IG Metall, the engineering union, whose members benefited most from Germany’s export strength. Berthold Huber, in an interview with the FT, said Germany should remain an export nation, but the extreme reliance on exports for growth was not healthy, and the focus had to shift towards domestic consumption.

Export reliance ‘not sustainable’ for Germany By Chris Bryant in Berlin Published: April 28 2009 00:15 | Last updated: April 28 2009 10:23 Very little happens in Germany these days without the input of Berthold Huber, the head of IG Metall, the country’s biggest trade union. The engineering union’s 2.3m members – many of whom work in export-dependent sectors such as the heavy machinery and car industries – have been among the hardest hit by the recession, giving Mr Huber a powerful voice as September’s general election approaches. He was among the guests last week at the latest economic summit held by Angela Merkel, the chancellor. Whether

487 urging a government rescue of Opel, the carmaker, or trying to safeguard the future of Schaeffler, the industrial group, Mr Huber is never far from the headlines. In an interview with the Financial Times the softly spoken trade union moderniser and former philosophy student calls for Germany to reduce its dependence on exports – in comments that could fuel a debate on the country’s future role in the world economy. “Germany was always an export nation but the question is: to what extent. Over the past decade we have neglected domestic consumption,” he says. “Of course Germany must remain an export nation. But in the long term I think this kind of dependence on exports in this extreme form is not sustainable.” Although his analysis might win him friends across the Atlantic it is not accepted by Ms Merkel, who told the FT last month that she would not boost consumption at the expense of exports. However, Mr Huber insists that Germany cannot simply carry on as it did before the crisis. While playing down the risk of social unrest he says people are “right to be outraged” at having to “pick up the cheque for things that were not their fault but rather the fault of reckless financial speculators and profiteers”. IG Metall is demanding a parliamentary inquiry to investigate the causes of the crisis. “We want financiers to admit their responsibility and apologise for what they’ve done,” Mr Huber says. ‘We cannot allow Germany’s industrial core to disappear, nor its supply chain. What [countries such as Britain] have lost they won’t get back’ Berthold Huber Government figures to be released tomorrow are likely to show the German economy contracting more than 5 per cent this year, stoking fears of a surge in unemployment. To avoid this, IG Metall has championed the extension of short-time working subsidies to struggling companies from six to 18 months and joined businesses in calling for government relief of social insurance contributions. The union was also among the first to propose a car-wrecking scheme that has provided a sales boost for the beleaguered sector. Nevertheless, union calls for economic stimulus measures were slapped down last week by a broad coalition of politicians and business leaders. “I look at this very coolly and without emotion,” says Mr Huber. “To try and force the issue probably won’t work yet. It’s very likely, however, that the course of events will compel [politicians to act].” IG Metall also wants the government to set up a €100bn ($130bn, £89bn) fund to take stakes in key industries and save them from insolvency. “We cannot allow Germany’s industrial core to disappear, nor its supply chain,” Mr Huber says. “What [countries such as Britain] have lost they won’t get back.” Looking ahead to September’s election, Mr Huber, a member of the Social Democratic party, says he is “to a large extent content” with chancellor candidate Frank-Walter Steinmeier’s draft electoral programme, which includes higher taxes for the rich and more spending on education. The relationship between German trade unions and the SPD soured during the previous government of chancellor Gerhard Schroeder who pushed through tough labour market reforms, aided by Mr Steinmeier, his chief-of-staff. There have been signs of a growing rapprochement between the SPD and the trade unions, but Mr Huber stops short of giving the party his endorsement.

France rejects Commission plans on hedge funds Christine Lagarde said the Commission’s plan to allow non-EU registered hedge funds in countries with reciprocal arrangements to trade in the EU was fundamentally flawed, as it would allow non-regulated funds to do business in the EU with no regulatory oversight, the FT reports. She is the first large country finance minister to respond to the Commission’s proposals. The Socialists in the European Parliament had earlier indicated that they found the proposal insufficient for similar reasons.

488 France fears hedge fund ‘Trojan Horse’ By Peggy Hollinger in Paris, Nikki Tait in Brussels and Martin Arnold in London Published: April 27 2009 22:41 | Last updated: April 27 2009 23:20 France has warned that Europe risks opening the door to a “Trojan Horse” of offshore hedge funds if it adopts plans circulating in Brussels to regulate the industry. Christine Lagarde, French finance minister, on Monday criticised legislation on regulation being prepared by the European Commission, saying it did not go far enough. Paris has objected to the Commission’s proposal that Brussels should be able to hand out “passports” to trade in Europe to offshore funds from territories that have reciprocal agreements. “The Commission wants to create a system of mutual recognition,” Ms Lagarde said in an interview with the French daily Le Figaro. “This is the kind of system that will open the door to a fund from the Cayman Islands that has never been regulated by Europe. The danger is that this could become the Trojan Horse of offshore funds.” France and Germany have been the standard bearers in Europe of stricter financial regulation of hedge funds. Nicolas Sarkozy, French president, has repeatedly attacked “speculative funds” and summoned French banking leaders to the Elysée this month, where he sought undertakings on the transparency of their dealings. The proposals in Brussels are seen by France as the bare minimum. Brussels’ ability to vet the funds from offshore jurisdictions was doubtful, said one French official. “We are not sure that the agreements will be sufficiently framed to allow for good control,” he said. France had proposed that the system of mutual recognition be barred to offshore funds, he said. Officials at the Commission said the proposed legislation would be made known on Wednesday. According to draft documents, the new regime would focus on regulating managers of “alternative investment funds”, rather than the funds directly. This would cover hedge funds and private equity funds, as well as commodity funds and property funds. The most recent versions of the draft appear to have incorporated some significant changes, particularly in relation to funds based in third countries, possibly reflecting a fierce internal debate within the Commission. It is the mutual recognition aspect of these changes that appears to have dismayed the French. France is the first big EU member state to question the adequacy of the prospective regime but the widely leaked draft has been heavily attacked from other quarters. Socialist lawmakers in the European parliament, who pushed the Commission to draw up rules for the hedge fund and private equity sectors, have described the proposals as “almost worthless”. They argue that because the focus is on managers, not funds, there are too many loopholes. They also think that the standards are too lax – for example, in terms of capital requirements for managers, disclosure rules and performance constraints, such as the rules on “naked short-selling”. The Unite union on Monday urged the Commission “to have the courage of the European parliament’s convictions”. Conversely, the private equity industry complains that it is being lumped in with the hedge fund sector and that this is unfair because only the latter poses any systemic risk. The hedge fund industry says the rules are “inappropriate” and rushed.

The economics of influenza The Wall Street Journal takes a look at the economics of flu outbreaks, and says that swine flu outbreak in Mexico could not have occurred at a worse time. There is the good news that the world is now more prepared for a pandemic since the 2003 SARS scare, and that this particular virus responds well to drug treatment, but there are concerns about the effect on trade, as any additional barriers to travel could exacerbate the downturn, or delay a recovery. Global markets yesterday, and overnight, took a dive on fears of the economic consequences of the disease.

Some good news from the credit market The FT reports that US junk-rated companies have easier access to credit. The amount of new

489 debt borrowed in April is the highest since July last year. But the article also said that this did not yet signal a complete turnaround given the probable rise in default rates as the economy worsens. But it was a sign that credit conditions in general were easing, and that aggressive policy action were having an effect. Zapatero on Sarkozy, post-crisis economy This is an accident of timing. After Nicholas Sarkozy called Jose Luis Zapatero “not very intelligent”, he is now scheduled to meet him on an official visit to Spain. In an interview with Le Monde Zapatero insisted that Sarkozy had always been diplomatic with him, and that he had no problem with the French president. In the interview he also talked about the priorities for the Spanish EU presidency in early 2010, which will focus on the post-crisis economic system. Heise on pessimism Michael Heise, chief economist of Allianz, writes in FT Deutschland that most of the current forecasts were too pessimistic. He says the worst falls in economic growth had already occurred, and that industry had reduced production to a much larger extent than consumption. He said the large global stimulus programmes, the fall in commodity prices, and the zero- interest rate policies would also have their effect. He also disagrees with recent forecasts that unemployment would reach 5m in 2010. He said that those who make such forecasts should also say that such a development would almost invariably lead to massive social unrest. O’Rourke on the IMF Kevin O’Rourke, writing in the Irish Economy blog, takes an in-depth look at the IMF’s World Economic Outlook, and says that it contains a very sharp analysis of the feedback loops in the global economy that would continue to drive demand downwards unless countered by fiscal expansion. He says the fiscal policy deniers should take a very hard look at this very disturbing evidence. Kobayashi on stimulus vs. bank rescue Keiichiro Kobayashi writes in Vox that fiscal stimulus is a much-needed temporary painkiller, but it is not enough to put the global economy on a path to recovery. This column argues that some economists – led by Paul Krugman – invest too much hope in the effects of fiscal stimulus while turning a blind eye towards the bad-debt mess. Stringent inspections and evaluations of bank assets by financial regulators, followed by sufficient infusions of taxpayer-funded capital will be the only effective means of clearing away the oppressive uncertainty. Chinn on US imports Menzie Chinn has a graph on his forecast for Q1 imports, after the annualised fall in the rate of imports of 36.5% in Q4. The graph essentially shows that those imports are cliff divining. Here it is.

April 27, 2009 The Decline in US Imports: I've been thinking about trying to convey exactly how startling the drop in U.S. imports has been. First, take a look how much non-oil goods imports (in real terms) have dropped, relative to, for instance, GDP.

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Figure 1: Log GDP (blue, left scale), log goods import ex.-oil from NIPA (red, right scale), estimated from trade release (purple, right scale), all in Ch.2000$, SAAR. 2009q1 estimate is based on actual January and February data and March estimate incorporating continued 5% decline from February. NBER recession dates shaded gray. Source: BEA, GDP final release of 26 March 2009, February trade release, NBER, and author's calculations. The annualized drop in these imports was 36.5% in 2008Q4 (log terms). In addition, with non-oil imports dropping about 5% (non-annualized, in logs) in the first two months of 2009, 2009Q1 imports seem set continue the drop. In Figure 1, I've assumed that the drop witnessed in January and February continues into March. These declines are so large that they are difficult to reconcile with standard models. To formalize this assertion, consider the predictions of a standard imperfect goods model used in traditional (i.e., old fashioned) macroeconometric models (see [1]. The model is given by:

Imp = α 0 + α 1 y + α 2 r Where Imp is real imports, y is real income, and r is the real value of the dollar. I estimate an error correction version of this model, wherein there is a long run relation between the levels of imports, income and the real dollar.

Δ imp t = β 0 + φ imp t-1 + β 1 y t-1 + β 2 r t-1 + γ 1 Δ imp t-1 + γ Δ 2 y t-1 + γ 3 Δ r t-1 + u t

In this specification, the long run elasticities are given by the ratio β i/ φ . When this model is estimated over the 1974q1-2008q4 period, one obtains sensible estimates (in that higher income or a stronger dollar induces greater imports in the long run). One way of evaluating whether the 2008q4 observation is anomalous, in a statistically significant sense, is to examine the recursive residuals. A recursive residual is the time t prediction error based upon the regression estimated up to time period t-1, but using time t values of the X variables. Figure 2 depicts the 95% standard error band; an observation outside that band suggestive structural instability in the regression equation. I thought that modeling imports with durable consumption as a trend variable would make this "instability" disappear. While it did mitigate the prediction error, a statistically significant overprediction remains. Another possible covariate is (log real) household net worth; adding this into the model, both with long and short run effects allowed does improve the fit (3 lags of the first difference of net worth).

Δ imp t = β 0 + φ imp t-1 + β 1 y t-1 + β 2 r t-1 + β 3 hh t-1 + γ 1 Δ imp t-1 + γ Δ 2 y t-1 + γ 3 Δ r t-1 + γ 4 Δ hh t- 1 + γ 5 Δ hh t-2 + γ 6 Δ hh t-3 + u t Where hh is log real household net worth, obtained from the Federal Reserve Board's Flow of Funds statistics. The adjusted-R 2 is 0.4 versus the 0.3 in the standard formulation. Figure 3 depicts the

491 recursive residuals for the augmented model.

Figure 4: Log goods import ex.-oil from NIPA (red), estimated from trade release (purple), all in Ch.2000$, SAAR. 2009q1 estimate is based on actual January and February data and March estimate incorporating continued 5% decline from February. "Standard model" is the static fit from basic regression; "Model w/HH net wealth" incorporates household net wealth. NBER recession dates shaded gray. Source: BEA, GDP final release of 26 March 2009, February trade release, Federal Reserve Flow of

492 Funds, NBER, and author's calculations. This model does not exhibit the instability apparent in the standard model. This suggests that household net worth is important to imports, which certainly makes sense if one thinks that the reason that non-oil goods imports are declining (recalling that non all imports are used for consumption). Of course, there are other explanations that are consistent with this effect. For instance, there could be a common shock affecting both household net worth, and trade financing. This latter interpretation could work on both LDC exports, and also LDC imports [2] -- given that some US imports are used to produce US exports (i.e., vertical specialization, as described in this post).

What do these models predict for 2009q1? Figure 4 depicts the results. The standard model badly mispredicts 2008q4, while the augmented model does slightly better (6% error vs. 9% error). Both models predict the downturn in 2009q1; which model proves more accurate depends upon what the March numbers will be. (That being said, these are all fitted models, and not dynamic forecasts). Posted by Menzie Chinn at April 27, 2009 10:10 PM 28.04.2009 Europe's banking crisis is much worse than we thought By: Wolfgang Munchau

The most shocking news from last week’s excellent Global Financial Stability Report from the International Monetary Fund was not the headline estimate of total bad assets. That number stands at $4,100bn (£2,800bn, €3,000bn) and will almost certainly be revised upwards. Much more shocking was that the lion’s share of these assets belong to European, not North American, banks. Of the total $4,100bn, the global banking system accounts for $2,800bn. Of that, a little over half – $1,426bn – is sitting in European banks, while US banks account for only $1,050bn. Even worse, European banks have written down much less than American ones. According to Reuters, the US and European banking and insurance sector has so far written down $740bn. More than 70 per cent of the write-downs come from the US. The eurozone’s share has been an appalling 14 per cent. Another statistic from the IMF report: to recapitalise the banking system to reach capital ratios that prevailed in the mid-1990s, capital injections of $275bn would be required for US banks, and a whopping $500bn for European banks. You get the picture. All these data tell us that Europe has both the biggest problem and has made the least progress. And since recessions associated with financial crises last longer than ordinary recessions, as the economic literature on financial crises suggests, the eurozone has a big problem. The IMF says that even if the right policies are implemented at the right time the recovery will be slow and painful, because deleveraging takes its time. But if the right policies are not implemented, the recovery will take much longer. The latest economic projections by German economic institutes are consistent with the IMF’s pessimistic analysis. The problem is not only that the German economy will shrink by some 6 per cent this year. The real issue is that there is no projected recovery even by the end of 2010. We are looking at economic stagnation that could last several years. So whatever legitimate criticism we may have of the Geithner/Summers plan for the US banking rescue, both in terms of its effectiveness and fairness, the situation is a lot worse in Europe. For example, the German bank rescue plan, details of which will become known next month,

493 will almost certainly remain a voluntary scheme. There will be no stress test to determine whether a bank should be forced to accept new capital. Of course, this plan is clearly better than nothing. But it is not going to solve the problem of an under-capitalised banking sector. Unlike the Geithner/Summers plan, it does not even pretend to do so. Yet the core problem with the European policy response, both in terms of bank rescues and stimulus packages, is a failure to co-ordinate across national borders. Last week’s spat between Axel Weber, the president of the Bundesbank, and the European Commission, over whether banks in receipt of government aid should unwind “foreign” European operations, highlights the problem that a single market does not work when all the policy decisions in a crisis are taken at national level. As Lord Turner, chairman of the UK’s Financial Services Authority, rightly said about the future of European banking: “Faced with the reality we either need more European co- ordination or more national powers, more Europe or less Europe – we can’t stay where we are.” The IMF has noted that unilateral government action to support the domestic financial sector can easily turn into financial protectionism. This is happening right now in the eurozone where governments have enacted policies that make public support conditional on maintaining domestic lending, thereby crowding out foreign-owned competitors. Europe’s macroeconomic response suffers from the same fundamental problem. Uncoordinated national stimulus programmes have ended up both ineffective and protectionist – such as Germany’s infrastructure investments or French subsidies for the car sector. When only uncoordinated national stimulus plans are on offer, the benefits are drowned by negative externalities. On those grounds, I would oppose another round of national programmes. What the eurozone needs is a co-ordinated European stimulus. Our Great Recession constitutes a seminal crisis for Europe’s internal market and its single currency. It still has the potential to strengthen both. If the eurozone were to enact policies to fix the banking sector and support growth, if it facilitated eurozone accession to central and east European countries (and the UK), and if it started to think about issuing a joint European bond, the euro could emerge strengthened from this crisis – both in terms of its exchange rate against the dollar, and its significance as a global currency. At this moment, however, that optimistic scenario is not very likely. European leaders are by and large an intellectually complacent lot. They have never paid sufficient attention to the spillovers of national policies in a single market under a single currency during a crisis. By pursuing what they mistakenly perceive to be policies in their short-term national interest, they not only damage the long-term prospects of the eurozone, but they ultimately end up damaging themselves. They are all under the illusion that they have a national strategy. But adding it all up, there is no joint strategy. I suspect that this ugly drama will play out the full five acts, in classic European style. And we are not even halfway through. Not even close. http://www.eurointelligence.com/article.581+M5efc320bf43.0.html

494 Apr 28, 2009 Assessing Stress Test Methodology And Results: Citigroup and Bank Of America Told To Raise More Capital Overview: Fed releases white paper on stress test methodology. "Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized" although the crisis has substantially reduced the capital buffer of some banks. All U.S. bank holding companies with year-end 2008 assets exceeding $100 billion were required to participate in the assessment, which began February 25. These institutions collectively hold two-thirds of the assets and more than half the loans in the U.S. banking system. Torres: Official says that supervisors concluded that banks’ lending practices need to be given as much weight as macroeconomic scenarios in determining the health of each bank and that the goal of the reviews is to keep the major financial institutions lending over the next two years.--> see Bank Lending Continues To Fall: Is There A Lack Of Credit Demand Or Supply? o April 28 WSJ: Regulators have told Bank of America and Citigroup that the banks may need to raise more capital based on early results of the government's so-called stress tests of lenders, according to people familiar with the situation. Industry analysts and investors predict that some regional banks, especially those with big portfolios of commercial real-estate loans, likely fared poorly on the stress tests. Analysts consider Regions Financial Corp., Fifth Third Bancorp and Wells Fargo & Co. to be among the leading contenders for more capital. o Ross Sorkin NYT: But what private investor is going to invest in any of the failing banks, knowing full well that the government may end up coming in later on and diluting the investor’s stake? o Guha (FT): US banks could be forced to hold more equity than initially expected after it emerged that "stress tests" organized by regulators take into account not only macro risks but also 'counterparty risk' on derivatives contracts, i.e.the risk that the party on the other end of the deal might default, depriving the bank of the payment that is due. o April 23 Weiss (M&M): OCC data show that as of Q4, the total credit exposure with derivatives as % of risk-based capital was: 179% for Bank of America, 278% for Citibank, 382% for JPMorganChase; 550% for HSBC (U.S.); 1056% for Goldman Sachs. "Moreover, since JPM holds half of all the derivatives in the U.S. banking industry, JPMorgan is ground zero in the debt crisis." o Industry analysts like Mike Mayo and GoldmanSachs report that unsecuritized legacy loans are currently marked at 92-98 cents on the dollar on banks' books. -- >White paper p3: Importantly, stress test relies on recent FASB changes as the majority of assets at most of the participating bank holding companies are loans

495 booked on accrual basis. "The results of this exercise are not comparable with those that would evaluate such assets on a mark-to-market basis." o April 22 WSJ: In particular, under a more adverse scenario, which assumes a 10.3% unemployment rate at the end of 2010, banks would have to calculate two-year losses of up to 8.5% on their first-lien mortgage portfolios, 11% on home-equity lines of credit, 8% on commercial and industrial loans, 12% on commercial real- estate loans and 20% on credit-card portfolios, according to a confidential document the Federal Reserve gave banks in February that was viewed by The Wall Street Journal. Regulators are expected to have used other assumptions as well when measuring a bank's strength. o Methodology: Regulators accounted for off-balance sheet units that banks will be re- intermediate in 2010 as a result of proposed accounting rules changes. Banks may bring on about $900 billion to their balance sheets (i.e. involuntary leverage) as a result of the change, and supervisors boosted the risk-weighted assets in their assessments by $700 billion, the Fed said. --> see FAS 140 Consolidation of $5 Trillion Variable Interest Entities (VIE) and QSPEs: Investment Banks' Stumbling Blocks? o April 23 Economist: The IMF has just had a stab at estimating the size of the new equity that is needed. This is based on writedowns of $550 billion over the next two years (on top of the $510 billion already booked), and incorporates existing capital and underlying earnings. It concludes that American banks need $275 billion to keep their tangible common equity above a floor of 4% of assets and $500bn for 6%. o cont.: The Treasury has only $110 billion left in its bail-out kitty. America’s ten biggest banks have $300-odd billion worth, about half of it from the state. Their capacity to absorb losses would rise if this was converted into common stock. This solution does have unpleasant side-effects. The government would end up with a 27% voting stake in the top-ten banks combined if all hybrid capital was converted at its book value. o Guha: Analysts have wildly different expectations as to the total amount of capital that the stress tests will identify as needed. Keefe, Bruyette and Woods, a brokerage firm, said yesterday its version suggests "$1,000bn (€760bn, £680bn) of capital would be needed industrywide". Others think much less capital will be required. o April 24 Financial Stability Oversight Board: "Going forward, the Oversight Board believes it will be important for the Treasury to continue to have the ability and flexibility to take effective actions under the TARP tostabilize financial markets."

Quantifying Toxic Assets In Europe: IMF Estimates $1.4T; German Supervisors Calculate $1T (EUR816bn) In Germany Alone Apr 28, 2009 Overview: Munchau: IMF reports that of the total $4,100bn in expected global writedowns until 2010, the global banking system accounts for $2,800bn. Of that, a little

496 over half – $1,426bn – is sitting in European banks, while US banks account for only $1,050bn. o IMF: In order to achieve a pre-crisis 4% Tangible Common Equity (TCE)/Tangible Common Assets (TCA), capital injections would need to be some $275 billion for U.S. banks, about $375 billion for Euro area banks, about $125 billion for U.K. banks, and about $100 billion for banks in the rest of mature Europe. To achieve this more demanding level of 6% TCE/TCA would require about $500 billion for U.S. banks, about $725 billion for Euro area banks, about $250 billion for U.K. banks, and about $225 billion for the banks in the rest of mature Europe. o Fed Board: Flow of funds data show that 40% of U.S. originated securitizations are held abroad--> about $4.4T out of $10.8T securitizations held abroad, assume $4 T in Europe. Average writedown rate on securitization is 17% as calculated by RGE, so about $680bn writedowns apply for Europe. Assume about half to 75% fall on eurozone banks, or $400 - 500bn. o Goldman Sachs: Domestic loan and securities losses in the eurozone are estimated at 6% of GDP in baseline scenario (in ugly scenario this could double)--> 6% of eurozone GDP in dollars is $730bn (eurozone 2008 GDP=EUR9.3T=$12.2T) .This is exactly in line with the IMF's April 20009 estimate for Eurozone+UK originated losses. o Danske; Fitch: European banks have $1.3T in claims on Central and Eastern European countries. Assuming that 20% of these loans turn bad, EU banks incur about $270bn in CEE-related losses, of which $30bn occur in Sweden (non- eurozone) which leaves writedowns of $240bn. o RGE: Adding all up, expected losses among European banks amount to about $450bn exposure to U.S. securities +$730+ domestic&foreign loan losses+240 CEE=$1.4T. This estimate is in line with the IMF's European bank loss estimate as mentioned in the overview above. o Note: If the domestic loans and securities loss share is assumed to approach the U.S. loss share of around 10-12% as estimated by RGE, then eurozone expected losses add up to about the same dollar value as in U.S., or $1.8T o Sueddeutsche Zeitung (via Harrison/Eurointelligence): German bank supervisor memo leaked to the press shows that the amount of toxic assets on German banks books amount to EUR816bn. Of these, Commerzbank bears EUR101bn including EUR49bn from Dresdner takeover; Landesbank HSH Nordbank bears EUR105bn; WestLB assumes EUR84bn and Landesbank Baden-Wuerttemberg EUR92bn. The situation is better for Deutsche Bank (EUR21bn) as well as Postbank and HVB with EUR5bn each. The worst affected is commercial real estate lender Hypo Real Estate (HRE) that is being seized by the government and which holds EUR268bn of toxic assets on its books. o April 28 FT: A confidential AIG document estimates that banks such as Royal Bank of Scotland, Banco Santander and BNP Paribas might have to raise some $10bn if Banque AIG financial unit collapsed. o see further: - The German Banking System: Bank Shareholder Expropriation Bill Clears Parliament - France's Bank Recapitalization Package: Carrots and Sticks

497 - Italian Banks Under Pressure: BPM Is Latest Italian Bank To Seek State Aid - Spanish Banks Alert: Government Takes Over Caja Castilla, First Since 1993 - Greek Banks' Exposure To South East Europe: Will They Weather The Storm? - Ireland Is the First Eurozone Country to Set Up A Swedish-Inspired 'Bad Bank': Will Others Follow Suit?

498 AIG acts to avoid default risk By Francesco Guerrera in New York Published: April 29 2009 04:31 | Last updated: April 29 2009 04:31 AIG has moved to stave off the risk of default on $234bn of derivatives by persuading a senior executive at its troubled financial products division to rescind his resignation and remain with the stricken insurer to unwind the complex trades. AIG insiders said James Shephard, the deputy chief executive of Paris-based Banque AIG, had decided to stay on as the unit’s chief less than a month after resigning in the midst of the political furore over the insurer’s bonuses. Mr Shephard’s U-turn, which could be announced on Wednesday, is likely to deter several European banks that bought the derivatives from taking legal action to force AIG to repay them, according to people familiar with the situation. The move should also avoid a showdown between US regulators, which control AIG after bailing it out, and their French counterparts. French banking regulators had threatened to appoint their own manager of Banque AIG, which is part of the insurer’s financial products unit, after Mauro Gabriele, the unit’s chief executive, and Mr Shephard announced their departures in late March. Mr Gabriele has not changed his mind but will remain with Banque AIG for a while to ensure an orderly transition, according to people familiar with the matter. AIG has maintained the departures of the two executives did not affect the status of its derivatives book. But legal experts said the appointment of an external manager chosen by the French authorities could have triggered a default on the derivatives because it could have constituted a change in control of the contract. That would have meant AIG having to repay the European banks before the contracts came due. A default would have also forced the banks, which bought the products to lower the amount of regulatory capital they need to hold against certain assets, to buy new derivatives or raise equity. A confidential AIG document estimates that banks such as Royal Bank of Scotland, Banco Santander and BNP Paribas might have to raise some $10bn if the financial unit collapsed. In March, AIG said Mr Gabriele and Mr Shephard had left because they felt they could not work “in the current hostile environment” – a reference to the political backlash triggered by AIG’s decision to pay $165m in retention bonuses to staff in its financial products division. The two executives had volunteered to return their bonuses and Mr Shephard will stick to that promise even after his decision to stay, said people familiar with the matter. Mr Shephard’s new compensation had not yet been set, they added. AIG and Mr Shephard declined to comment. http://www.ft.com/cms/s/0/f70c7736-3453-11de-9eea-00144feabdc0.html

499 Global Business April 28, 2009 Italy Seizes Millions in Assets From Four Banks By CLAUDIO GATTI With investigations spreading to Europe from the United States, Italian authorities have seized about $300 million in assets of four global banks — JPMorgan Chase, Deutsche Bank, UBS and Depfa — whose officials have been accused of fraud. The Guardia di Finanza in Milan, the financial police of Italy, took over real estate properties, bank accounts and stock holdings on Monday to assure it could collect from the banks if their officials were found guilty and the banks were held responsible. The seizures stem from the banks’ handling of a $2.2 billion municipal bond issue and related financial contracts known as swaps that Milan undertook to retire other debt in June 2005. The lead prosecutor accused the bankers of misleading the city and falsely claiming that the deal would generate savings. If all the costs had been properly included, the prosecutor said, the entire deal would have been illegal under a national law that allows restructuring of debt only if it produces a savings. Alfredo Robledo, the prosecutor in Milan, suspects the banks made $130 million in illicit profits, according to information obtained in a joint investigation by the Italian business newspaper Il Sole 24 Ore and The International Herald Tribune. He is also investigating transactions by the banks with other local Italian governments and the possibility that public officials received kickbacks. About 35 billion euros ($46 billion) in bonds were issued by local Italian governments over the last decade, mostly by the London units of large banks based in the United States and Europe. A former executive from one of the banks being investigated in Milan said that all of these could be subject to challenge. Representatives of each of the four banks declined to comment. JPMorgan is based in New York, Deutsche Bank in Frankfurt, UBS in Zurich and Depfa is a unit of Hypo Real Estate in Munich. Three of the banks are also being investigated over their municipal bond practices in the United States. Officials or former officials of JPMorgan Chase, Deutsche Bank and UBS, along with the institutions themselves, are the subjects of investigations, company filings and documents filed in civil cases show. In its annual report released last month, JPMorgan Chase acknowledged parallel investigations in the United States by the Justice Department and the Securities and Exchange Commission into possible antitrust and securities violations involving derivatives sold to local governments. JPMorgan said it was cooperating with the investigations and had provided documents. On both sides of the Atlantic, the banks and their executives have been accused of misleading local governments and selling officials exotic financial products known as derivatives that they did not fully understand.

500 These derivatives, when combined with bond offerings, were presented as ways to raise cash and reduce the long-term cost of debt, but officials claim now that many of the contracts, in the form of swaps, were packed with millions of dollars in fees that were not disclosed. In his filings to a judge in Italy seeking the asset seizure, Mr. Robledo asserted that the bankers falsely claimed that the deal would save 57.3 million euros. While charging only nominal fees to show the refinancing would be beneficial, he said, the bank then hid their profits in the spread between what the city paid to the banks and what the banks gave in return on swaps contracts that accompanied the bond issue — a difference of 52.7 million euros. The original deal was rescheduled five times until October 2007 and produced an additional 48 million euros of profit for the banks. In total, the banks earned about 101 million euros in such payments over a two-year period. The largest share went to JPMorgan Chase, which the prosecutor said took in almost 45 million euros. It is too soon to tell whether the long-term cost of the deal and the swaps contracts, which carry more risk than a plain-vanilla bond offering, will be even higher. The jurisdiction of this case is in dispute. Last January, days after Milan announced that it was suing the banks in civil court, JPMorgan filed a countersuit in the High Court in London to have the claim heard there instead. In their presentations, the banks noted that they were regulated by the Financial Securities Authority in Britain, an agency similar to the S.E.C., and that their contracts were subject to British laws. But the Italian investigators argue that they have authority to investigate any fraud. British law “would be applicable to civil proceedings, not a criminal one, such as this,” said an investigator involved in the case who said he was not authorized to speak about a continuing investigation. According to the Italian magistrate, British rules may have been violated as well. Citing the opinion of David Dobell, a former British financial regulator who is now a partner in CCL, a compliance consultancy, the prosecutor claimed that the banks breached their fiduciary duties as defined by the F.S.A. when dealing with a nonprofessional customer like Milan. These and other similar transactions could be invalidated if the banks breached those duties, requiring the banks to disgorge their profits from the deals and pay damages. Beside the 10 bankers, Giorgio Porta, Milan’s general manager at the time of the deal, and Mario Mauri, then a financial adviser to the mayor, are also under investigation. The Italian prosecutor could soon request help from the British regulator in determining whether intermediary or consultant fees were paid by the banks and to whom. Claudio Gatti is an investigative reporter for Il Sole 24 Ore. He is based in New York. http://www.nytimes.com/2009/04/28/business/global/28muni.html?th&emc=th

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Mortgage Modification Bill Faces Trouble in Senate By Renae Merle Washington Post Staff Writer Tuesday, April 28, 2009 Days before an expected vote, Senate leaders yesterday touted their version of a proposal to allow bankruptcy judges to modify mortgages, but have yet to secure the support of the financial services industry and face fierce opposition that could derail the proposal again. Senate Majority Whip Richard J. Durbin (D-Ill.) has been negotiating with Bank of America, J.P. Morgan Chase and Wells Fargo for weeks. They are facing increasing pressure to conclude negotiations before a Senate vote later this week, but talks continue, according to Senate aides. "I hope we can muster the courage and find the votes, although I know it will be hard," Durbin said on the Senate floor yesterday. Durbin has been pushing the measure for more than two years. "It's hard to imagine that today the mortgage bankers would have clout in this chamber, but they do." Under the measure, a key part of President Obama's housing plan, a bankruptcy judge could modify the terms of a troubled mortgage, including lowering the principal owed by the borrower. It's a process known as a cramdown. Citigroup backed the proposal earlier this year, giving it momentum. But the legislation has been stalled in the Senate for more than a month. It passed the House in March. Despite the ongoing negotiations, Senate aides said the section covering bankruptcy modification is near completion. It would weaken the bill by requiring homeowners to be two months delinquent and have an outstanding balance of less than $729,750 to qualify. If a bankruptcy judge lowers the principal balance, the borrowers would have to split any profit with the lender if they sold the home while still in bankruptcy proceedings. The current proposal would also restrict the ability of homeowners to receive a bankruptcy modification if their lender has offered them a loan modification similar to those in a government program being put in place. "This amendment limits assistance in bankruptcy to situations where lenders are so intransigent that they are unwilling to cooperate with the foreclosure prevention efforts already underway," Durbin said. The negotiations are focused on other parts of the legislation, not the bankruptcy- modification provision, according to Senate aides. "We have come up with a bankruptcy proposal that is so air tight, we're confident in the proposal," one of the aides said. However, the compromise version of the bankruptcy-modification provision is still too broad, said Scott E. Talbott, senior vice president of government affairs for the Financial Services Roundtable, an industry group. "The uphill battle that the bill has faced for years has continued. It will be very difficult to garner the votes," he said. Durbin had hoped to secure the support of the major lenders, which industry officials said is increasingly unlikely.

502 The bill is expected to come up for a vote Thursday, but what form it will take is unclear, the Senate aides said. A housing bill could be introduced without the bankruptcy provision, for example, forcing Durbin to introduce it as an amendment.

Book Review by Frank J. Navran (Published: April 27, 2009) The Ethical Executive: Becoming Aware of the Root Causes of Unethical Behavior: 45 Psychological Traps That Every One of Us Falls Prey To By Robert Hoyk and Paul Hersey. (Stanford University Press, 2008). For years now, many of us in the ethics and compliance world have been engaged in an ongoing debate as to why good people do bad things. In this recent collaboration, Robert Hoyt and Paul Hersey have identified 45 psychological traps that we all fall prey to as their answer to the question. Hoyk brings a clinical psychology background to the task. Hersey made his mark in the field of leadership. The style and compactness of the book suggests his earlier collaborations with Ken Blanchard (of The One Minute Manager fame). This is a quick, easy read - more headlines than treatise. The psychological key is that we actually look for unethical choices as an option for achieving desired outcomes. We know them to be wrong but have long since learned to fool ourselves into thinking it is right, or at least not so wrong as to keep us from our goal. The traps are described in three broad categories. Primary traps are predominantly external stimuli, such as obedience to authority. Defensive traps are typically attempts to justify misconduct already committed and are usually triggered by guilt and/or shame. Personality traps are traits such as low self-esteem (a negative) and empathy (a positive) that make us vulnerable to wrongdoing when triggered by situational pressure. In my own work on ethics I had characterized Hoyk and Hersey’s “traps” as rationalizations: lies we tell ourselves to give us permission to do what we know is wrong. I suspect that many readers will recognize these traps – so the value is less that of discovery than having a taxonomy to facilitate discussion of their origins and coping strategies. After discussing the 45 traps the authors go on to discussion of dilemmas. This section relies on well-known cases: The Parable of the Sadhu, Harvard Business Review (1983) and a discussion of the Jonestown suicides of 1970. These cases allow for a more complex exploration of how various traps emerge and inter-relate. I admit to being ambivalent about the authors’ approach. I see the value of simple examples as illustration - a precursor to a more thoughtful dialogue or study. That said, I also find this simplification lacking - unsatisfying. It leaves me hungry for more insight. The book implies but does not detail remedies for the various traps or ways to add rigor to one’s thought processes to preclude the traps from undue influence in our decision- making. Consequently it may not satisfy the appetites of the more serious student.

503 It does, however, exactly match the attention span of its intended audience: the ethical executive. Overall, this is a worthwhile addition to the bookshelf of the typical ethics and compliance office. It would be a ready recommendation to those seeking insight into some of the common ethical challenges, who would be satisfied with a list of warning signs but would not necessarily choose to explore the issues in greater depth. For what it is, it is well done - a "quick read" that has a point to make and makes it simply and clearly. Frank J. Navran President, Navran Associates

Opinion

April 27, 2009 OP-ED COLUMNIST Money for Nothing By PAUL KRUGMAN On July 15, 2007, The New York Times published an article with the headline “The Richest of the Rich, Proud of a New Gilded Age.” The most prominently featured of the “new titans” was Sanford Weill, the former chairman of Citigroup, who insisted that he and his peers in the financial sector had earned their immense wealth through their contributions to society. Soon after that article was printed, the financial edifice Mr. Weill took credit for helping to build collapsed, inflicting immense collateral damage in the process. Even if we manage to avoid a repeat of the Great Depression, the world economy will take years to recover from this crisis. All of which explains why we should be disturbed by an article in Sunday’s Times reporting that pay at investment banks, after dipping last year, is soaring again — right back up to 2007 levels. Why is this disturbing? Let me count the ways. First, there’s no longer any reason to believe that the wizards of Wall Street actually contribute anything positive to society, let alone enough to justify those humongous paychecks. Remember that the gilded Wall Street of 2007 was a fairly new phenomenon. From the 1930s until around 1980 banking was a staid, rather boring business that paid no better, on average, than other industries, yet kept the economy’s wheels turning. So why did some bankers suddenly begin making vast fortunes? It was, we were told, a reward for their creativity — for financial innovation. At this point, however, it’s hard to think of any major recent financial innovations that actually aided society, as opposed to being new, improved ways to blow bubbles, evade regulations and implement de facto Ponzi schemes. Consider a recent speech by Ben Bernanke, the Federal Reserve chairman, in which he tried to defend financial innovation. His examples of “good” financial innovations were (1) credit cards — not exactly a new idea; (2) overdraft

504 protection; and (3) subprime mortgages. (I am not making this up.) These were the things for which bankers got paid the big bucks? Still, you might argue that we have a free-market economy, and it’s up to the private sector to decide how much its employees are worth. But this brings me to my second point: Wall Street is no longer, in any real sense, part of the private sector. It’s a ward of the state, every bit as dependent on government aid as recipients of Temporary Assistance for Needy Families, a k a “welfare.” I’m not just talking about the $600 billion or so already committed under the TARP. There are also the huge credit lines extended by the Federal Reserve; large-scale lending by ; the taxpayer-financed payoffs of A.I.G. contracts; the vast expansion of F.D.I.C. guarantees; and, more broadly, the implicit backing provided to every financial firm considered too big, or too strategic, to fail. One can argue that it’s necessary to rescue Wall Street to protect the economy as a whole — and in fact I agree. But given all that taxpayer money on the line, financial firms should be acting like public utilities, not returning to the practices and paychecks of 2007. Furthermore, paying vast sums to wheeler-dealers isn’t just outrageous; it’s dangerous. Why, after all, did bankers take such huge risks? Because success — or even the temporary appearance of success — offered such gigantic rewards: even executives who blew up their companies could and did walk away with hundreds of millions. Now we’re seeing similar rewards offered to people who can play their risky games with federal backing. So what’s going on here? Why are paychecks heading for the stratosphere again? Claims that firms have to pay these salaries to retain their best people aren’t plausible: with employment in the financial sector plunging, where are those people going to go? No, the real reason financial firms are paying big again is simply because they can. They’re making money again (although not as much as they claim), and why not? After all, they can borrow cheaply, thanks to all those federal guarantees, and lend at much higher rates. So it’s eat, drink and be merry, for tomorrow you may be regulated. Or maybe not. There’s a palpable sense in the financial press that the storm has passed: stocks are up, the economy’s nose-dive may be leveling off, and the Obama administration will probably let the bankers off with nothing more than a few stern speeches. Rightly or wrongly, the bankers seem to believe that a return to business as usual is just around the corner. We can only hope that our leaders prove them wrong, and carry through with real reform. In 2008, overpaid bankers taking big risks with other people’s money brought the world economy to its knees. The last thing we need is to give them a chance to do it all over again. http://www.nytimes.com/2009/04/27/opinion/27krugman.html?_r=1&th&emc=th

April 26, 2009, 5:05 pm Trickle-down economics Check out this photo from today’s Times, about Iceland’s rejection of the free- marketeers.

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Olivier Morin/Agence France-Presse — Getty Images Photographs of bankers who left Iceland after the financial crisis have a new use in the restroom of a bar in Reykjavik, the capital.

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bepress Journals April 27, 2009

New Articles The Economists' Voice http://www.bepress.com/ev

The Berkeley Electronic Press is pleased to announce the following new articles recently published in The Economists' Voice. To view any of the new articles, simply click on the links below: Columns Getting Serious about Job Creation: Part I Aaron S. Edlin and Edmund Phelps The ideal economic stimulus would be something that should be done in any event --- making work pay with employee tax credits --- according to Aaron Edlin and Edmund Phelps. Now Is the Right Time to Regulate Bankers' Pay John Thanassoulis John Thanassoulis of Oxford argues that the level of bankers' pay is a result of market failure, and pay caps are not the politics of envy. The Elephant in the Room: Coping with the Long-Term Problem of Medicare Costs Andrew J. Rettenmaier and Thomas R. Saving Medicare reform is the elephant in the room, according to Andrew J. Rettenmaier and Thomas R. Saving, who propose a solution. Letters Comment on Brad Delong: Can We Generate Controlled Reflation in a Liquidity Trap? Scott Sumner Brad Delong overlooks several highly effective ways of exiting liquidity traps without overshooting toward excess inflation, according to Scott Sumner of Bentley University. Comment on Luigi Zingales: Why not Consider Maximum Reserve Ratios? Swapan Dasgupta Why not set a maximum on bank reserves, wonders Swapan Dasgupta? Comment on Robert Barro: The Little Learned of Multipliers from 1943-44 Sherman J. Maisel The multiplier in 1943-44 may have been low by design, according to Sherman Maisel, Professor Emeritus at UC Berkeley and former Member of the Board of Governors of the Federal Reserve.

Business

507 April 27, 2009 Geithner, as Member and Overseer, Forged Ties to Finance Club By JO BECKER and GRETCHEN MORGENSON Last June, with a financial hurricane gathering force, Treasury Secretary Henry M. Paulson Jr. convened the nation’s economic stewards for a brainstorming session. What emergency powers might the government want at its disposal to confront the crisis? he asked. Timothy F. Geithner, who as president of the New York Federal Reserve Bank oversaw many of the nation’s most powerful financial institutions, stunned the group with the audacity of his answer. He proposed asking Congress to give the president broad power to guarantee all the debt in the banking system, according to two participants, including Michele Davis, then an assistant Treasury secretary. The proposal quickly died amid protests that it was politically untenable because it could put taxpayers on the hook for trillions of dollars. “People thought, ‘Wow, that’s kind of out there,’ ” said John C. Dugan, the comptroller of the currency, who heard about the idea afterward. Mr. Geithner says, “I don’t remember a serious discussion on that proposal then.” But in the 10 months since then, the government has in many ways embraced his blue-sky prescription. Step by step, through an array of new programs, the Federal Reserve and Treasury have assumed an unprecedented role in the banking system, using unprecedented amounts of taxpayer money, to try to save the nation’s financiers from their own mistakes. And more often than not, Mr. Geithner has been a leading architect of those bailouts, the activist at the head of the pack. He was the federal regulator most willing to “push the envelope,” said H. Rodgin Cohen, a prominent Wall Street lawyer who spoke frequently with Mr. Geithner. Today, Mr. Geithner is Treasury secretary, and as he seeks to rebuild the nation’s fractured financial system with more taxpayer assistance and a regulatory overhaul, he finds himself a locus of discontent. Even as banks complain that the government has attached too many intrusive strings to its financial assistance, a range of critics — lawmakers, economists and even former Federal Reserve colleagues — say that the bailout Mr. Geithner has played such a central role in fashioning is overly generous to the financial industry at taxpayer expense. An examination of Mr. Geithner’s five years as president of the New York Fed, an era of unbridled and ultimately disastrous risk-taking by the financial industry, shows that he forged unusually close relationships with executives of Wall Street’s giant financial institutions. His actions, as a regulator and later a bailout king, often aligned with the industry’s interests and desires, according to interviews with financiers, regulators and analysts and a review of Federal Reserve records.

508 In a pair of recent interviews and an exchange of e-mail messages, Mr. Geithner defended his record, saying that from very early on, he was “a consistently dark voice about the potential risks ahead, and a principal source of initiatives designed to make the system stronger” before the markets started to collapse. Mr. Geithner said his actions in the bailout were motivated solely by a desire to help businesses and consumers. But in a financial crisis, he added, “the government has to take risk, and we are going to be doing things which ultimately — in order to get the credit flowing again — are going to benefit the institutions that are at the core of the problem.” The New York Fed is, by custom and design, clubby and opaque. It is charged with curbing banks’ risky impulses, yet its president is selected by and reports to a board dominated by the chief executives of some of those same banks. Traditionally, the New York Fed president’s intelligence-gathering role has involved routine consultation with financiers, though Mr. Geithner’s recent predecessors generally did not meet with them unless senior aides were also present, according to the bank’s former general counsel. By those standards, Mr. Geithner’s reliance on bankers, hedge fund managers and others to assess the market’s health — and provide guidance once it faltered — stood out. His calendars from 2007 and 2008 show that those interactions were a mix of the professional and the private. He ate lunch with senior executives from Citigroup, Goldman Sachs and Morgan Stanley at the Four Seasons restaurant or in their corporate dining rooms. He attended casual dinners at the homes of executives like Jamie Dimon, a member of the New York Fed board and the chief of JPMorgan Chase. Mr. Geithner was particularly close to executives of Citigroup, the largest bank under his supervision. Robert E. Rubin, a senior Citi executive and a former Treasury secretary, was Mr. Geithner’s mentor from his years in the Clinton administration, and the two kept in close touch in New York. Mr. Geithner met frequently with Sanford I. Weill, one of Citi’s largest individual shareholders and its former chairman, serving on the board of a charity Mr. Weill led. As the bank was entering a financial tailspin, Mr. Weill approached Mr. Geithner about taking over as Citi’s chief executive. But for all his ties to Citi, Mr. Geithner repeatedly missed or overlooked signs that the bank — along with the rest of the financial system — was falling apart. When he did spot trouble, analysts say, his responses were too measured, or too late. In 2005, for instance, Mr. Geithner raised questions about how well Wall Street was tracking its trading of complex financial products known as derivatives, yet he pressed reforms only at the margins. Problems with the risky and opaque derivatives market later amplified the economic crisis. As late as 2007, Mr. Geithner advocated measures that government studies said would have allowed banks to lower their reserves. When the crisis hit, banks were vulnerable because their financial cushion was too thin to protect against large losses. In fashioning the bailout, his drive to use taxpayer money to backstop faltering firms overrode concerns that such a strategy would encourage more risk-taking in the

509 future. In one bailout instance, Mr. Geithner fought a proposal to levy fees on banks that would help protect taxpayers against losses. The bailout has left the Fed holding a vast portfolio of troubled securities. To manage them, Mr. Geithner gave three no-bid contracts to BlackRock, an asset-management firm with deep ties to the New York Fed. To Joseph E. Stiglitz, a Nobel-winning economist at Columbia and a critic of the bailout, Mr. Geithner’s actions suggest that he came to share Wall Street’s regulatory philosophy and world view. “I don’t think that Tim Geithner was motivated by anything other than concern to get the financial system working again,” Mr. Stiglitz said. “But I think that mindsets can be shaped by people you associate with, and you come to think that what’s good for Wall Street is good for America.” In this case, he added, that “led to a bailout that was designed to try to get a lot of money to Wall Street, to share the largesse with other market participants, but that had deeply obvious flaws in that it put at risk the American taxpayer unnecessarily.” But Ben S. Bernanke, the chairman of the Federal Reserve, said in an interview that Mr. Geithner’s Wall Street relationships made him “invaluable” as they worked together to steer the country through crisis. “He spoke frequently to many, many different players and kept his finger on the pulse of the situation,” Mr. Bernanke said. “He was the point person for me in many cases and with many individual firms so that we were prepared for any kind of emergency.” An Alternate Path A revolving door has long connected Wall Street and the New York Fed. Mr. Geithner’s predecessors, E. Gerald Corrigan and William J. McDonough, wound up as investment-bank executives. The current president, William C. Dudley, came from Goldman Sachs. Mr. Geithner followed a different route. An expert in international finance, he served under both Clinton-era Treasury secretaries, Mr. Rubin and Lawrence H. Summers. He impressed them with his handling of foreign financial crises in the late 1990s before landing a top job at the International Monetary Fund. When the New York Fed was looking for a new president, both former secretaries were advisers to the bank’s search committee and supported Mr. Geithner’s candidacy. Mr. Rubin’s seal of approval carried particular weight because he was by then a senior official at Citigroup. Mr. Weill, Citigroup’s architect, was a member of the New York Fed board when Mr. Geithner arrived. “He had a baby face,” Mr. Weill recalled. “He didn’t have a lot of experience in dealing with the industry.” But, he added, “He quickly earned the respect of just about everyone I know. His knowledge, his willingness to listen to people.” At the age of 42, Mr. Geithner took charge of a bank with enormous influence over the American economy. Sitting like a fortress in the heart of Manhattan’s financial district, the New York Fed is, by dint of the city’s position as a world financial center, the most powerful of the 12 regional banks that make up the Federal Reserve system.

510 The Federal Reserve was created after a banking crisis nearly a century ago to manage the money supply through interest-rate policy, oversee the safety and soundness of the banking system and act as lender of last resort in times of trouble. The Fed relies on its regional banks, like the New York Fed, to carry out its policies and monitor certain banks in their areas. The regional reserve banks are unusual entities. They are private and their shares are owned by financial institutions the bank oversees. Their net income is paid to the Treasury. At the New York Fed, top executives of global financial giants fill many seats on the board. In recent years, board members have included the chief executives of Citigroup and JPMorgan Chase, as well as top officials of Lehman Brothers and industrial companies like General Electric. In theory, having financiers on the New York Fed’s board should help the president be Washington’s eyes and ears on Wall Street. But critics, including some current and former Federal Reserve officials, say the New York Fed is often more of a Wall Street mouthpiece than a cop. Willem H. Buiter, a professor at the London School of Economics and Political Science who caused a stir at a Fed retreat last year with a paper concluding that the Federal Reserve had been co-opted by the financial industry, said the structure ensured that “Wall Street gets what it wants” in its New York president: “A safe pair of hands, someone who is bright, intelligent, hard-working, but not someone who intends to reform the system root and branch.” Mr. Geithner took office during one of the headiest bull markets ever. Yet his most important task, he said in an interview, was to prepare banks for “the storm that we thought was going to come.” In his first speech as president in March 2004, he advised bankers to “build a sufficient cushion against adversity.” Early on, he also spoke frequently about the risk posed by the explosion of derivatives, unregulated insurancelike products that many companies use to hedge their bets. But Mr. Geithner acknowledges that “even with all the things that we took the initiative to do, I didn’t think we achieved enough.” Derivatives were not an altogether new issue for him, since the Clinton Treasury Department had battled efforts to regulate the multitrillion-dollar market. As Mr. Geithner shaped his own approach, records and interviews show, he consulted veterans of that fight at Treasury, including Lewis A. Sachs, a close friend and tennis partner who managed a hedge fund. Mr. Geithner pushed the industry to keep better records of derivative deals, a measure that experts credit with mitigating the chaos once firms began to topple. But he stopped short of pressing for comprehensive regulation and disclosure of derivatives trading and even publicly endorsed their potential to damp risk. Nouriel Roubini, a professor of economics at the Stern School of Business at New York University, who made early predictions of the crisis, said Mr. Geithner deserved credit for trying, especially given that the Fed chairman at the time, Alan Greenspan, was singing the praises of derivatives.

511 Even as Mr. Geithner was counseling banks to take precautions against adversity, some economists were arguing that easy credit was feeding a more obvious problem: a housing bubble. Despite those warnings, a report released by the New York Fed in 2004 called predictions of gloom “flawed” and “unpersuasive.” And as lending standards evaporated and the housing boom reached full throttle, banks plunged ever deeper into risky mortgage-backed securities and derivatives. The nitty-gritty task of monitoring such risk-taking is done by 25 examiners at each large bank. Mr. Geithner reviewed his examiners’ reports, but since they are not public, it is hard to fully assess the New York Fed’s actions during that period. Mr. Geithner said many of the New York Fed’s supervisory actions could not be disclosed because of confidentiality issues. As a result, he added, “I realize I am vulnerable to a different narrative in that context.” The ultimate tool at Mr. Geithner’s disposal for reining in unsafe practices was to recommend that the Board of Governors of the Fed publicly rebuke a bank with penalties or cease and desist orders. Under his watch, only three such actions were taken against big domestic banks; none came after 2006, when banks’ lending practices were at their worst. The Citigroup Challenge Perhaps the central regulatory challenge for Mr. Geithner was Citigroup. Cobbled together by Mr. Weill through a series of pell-mell acquisitions into the world’s largest bank, Citigroup reached into every corner of the financial world: credit cards, auto loans, trading, investment banking, as well as mortgage securities and derivatives. But it was plagued by mismanagement and wayward banking practices. In 2004, the New York Fed levied a $70 million penalty against Citigroup over the bank’s lending practices. The next year, the New York Fed barred Citigroup from further acquisitions after the bank was involved in trading irregularities and questions about its operations. The New York Fed lifted that restriction in 2006, citing the company’s “significant progress” in carrying out risk-control measures. In fact, risk was rising to dangerous levels at Citigroup as the bank dove deeper into mortgage-backed securities. Throughout the spring and summer of 2007, as subprime lenders began to fail and government officials reassured the public that the problems were contained, Mr. Geithner met repeatedly with members of Citigroup’s management, records show. From mid-May to mid-June alone, he met over breakfast with Charles O. Prince, the company’s chief executive at the time, traveled to Citigroup headquarters in Midtown Manhattan to meet with Lewis B. Kaden, the company’s vice chairman, and had coffee with Thomas G. Maheras, who ran some of the bank’s biggest trading operations. (Mr. Maheras’s unit would later be roundly criticized for taking many of the risks that led Citigroup aground.) His calendar shows that during that period he also had breakfast with Mr. Rubin. But in his conversations with Mr. Rubin, Mr. Geithner said, he did not discuss bank matters. “I did not do supervision with Bob Rubin,” he said.

512 Any intelligence Mr. Geithner gathered in his meetings does not appear to have prepared him for the severity of the problems at Citigroup and beyond. In a May 15, 2007, speech to the Federal Reserve Bank of Atlanta, Mr. Geithner praised the strength of the nation’s top financial institutions, saying that innovations like derivatives had “improved the capacity to measure and manage risk” and declaring that “the larger global financial institutions are generally stronger in terms of capital relative to risk.” Two days later, interviews and records show, he lobbied behind the scenes for a plan that a government study said could lead banks to reduce the amount of capital they kept on hand. While waiting for a breakfast meeting with Mr. Weill at the Four Seasons Hotel in Manhattan, Mr. Geithner phoned Mr. Dugan, the comptroller of the currency, according to both men’s calendars. Both Citigroup and JPMorgan Chase were pushing for the new standards, which they said would make them more competitive. Records show that earlier that week, Mr. Geithner had discussed the issue with JPMorgan’s chief, Mr. Dimon. At the Federal Deposit Insurance Corporation, which insures bank deposits, the chairwoman, Sheila C. Bair, argued that the new standards were tantamount to letting the banks set their own capital levels. Taxpayers, she warned, could be left “holding the bag” in a downturn. But Mr. Geithner believed that the standards would make the banks more sensitive to risk, Mr. Dugan recalled. The standards were adopted but have yet to go into effect. Callum McCarthy, a former top British financial regulator, said regulators worldwide should have focused instead on how undercapitalized banks already were. “The problem is that people in banks overestimated their ability to manage risk, and we believed them.” By the fall of 2007, that was becoming clear. Citigroup alone would eventually require $45 billion in direct taxpayer assistance to stay afloat. On Nov. 5, 2007, Mr. Prince stepped down as Citigroup’s chief in the wake of multibillion-dollar mortgage write-downs. Mr. Rubin was named chairman, and the search for a new chief executive began. Mr. Weill had a perfect candidate: Mr. Geithner. The two men had remained close. That past January, Mr. Geithner had joined the board of the National Academy Foundation, a nonprofit organization founded by Mr. Weill to help inner-city high school students prepare for the work force. “I was a little worried about the implications,” Mr. Geithner said, but added that he had accepted the unpaid post only after Mr. Weill had stepped down as Citigroup’s chairman, and because it was a good cause that the Fed already supported. Although Mr. Geithner was a headliner with Mr. Prince at a 2004 fundraiser that generated $1.1 million for the foundation, he said he did not raise money for the group once on the board. He attended regular foundation meetings at Mr. Weill’s Midtown Manhattan office. In addition to charity business, Mr. Weill said, the two men often spoke about what was happening at Citigroup. “It would be logical,” he said.

513 On Nov. 6 and 7, 2007, as Mr. Geithner’s bank examiners scrambled to assess Citigroup’s problems, the two men spoke twice, records show, once for a half-hour on the phone and once for an hourlong meeting in Mr. Weill’s office, followed by a National Academy Foundation cocktail reception. Mr. Geithner also went to Citigroup headquarters for a lunch with Mr. Rubin on Nov. 16 and met with Mr. Prince on Dec. 4, records show. Mr. Geithner acknowledged in an interview that Mr. Weill had spoken with him about the Citigroup job. But he immediately rejected the idea, he said, because he did not think he was right for the job. “I told him I was not the right choice,” Mr. Geithner said, adding that he then spoke to “one other board member to confirm after the fact that it did not make sense.” According to New York Fed officials, Mr. Geithner informed the reserve bank’s lawyers about the exchange with Mr. Weill, and they told him to recuse himself from Citigroup business until the matter was resolved. Mr. Geithner said he “would never put myself in a position where my actions were influenced by a personal relationship.” Other chief financial regulators at the Federal Deposit Insurance Company and the Securities and Exchange Commission say they keep officials from institutions they supervise at arm’s length, to avoid even the appearance of a conflict. While the New York Fed’s rules do not prevent its president from holding such one-on-one meetings, that was not the general practice of Mr. Geithner’s recent predecessors, said Ernest T. Patrikis, a former general counsel and chief operating officer at the New York Fed. “Typically, there would be senior staff there to protect against disputes in the future as to the nature of the conversations,” he said. Coping With Crisis As Mr. Geithner sees it, most of the institutions hit hardest by the crisis were not under his jurisdiction — some foreign banks, mortgage companies and brokerage firms. But he acknowledges that “the thing I feel somewhat burdened by is that I didn’t attempt to try to change the rules of the game on capital requirements early on,” which could have left banks in better shape to weather the storm. By last fall, it was too late. The government, with Mr. Geithner playing a lead role alongside Mr. Bernanke and Mr. Paulson, scurried to rescue the financial system from collapse. As the Fed became the biggest vehicle for the bailout, its balance sheet more than doubled, from $900 billion in October 2007 to more than $2 trillion today. “I couldn’t have cared less about Wall Street, but we faced a crisis that was going to cause enormous damage to the economy,” Mr. Geithner said. The first to fall was Bear Stearns, which had bet heavily on mortgages and by mid- March was tottering. Mr. Geithner and Mr. Paulson persuaded JPMorgan Chase to take over Bear. But to complete the deal, JPMorgan insisted that the government buy $29 billion in risky securities owned by Bear. Some officials at the Federal Reserve feared encouraging risky behavior by bailing out an investment house that did not even fall under its umbrella. To Mr. Geithner’s supporters, that he prevailed in the case of Bear and other bailout decisions is testament to his leadership.

514 “He was a leader in trying to come up with an aggressive set of policies so that it wouldn’t get completely out of control,” said Philipp Hildebrand, a top official at the Swiss National Bank who has worked with Mr. Geithner to coordinate an international response to the worldwide financial crisis. But others are less enthusiastic. William Poole, president of the Federal Reserve Bank of St. Louis until March 2008, said that the Fed, by effectively creating money out of thin air, not only runs the risk of “massive inflation” but has also done an end-run around Congressional power to control spending. Many of the programs “ought to be legislated and shouldn’t be in the Federal Reserve at all,” he contended. In making the Bear deal, the New York Fed agreed to accept Bear’s own calculation of the value of assets acquired with taxpayer money, even though those values were almost certain to decline as the economy deteriorated. Although Fed officials argue that they can hold onto those assets until they increase in value, to date taxpayers have lost $3.4 billion. Even these losses are probably understated, given how the Federal Reserve priced the holdings, said Janet Tavakoli, president of Tavakoli Structured Finance, a consulting firm in Chicago. “You can assume that it has used magical thinking in valuing these assets,” she said. Mr. Geithner played a pivotal role in the next bailout, which was even bigger — that of the American International Group, the insurance giant whose derivatives business had brought it to the brink of collapse in September. He also went to bat for Goldman Sachs, one of the insurer’s biggest trading partners. As A.I.G. bordered on bankruptcy, Mr. Geithner pressed first for a private sector solution. A.I.G. needed $60 billion to meet payments on insurance contracts it had written to protect customers against debt defaults. A.I.G.’s chief executive at the time, Robert B. Willumstad, said he had hired bankers at JPMorgan to help it raise capital. Goldman Sachs had jockeyed for the job as well, but because the investment bank was one of A.I.G.’s biggest trading partners, Mr. Willumstad rejected the idea. The potential conflicts of interest, he believed, were too great. Nevertheless, on Monday, Sept. 15, Mr. Geithner pushed A.I.G. to bring Goldman onto its team to raise capital, Mr. Willumstad said. Mr. Geithner and Mr. Corrigan, a Goldman managing director, were close, speaking frequently and sometimes lunching together at Goldman headquarters. On that day, the company’s chief executive, Lloyd C. Blankfein, was at the New York Fed. A Goldman spokesman said, “We don’t believe anyone at Goldman Sachs asked Mr. Geithner to include the firm in the assignment.” Mr. Geithner said he had suggested Goldman get involved because the situation was chaotic and “time was running out.” But A.I.G.’s search for capital was fruitless. By late Tuesday afternoon, the government would step in with an $85 billion loan, the first installment of a bailout that now stands at $182 billion. As part of the bailout, A.I.G.’s trading partners, including Goldman, were compensated fully for money owed to them by A.I.G. Analysts say the New York Fed should have pressed A.I.G.’s trading partners to take a deep discount on what they were owed. But Mr. Geithner said he had no bargaining

515 power because he was unwilling to threaten A.I.G.’s trading partners with a bankruptcy by the insurer for fear of further destabilizing the system. A recent report on the A.I.G. bailout by the Government Accountability Office found that taxpayers may never get their money back. The Debt Guarantee Over Columbus Day weekend last fall, with the market gripped by fear and banks refusing to lend to one another, a somber group gathered in an ornate conference room across from Mr. Paulson’s office at the Treasury. Mr. Paulson, Mr. Bernanke, Ms. Bair and others listened as Mr. Geithner made his pitch, according to four participants. Mr. Geithner, in the words of one participant, was “hell bent” on a plan to use the Federal Deposit Insurance Corporation to guarantee debt issued by bank holding companies. It was a variation on Mr. Geithner’s once-unthinkable plan to have the government guarantee all bank debt. The idea of putting the government behind debt issued by banking and investment companies was a momentous shift, an assistant Treasury secretary, David G. Nason, argued. Mr. Geithner wanted to give the banks the guarantee free, saying in a recent interview that he felt that charging them would be “counterproductive.” But Ms. Bair worried that her agency — and ultimately taxpayers — would be left vulnerable in the event of a default. Mr. Geithner’s program was enacted and to date has guaranteed $340 billion in loans to banks. But Ms. Bair prevailed on taking fees for the guarantees, and the government so far has collected $7 billion. Mr. Geithner has also faced scrutiny over how well taxpayers were served by his handling of another aspect of the bailout: three no-bid contracts the New York Fed awarded to BlackRock, a money management firm, to oversee troubled assets acquired by the bank. BlackRock was well known to the Fed. Mr. Geithner socialized with Ralph L. Schlosstein, who founded the company and remains a large shareholder, and has dined at his Manhattan home. Peter R. Fisher, who was a senior official at the New York Fed until 2001, is a managing director at BlackRock. Mr. Schlosstein said that while he and Mr. Geithner spoke frequently, BlackRock’s work for the Fed never came up. “Conversations with Tim were appropriately a one-way street. He’d call you and pepper you with a bunch of questions and say thank you very much and hang up,” he said. “My experience with Tim is that he makes those kinds of decisions 100 percent based on capability and zero about relationships.” For months, New York Fed officials declined to make public details of the contract, which has become a flash point with some lawmakers who say the Fed’s handling of the bailout is too secretive. New York Fed officials initially said in interviews that they could not disclose the fees because they had agreed with BlackRock to keep them confidential in exchange for a discount. The contract terms they subsequently disclosed to The New York Times show that the contract is worth at least $71.3 million over three years. While that rate is largely

516 in keeping with comparable fees for such services, analysts say it is hardly discounted. Mr. Geithner said he hired BlackRock because he needed its expertise during the Bear Stearns-JPMorgan negotiations. He said most of the other likely candidates had conflicts, and he had little time to shop around. Indeed, the deal was cut so quickly that they worked out the fees only after the firm was hired. But since then, the New York Fed has given two more no-bid contracts to BlackRock related to the A.I.G. bailout, angering a number of BlackRock’s competitors. The fees on those contracts remain confidential. Rescues Revisited As Mr. Geithner runs the Treasury and administration officials signal more bailout money may be needed, the specter of bailouts past haunts his efforts. He recently weathered a firestorm over retention payments to A.I.G. executives made possible in part by language inserted in the administration’s stimulus package at the Treasury Department’s insistence. And his new efforts to restart the financial industry suggest the same philosophy that guided Mr. Geithner’s Fed years. According to a recent report by the inspector general monitoring the bailout, Neil M. Barofsky, Mr. Geithner’s plan to underwrite investors willing to buy the risky mortgage-backed securities still weighing down banks’ books is a boon for private equity and hedge funds but exposes taxpayers to “potential unfairness” by shifting the burden to them. The top echelon of the Treasury Department is a common destination for financiers, and Mr. Geithner has also recruited aides from Wall Street, some from firms that were at the heart of the crisis. For instance, his chief of staff, Mark A. Patterson, is a former lobbyist for Goldman Sachs, and one of his top counselors is Lewis S. Alexander, a former chief economist at Citigroup. A bill sent recently by the Treasury to Capitol Hill would give the Obama administration extensive new powers to inject money into or seize systemically important firms in danger of failure. It was drafted in large measure by Davis Polk & Wardwell, a law firm that represents many banks and the financial industry’s lobbying group. Mr. Geithner also hired Davis Polk to represent the New York Fed during the A.I.G. bailout. Treasury officials say they inadvertently used a copy of Davis Polk’s draft sent to them by the Federal Reserve as a template for their own bill, with the result that the proposed legislation Treasury sent to Capitol Hill bore the law firm’s computer footprints. And they point to several significant changes to that draft that “better protect the taxpayer,” in the words of Andrew Williams, a Treasury spokesman. But others say important provisions in the original industry bill remain. Most significant, the bill does not require that any government rescue of a troubled firm be done at the lowest possible cost, as is required by the F.D.I.C. when it takes over a failed bank. Treasury officials said that is because they would use the rescue powers only in rare and extreme cases that might require flexibility. Karen Shaw Petrou, managing director of the Washington research firm Federal Financial Analytics, said it essentially gives Treasury “a blank check.”

517 One year and two administrations into the bailout, Mr. Geithner is perhaps the single person most identified with the enormous checks the government has written. At every turn, he is being second-guessed about the rescues’ costs and results. But he remains firm in his belief that failure to act would have been much more costly. “All financial crises are a fight over how much losses the government ultimately takes on,” he said. And every decision “requires we balance how to achieve the most benefits in terms of improving confidence and the flow of credit at the least risk to taxpayers.” http://www.nytimes.com/2009/04/27/business/27geithner.html?_r=1&th&emc=th

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27.04.2009 German toxic waste totals over €800bn

A report by Sueddeutsche Zeitung, http://www.sueddeutsche.de/finanzen/735/466319/text/ citing an internal paper by the banking regulator that puts the total of bad assets in the German banking system at €817bn, caused outrage among German officials (in particular as the report appears to be true). The number includes toxic securitised assets, and also bad loans, and unlike previous lists, this one names and shames the banks. In one case, half of all assets of a particular Landesbank are classified as toxic, Commerzbank is also on the list with a huge depot of toxic waste. German officials, including Bundesbank president Axel Weber, and finance ministry officials, were at pains to play down the significance of this number. The banking regulator has called for a criminal investigation into the publication of the list. (which tells us that the information is sensitive, in need of some interpretation, but probably true).

Iceland plans to join EU, euro After her election victory, Iceland’s PM Johanna Sigurdardotti yesterday confirmed that Iceland will apply for EU membership, and hold a referendum within the next 12-18 month. The euro could become Iceland’s new currency within 4 four years – on the most optimistic deadline for EU membership and euro accession (which is not entirely clear to us). The Iceland’s Socialists and Greens won the election, and FT Deutschland has a detailed report about the politics of EU membership, which is favoured more by the Socialists than the Greens – so this is not entirely a done deal yet.

IMF warns on deficits Industrial world budget deficit will be 6.6% this year, and still at 6.5% next year, according to the IMF – most of which comes in the form of non-discretionary spending, and falling tax revenue as the recession continues. The FT, which has the story, also said that according to a Federal Reserve estimate, the ideal interest rate in the US would be minus 5% now.

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In a separate article, the FT quotes Dominique Straus Kahn as saying that the present stimulus is sufficient provided countries cleaned up their banking systems vigorously. He called the transatlantic discussion on the size of the stimulus childish, and that countries had now moved past this discussion. IMF says national deficits to remain sky-high By Chris Giles and Krishna Guha in Washington Published: April 26 2009 21:50 | Last updated: April 27 2009 03:06 Budget deficits across the industrialised world will remain sky-high next year in spite of reduced spending on fiscal stimulus packages, the International Monetary Fund warned on Sunday. It said the Group of 20 leading economies taken together would run a budget deficit of 6.5 per cent next year compared with 6.6 per cent in 2009. The huge deficits owe more to weakness in the world’s big economies than to discretionary spending on stimulus packages, which is set to decline in 2010. Staff at the US Federal Reserve estimate that the ideal interest rate for the US economy under current conditions is minus 5 per cent, according to an internal analysis prepared for its last policy meeting. The IMF said on Sunday the UK deficit would rise from 9.8 per cent of gross domestic product this year to 10.9 per cent next, while the deficit in Japan would increase to 9.6 per cent of GDP. It predicted that the US deficit would inch lower, but to a still high 8.8 per cent of GDP. The biggest deterioration would come in Germany, the IMF forecast, with the deficit jumping from 4.7 per cent of GDP to 6.1 per cent. The deficit will also move higher in France, to 6.5 per cent of GDP. The IMF budget forecasts came after three days of meetings of world finance ministers and central bank governors in Washington. In a statement, the Group of Seven industrialised nations said “some signs of stabilisation are emerging” in the world economy. However, US and UK officials worry that continental European nations might backslide on the stimulus, while French and German officials fear the US and UK could backslide on regulation. IMF says existing stimulus could suffice By Chris Giles in Washington Published: April 26 2009 00:05 | Last updated: April 26 2009 00:05 The head of the International Monetary Fund said on Saturday that if countries are successful in cleansing their financial systems, the fiscal stimulus already implemented for 2009 “may be enough”. Dominique Strauss Kahn, the Fund’s managing director, said that all the IMF’s main members agreed on the need for fiscal stimulus in 2009 and had stopped worrying about small differences in the degree of stimulus. He called the transatlantic arguments that raged earlier this year “a little bit childish”. There was no agreement yet on the need for further fiscal action in 2010, but the International Monetary and Financial Committee, the Fund’s governing body agreed to “deliver the scale of sustained fiscal effort necessary to restore growth within credible fiscal frameworks to ensure long-term sustainability”. Mr Strauss Kahn again stressed the importance of action to repair the financial system and the IMFC’s confirmation of countries’ commitment not to allow any large institutions to fail. He said that the finance ministers meeting in Washington agreed that the individual actions of countries – whether to nationalise banks, create insurance systems, recapitalise or instigate public private partnerships – was less important than the speed of action. “All ministers go back committed to speed up the process,” he said. The IMFC confirmed the new responsibility of the Fund to assess and monitor the actions taken by individual countries on fiscal expansion and restoring the financial system to health, with ministers agreeing to “evaluate progress and the need for further action at our next meeting” in early October. Mr Strauss Kahn said the remaining disagreements among members related to the “exit strategy” from government action as countries see the world economy returning to normal. He described a tension between those countries - including many continental European nations – who want to devise ways to dismantle the extensive government support and those – including the US – who think it is still to early to be thinking

520 about the end of the crisis. The Fund said it was making good progress in securing the $500bn additional resources that the Group of 20 leading countries called for at the London Summit earlier in April. The IMF, Mr Strauss Kahn said, would soon issue bonds, paying interest at the rate charged on Special Drawing Rights, to allow additional countries to contribute to the Fund’s resources. China wants to use this mechanism to provide the Fund with new resources. The Fund repeated its

Blanchard says Germany ok Olivier Blanchard says Germany was exposed to wild global swings due its reliance on exports, according to FT Deutschland, but he sees no necessity for Germany to reduce its dependence on exports. The current structure would force Germany to become ever more competitive, and to produce high quality jobs, but the negative side is execessive volatility. He also defended the ECB against criticism that it had done too little.

A constructive proposal from Lafontaine Oskar Lafontaine, former German finance minister and now president of the The LeftParty, incites workers to do the same as their counterparts in France and hold up managers to show their anger and their fear, reports Le Monde. Munchau on the GFSR In his FT Column, Wolfgang Munchau notes that the amount of estimated toxic assets is higher in Europe (both including and excluding UK) than in the US, and that in terms of write-offs, the Europeans also have a lot less. This means that the banking crisis is likely to last a lot longer in Europe than in the US as a result. He says the reason for this situation is lack of policy co-ordination, as countries bail out domestic banks at the expensive of foreign competition – a policy that is considered optimal from a national perspective, but highly suboptimal for the euro area as a whole. What is needed is both restructuring and recapitalisation. He is sceptical about the forthcoming German bank rescue programme, as it will remain a voluntary scheme. Eurozone banking needs a co-ordinated strategy By Wolfgang Münchau Published: April 26 2009 19:00 | Last updated: April 26 2009 19:00 The most shocking news from last week’s excellent Global Financial Stability Report from the International Monetary Fund was not the headline estimate of total bad assets. That number stands at $4,100bn (£2,800bn, €3,000bn) and will almost certainly be revised upwards. Much more shocking was that the lion’s share of these assets belong to European, not North American, banks. Of the total $4,100bn, the global banking system accounts for $2,800bn. Of that, a little over half – $1,426bn – is sitting in European banks, while US banks account for only $1,050bn. Even worse, European banks have written down much less than American ones. According to Reuters, the US and European banking and insurance sector has so far written down $740bn. More than 70 per cent of the write-downs come from the US. The eurozone’s share has been an appalling 14 per cent. Another statistic from the IMF report: to recapitalise the banking system to reach capital ratios that prevailed in the mid-1990s, capital injections of $275bn would be required for US banks, and a whopping $500bn for European banks. You get the picture. All these data tell us that Europe has both the biggest problem and has made the least progress. And since recessions associated with financial crises last longer than ordinary recessions, as the economic literature on financial crises suggests, the eurozone has a big problem. The IMF says that even if the right policies are implemented at the right time the recovery will be slow and painful, because deleveraging takes its time. But if the

521 right policies are not implemented, the recovery will take much longer. The latest economic projections by German economic institutes are consistent with the IMF’s pessimistic analysis. The problem is not only that the German economy will shrink by some 6 per cent this year. The real issue is that there is no projected recovery even by the end of 2010. We are looking at economic stagnation that could last several years. So whatever legitimate criticism we may have of the Geithner/Summers plan for the US banking rescue, both in terms of its effectiveness and fairness, the situation is a lot worse in Europe. For example, the German bank rescue plan, details of which will become known next month, will almost certainly remain a voluntary scheme. There will be no stress test to determine whether a bank should be forced to accept new capital. Of course, this plan is clearly better than nothing. But it is not going to solve the problem of an under-capitalised banking sector. Unlike the Geithner/Summers plan, it does not even pretend to do so. Yet the core problem with the European policy response, both in terms of bank rescues and stimulus packages, is a failure to co-ordinate across national borders. Last week’s spat between Axel Weber, the president of the Bundesbank, and the European Commission, over whether banks in receipt of government aid should unwind “foreign” European operations, highlights the problem that a single market does not work when all the policy decisions in a crisis are taken at national level. As Lord Turner, chairman of the UK’s Financial Services Authority, rightly said about the future of European banking: “Faced with the reality we either need more European co-ordination or more national powers, more Europe or less Europe – we can’t stay where we are.” The IMF has noted that unilateral government action to support the domestic financial sector can easily turn into financial protectionism. This is happening right now in the eurozone where governments have enacted policies that make public support conditional on maintaining domestic lending, thereby crowding out foreign-owned competitors. Europe’s macroeconomic response suffers from the same fundamental problem. Uncoordinated national stimulus programmes have ended up both ineffective and protectionist – such as Germany’s infrastructure investments or French subsidies for the car sector. When only uncoordinated national stimulus plans are on offer, the benefits are drowned by negative externalities. On those grounds, I would oppose another round of national programmes. What the eurozone needs is a co-ordinated European stimulus. Our Great Recession constitutes a seminal crisis for Europe’s internal market and its single currency. It still has the potential to strengthen both. If the eurozone were to enact policies to fix the banking sector and support growth, if it facilitated eurozone accession to central and east European countries (and the UK), and if it started to think about issuing a joint European bond, the euro could emerge strengthened from this crisis – both in terms of its exchange rate against the dollar, and its significance as a global currency. At this moment, however, that optimistic scenario is not very likely. European leaders are by and large an intellectually complacent lot. They have never paid sufficient attention to the spillovers of national policies in a single market under a single currency during a crisis. By pursuing what they mistakenly perceive to be policies in their short-term national interest, they not only damage the long-term prospects of the eurozone, but they ultimately end up damaging themselves. They are all under the illusion that they have a national strategy. But adding it all up, there is no joint strategy. I suspect that this ugly drama will play out the full five acts, in classic European style. And we are not even halfway through. Not even close. http://www.ft.com/cms/s/0/1478ef82-328a-11de-8116-00144feabdc0.html

naked capitalism Monday, October 6, 2008 The case for a European rescue plan By Wolfgang Münchau Published: October 5 2008 http://www.nakedcapitalism.com/2008/10/wolfgang-munchau-europe-needs-bank.html Wolfgang Munchau: Europe Needs a Bank Rescue Plan Wolfgang Munchau, who writes for the Financial Times and the blog EuroIntelligence, argues that the fact that EU member nations managed to survive their first series of bank failures does not mean it can afford to take the risk of defaulting to continued improvisation. Munchau comes out squarely in favor of a coordinated, funded rescue program. From the Financial Times: This has been a week of self-congratulation in Europe. We have saved a handful of banks. We have, in effect, started to cut interest rates. We even had a summit of European leaders that produced warm words of solidarity. It looks as though the Europeans have reached

522 substantive agreement that no systemically important bank should ever be allowed to fail....The rescue of Fortis and Dexia last week, two large, but not too large, cross-border European banks, should be seen as a sign that our emergency procedures are working. Look, they say, we met quickly and decided what needed to be decided. It was fast and unbureaucratic. We do not need a European rescue fund, let alone any new institutional set- up to deal with this, they say. We can do it ourselves. I agree that the few ad hoc rescues have worked. But do not fool yourself. They worked because they were the first wave of rescues and because they involved banks such as Fortis – of just the right size, based in just the right small- to medium-sized country where political leaders are sufficiently rational not to hold each other to ransom as midnight approaches on Sunday.

But what if this had been a bank with a name of a large European country, or an acronym that refers to a large European city, banks that are simultaneously too big to fail and too big to save? I shudder to think what would happen when Silvio Berlusconi, Angela Merkel, Lech Kaczynski and the next Austrian leader have to meet to discuss the future of a large cross-border European bank.

What worked for banking rescues numbers one to five may not work for rescues number six to 50 – the estimated number of systemically important banks in Europe. And that number does not include some banks we have already rescued, which politicians judged to be important for their domestic banking system, like Germany’s IKB Bank, but with no European relevance whatsoever. We have been squandering money. Nor does it include the likes of Hypo Real Estate, which is not even a bank at all,.... The Europeans are of course right in their overall ambition not to allow systemically important banks to fail. They are also right in their scepticism about their ability to distinguish between illiquidity and insolvency during an emergency. But I fear we are still well short of a strategy. We might be lucky, and scrape through what could well become the most dangerous month of the crisis so far. If, for example, the credit default swap market were to blow up in the next couple of weeks – a non-trivial probability – we have no plan. Nicolas Sarkozy, the French president, was therefore right when he appeared to back a €300bn rescue fund. Regular readers of this column will probably recall my somewhat constrained enthusiasm for his economic policies. But this had the makings of a good plan. He ended up distancing himself from it, when it became clear that Angela Merkel, the German chancellor, would not support it. But he was right and she was wrong. Of course, a European plan should not have been a copy of the bail-out that was finally adopted by Congress on Friday. The US plan failed to address the problem of an undercapitalised banking sector. That issue is even more important in Europe where many banks have an extremely weak capital base, with leverage ratios of 50 or more. Europe does therefore not need any bail-out plan, but a plan that specifically addresses the capitalisation problem. Concretely, three things are needed: the first and most important is money. A sum of €300bn will not cover the EU in a worst-case scenario, but it is a sensible number to start with; secondly, you need a semi-permanent crisis committee empowered to take decisions; and finally you need a strategy to apply symmetrically and based on clear rules about when to recapitalise, and when not. If you pursue a strategy of taking purely national decisions, you run the risk that at least one government will hit its own financial ceiling before this crisis is over, or that decisions have negative spillovers on the banking systems of other countries. Moreover, you end up with a beggar-thy-neighbour regulatory race, as we saw last week when Ireland and Greece unilaterally issued blanket guarantees for large parts of their banking sector. Last night, Germany was preparing a full deposit guarantee for its own banking system. Last but not

523 least is the risk of violent political setback against a process that lacks transparency. For Europe, this is more than just a banking crisis. Unlike in the US, it could develop into a monetary regime crisis. A systemic banking crisis is one of those few conceivable shocks with the potential to destroy Europe’s monetary union. The enthusiasm for creating a single currency was unfortunately never matched by an equal enthusiasm to provide the correspondingly effective institutions to handle financial crises. Most of the time, it does not matter. But it matters now. For that reason alone, the case for a European rescue plan is overwhelming. http://www.eurointelligence.com/article.581+M5a24f672d3d.0.html#

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Balance of the fright Internal paper of the Bafin 24.04.2009, 19:00 From Guido Bohsem, Martin Hesse and Claus Hulverscheidt Gigantic billion risk: the financial crisis meets the German banks far stronger than so far confesses. Credits and securities in problematic spheres of business add themselves on 816 billion Euros how it comes out from a Bafin paper which is present of the South German newspaper. In the balances of the German banks (here the finance metropolis of Frankfurt on the Main) slumber risks worth of more than 800 billion Euros. (Photo: GPA) The financial crisis meets the German banks much stronger than up to now confesses. This comes out from an internal installation of the finance surveillance Bafin. The paper gives for the first time a view about the fact which credits and securities possess the institutes in problematic spheres of business. Their risk adds up to 816 billion Euros. Particularly the HRE, several regional banks and the Commerzbank are concerned Only at the Commerzbank are concerned after Bafin installation which is present of the South German newspaper securities and credits worth of 101 billion Euros by the financial crisis. In it are contained 49 billion Euros from the balance of the taken over Dresdner Bank. Therefore, the Commerzbank is similarly strongly affected from the financial crisis like the regional bank of Hamburg and Schleswig - Holstein, the north bank HSH for which the Bafin 105 billion Euros starts. With the West German regional bank with 84 billion Euros and the regional bank Baden-Wurtemberg with 92 billion Euros the surveillance sees risks in a similar order of magnitude. Much better stand there the German bank with 21 billion Euros, as well as the post bank and the hypoassociation bank with five billion Euros in each case. Strongest the Hypo standing before the nationalization real Estate (HRE) is concerned according to Bafin paper which holds 268 billion Euros in problem arrangements. Banks wise bill back Most of 17 specified banks rejected the numbers as misleadingly. " We do not know who has put together the numbers and they can also not understand ", said a speaker of the Commerzbank. The north bank HSH explained, auditors and the bank rescue funds Soffin would have certified the HSH a sufficient and appropriate prevention of risk. Other institutes referred to numbers in their business reports or on the fact that they would have secured the arrangements. The Commerzbank has got so far state help of 18.2 billion Euros. In their business report the bank itself had broken down risks and had pointed other " significant loads " which threatened in different areas of the security business and credit business. But is controversial under banks, investors and keepers which papers are to be understood as scrap arrangements. The SZ said a Bafin speaker that it is not with the numbers about real or future losses. Moreover, the data admitted " no conclusions on the credit standing of the banks ".

525 Installation with big importance The internal installation is for the government of big importance. The calculations of the Bafin flow in onto the plans to the establishment of so-called bath Banks, also to rallying institutes of problem papers. According to plans of the Ministry of Finance only approximately one third of the arrangements specified in the list should be possible to the paging in a bath bank. The government wants to restore with the help of the bath Banks the function of the finance markets and put the basis for an impetus. The numbers of the Bafin are for the government meanwhile no surprise. So was in the documents which had sent Minister of Finance Peer Steinbrück weeks ago to chancellor Angela Merkel to the preparations of the bank summit on Tuesday, even from potentially endangered arrangements of 853 billion Euros the speech. However, these numbers from the beginning of the year are not considered as any more current. The new paper names as an appreciation deadline to him 26th February. http://www.sueddeutsche.de/finanzen/735/466319/text/ Appears strange about the occurrence " Reactions to internal paper 24.04.2009, 19:00 From Guido Bohsem, Martin Hesse and Claus Hulverscheidt Billion difficult failure risks: How the German banks reacted to the risk list of the Federal Institution of finance service surveillance. Dark cloud about Frankfurt on the Main: in the balances of the banks risks slumber to the amount of more than 800 billion Euros. (Photo: ddp) Has specified the Federal Institution of finance service surveillance (Bafin) on a German Institute for Standardization A4 page specified, in which size in which risky spheres of business 17 leading banks of the country are active. The Bafin refused on Friday exact information about the composition of the numbers and according to which criteria the table was constructed. How likely it is that comes to failures by the named height, also it does not come out from the paper present to the South German newspaper. However, a speaker did clear that security and security business is not included. The fact that the picture drawn by their institution appears more dramatic than it is. To the banks the installation of the Bafin was not known so far evidently. And so they tried on Friday to straighten the data " Appears extremely strange about the occurrence " Most drastic a speaker of the LBB from Berlin expressed it. The bank does not know the listing, she has not been asked and has supplied no information. " The numbers named by them have no relation to the reality of our bank. " Altogether one appears in Berlin " extremely appears strange about the occurrence ". Not to be able to understand the bank DZ which explained north LB and the BayernLB, the numbers. Bavaria LB stressed to have seized extensive precautionary measures against possible failures already during the last months. The ABS security Portfolio of the bank has amounted to about 19.6 billion Euros at the end of the year. The institute would be secured by the help of the country up to six billion Euros in this area. According to the NordLB no toxic papers are in their Portfolio. One would be concerned by the financial crisis only indirectly and will be able to show next week

526 again a positive result - before as well as after taxes. The numbers of the Bafin would prove " no sense ". The German bank explains, she has diminished their critical positions far and they would lie under the values named by the Bafin. The LBBW did not want to comment on the numbers. But LBBW chief Siegfried Jaschinski referred by the balance presentation to the fact that almost half of it are government loans and proficient loans. The risk that loans of governments or big banks fell out is very low. The WestLB whose whole risk existence numbers the Bafin at 84 billion Euros referred to the fact that it would be generally known that she intends evacuating activities in the range of approximately 80 billion Euros. Besides, it is about a Portfolio with high Werthaltigkeit. Already in spring, 2008 the WestLB has been freed from risky securities to the amount of 23 billion Euros. These would not be any more in the balance. Hypo real Estate, in the Bafin list as an institute with the biggest risks is described (268 billion Euros), wanted to comment the numbers not. She referred instead to the current business report. The north bank HSH explained, the composition of the Bafin with a whole volume of 105 billion Euros seems to be a composition of book values which one has announced previously to the institution. " A specific statement to failure probabilities of these book values is not met with it. " For all parts of the Kreditportfolios there are by the worldwide economic crisis raised failure risks. But auditors and also the bank rescue funds Soffin of the HSH would have certified a sufficient and appropriate prevention of risk. " To subordinate a complete failure of the book values of the whole Portfolios, was wrong. " The HSH has structured capital market products to the amount of about thirteen billion Euros. These are endangered stronger. From a complete blackout one does not go out. http://www.sueddeutsche.de/finanzen/736/466320/text/ http://elmundo.reverso.net/url/result.asp?url=http%3A//www.sueddeutsche.de/finanzen/ 736/466320/text/&direction=65540 Union aims at 90-per cent solution

Hypo real Estate 24.04.2009, 17:04 From t. Piously The government takes over the command with the Hypo real Estate: the union wants to acquire 90 per cent of the interests about the banks-rescue funds. The Federal Government stands before the assumption of the majority in the chipped real-estate business bank Hypo real Estate (HRE). How the HRE informed on Friday, this should happen at an exceptional general meeting on the 2nd June. Then should be decided on a capital increase to the amount of 5.64 billion Euros. While old shareholders of the institute like the US-big investor Flowers are expelled by a participation in the issue of new shares, if the union about the finance market stabilization funds (Soffin) could develop de facto his interest on 90 per cent. The aim of the government is to take over medium-term 100 per cent of the crises bank to secure up to now help performed. The HRE must be already kept alive with help of more than 100 billion Euros artificially. The HRE is considered as a

527 so-called bank relevant to system: should she collapse, had to these disastrous effects on the international finance markets as well as for separate governments. Hypo real Estate 1.39? 0 0.00%

Flowers speculates on rally in prices Meanwhile the assumption offer runs on for the shareholders of the bank. The HRE recommends to their shareholders to accept the offer still running up to the 4th May of 1.39 Euros per share. However, so far only 1.3 per cent have accepted the offer and have sold their shares to the union. Berlin possesses with it about ten per cent in the bank; he had protected himself only from some weeks about a capital increase the first interest of 8.7 per cent in the HRE. The Federal Government has provided. Should the shareholders on the assumption offer not come, she reserves herself in another step an expropriation of the old shareholders. However, this step is considered as " ultima ratio ". Affected from such an expropriation would be, first of all, Christopher Flowers who still holds altogether approximately 24 per cent in the HRE. The US investor had put more than one billion Euros in the building society; after the almost breakdown of the HRE in autumn of last year he stood almost before a total loss of his application. The calculation of Flowers: He would gladly keep his interest and speculates on the fact that the share quotation rises after an entrance of the state again. Finally Flowers had hardly let doubt at the fact that he does not want to accept the offer of the union and risk it a trial of strength. Finally he threatened with legal steps against an expropriation of his HRE interest. Traducido mediante el programa: http://elmundo.reverso.net/url/default.asp, creando la página: http://elmundo.reverso.net/url/result.asp?url=http%3A//www.sueddeutsche.de/finanzen/ 722/466306/text/&direction=65540

528 Government is responsible for scrap papers The bad bank comes 21.04.2009, 17:41 From g. Bohsem u. S. Höll Arrangement in Berlin: the government does the way freely for the model Bath to bank. Already in two weeks a specific draft should be present.

Model Bath bank: So the solution of the union should function for the private banks. (Graphic: sueddeutsche.de) The government has communicated to create so named bath Banks. There is unity, said Minister of Finance Peer Steinbrück (SPD) after a meeting of the responsible Ministers under administration of chancellor Angela Merkel (CDP). The government will submit a draft in 14 days. With the decision the government and with it the taxpayer takes over a billion difficult finance risks. He answers presumably during two decades for the so-called scrap papers which load the bank balances at present. This happens first with guarantees and later with specific amounts of money. The bath Banks should enable for chipped financial institutions to create their papers strongly impaired by the crisis from the balances. With it the survival of the institutes is protected, one said in the government to the reason. Only so the bank sector gets going again.

Blow-up The model " bath bank ": How it should just function, see in this graphic. (Graphic: sueddeutsche.de) At present the also toxically named papers lose in the course of the financial crisis almost daily to value. This forces the banks, all three months to new writing-offs what decreases their company capital again. If the company capital of a bank decreases too strongly, she is threatened in their existence. After the youngest estimates of the International Monetary Fund losses of more than four trillions dollar (3.09 trillions

529 Euro) appear to the finance branch from the scrap papers and rotten credits world-wide. This is accepted possibly twice as a lot like so far. Moreover, the scrap papers load the economic cycle. Because no bank knows how strongly the other is loaded with such papers, the institutes lend themselves at present together hardly money. This leads to the fact that they give away only hesitantly credits at present also to enterprise. Now after the decision of the Minister's round the responsible Assistant Secretaries should work out a load-carrying draft, one said in government circles. The administration of the study group becomes presumably a finance Assistant Secretary Jörg Asmussen take over. The Central Bank and the banks-rescue funds Soffin are also involved. Two models Till the middle of May a law draft should be present which the cabinet can dismiss then. Not later than in summer the legislation procedure should be concluded. Then the banks could evacuate under circumstances already in the third quarter their scrap papers. A basis for the rescue plan are two models, one for the private banks and one for the regional banks. After an estimate of the federal agency for finance service surveillance the value of the rotten papers amounts altogether to maximally 830 billion Euros. So only she should go North bank HSH more than 100 billion Euros in incriminating papers hold. Also in the balances of the Commerzbank almost 100 billion Euros are together with the papers of the Dresdner Bank in rotten securities. More on the subject How many of it at the end the taxpayer must carry, depends, on the one hand, on the development of the papers which are given in the bath bank. Moreover, Steinbrück estimates the circle of the being possible institutes smally. So the German bank has already explained not to want to participate. The CDP finance expert Otto Bernhardt spoke from 20 banks, mostly regional banks. " Institutions in the institution " After the considerations of the government the affected private banks should create special societies which take over the scrap papers. As a countermove the bank gets a bond whose value of the Soffin should guarantee 20 years. For it the bank Gebühren must pay and participate in possible failures. Unclear is still how the value of the arrangements is determined. In the discussion documents present the SZ of the government one says, a fair value should be determined. That is on the present book value in the balances of the bank there should be a drop in prices. How high this drop in prices will be and how he is determined, the study group of the government should clear. To the rescue of the regional banks should be worked out on one model developed by the Soffin. It carries the name " institutions in the institution " or shortly Aida. Also here the papers should be evacuated in a special society. Here fiele to the countries the biggest weight to if it comes to losses.

( SZ rave from the 22.04.2009/) http://www.sueddeutsche.de/finanzen/272/465858/text/

530 SUNDAY, APRIL 26, 2009 Bank Balance Sheet: Liquidity and Solvency, Part I by CalculatedRisk on 4/26/2009 11:57:00 AM This post looks at a bank balance sheet and a liquidity crisis. In a subsequent post, I'll look at a solvency crisis and two possible solutions.

A special hat tip to This American Life’s Alex Blumberg and NPR’s Adam Davidson who presents some of the same ideas (although I'm going to go further). Here is the website for their presentation.

If you watch the Planet Money presentation, they explain the basics of a bank from a balance sheet perspective. It doesn't matter if the left scale is in dollars or billions of dollars - the structure is the same. Capital is the amount of money investors put into the bank plus any retained earnings. Liabilities is the money the bank borrows from depositors or other sources. And assets are loans that the bank makes (and a little cash and other assets). (see Alex and Adam's presentation to make this clear). The balance is: Assets = Capital + Liabilities Banks make money by lending at a higher rate than they borrow. In the Planet Money example, the banks borrowed at 3%, loaned the money at 6%, for a spread of 3%. The difference between 6% and 3% is called the "net interest spread". Banks report something a little different called the "net interest margin". The difference between the "spread" and the "margin" is because not all assets are loans (some might be held as cash for regulatory reasons). Net Interest Margin (NIM) is the interest earned, minus the interest paid, divided by total assets. As an example, Wells Fargo just reported a net interest margin of "approximately 4.1 percent". Now look at how profitable a bank could be. If this bank had $100 billion in assets, and a NIM of 4.1% that would be $4.1 billion in annual profits before expenses and charge- offs - on just $10 billion in capital (Note: The diagram shows 10-to-1 leverage; many banks were levered 30-to-1 or more). Of course the bank has expenses (all those nice buildings and employees) - and there are always charge-offs for loans that don't get

531 repaid, even in good times. For reference, the Federal Reserve tracks the charge-offs by loan category here. Banks have two main risks: interest rate risks and credit risks. Since banks mostly borrow short and lend long, they are exposed to increases in short term interest rates, and this would lead to lower NIMs. The credit risk is that too many of those assets will go bad (more on credit risks in the next post).

Not all liabilities are the same. The second diagram shows three categories of liabilities: 1) Long term bank debt, 2) commercial paper (called CP, this is less than 270 days duration, and usually much shorter), and 3) FDIC insured deposits. Each category has advantages and disadvantages. Commercial paper is usually the lowest interest rate, but it is the shortest duration and has the highest interest risk. Usually the bank pays the highest interest rate on long term debt, but there is no interest risk for the duration of the security. Most banks have a mix of liabilities. Now imagine the bank starts reporting higher than expected credit losses - or at least depositors believe the bank will start reporting huge loses.

532 Here the bank has lost $5 billion, and the capital has been cut in half. Fearing further losses, the commercial paper (CP) investors run for the hills and refuse to reinvest again when their short term paper matures. The FDIC insured depositors run (or amble) towards the hills too. A classic bank run. The long term debt holders are stuck. They can sell in the market, but at a lower price - and that doesn't impact the bank's balance sheet (OK, there are some accounting issues here that I will ignore). To stop the bank run, the FDIC stepped up and increased the guarantee on FDIC insured assets to $250 thousand. But this did nothing for the commercial paper investors.

Next the Fed steps in and replaces the commercial paper liability at it matures. If this was just a panic, and the bank was actually fine, the commercial paper investors would return (or the bank could sell more long term debt), and the Fed would be replaced by private debt. However this is not just a liquidity crisis, and the Fed is still providing liquidity to the banks. This doesn't work long term because the Fed requires the banks to over collateralize any money borrowed from the Fed. As the long term debt starts to mature, those investors will follow the commercial paper investors to the hills - and the Fed will have to provide more and more liquidity. And eventually there will not be enough collateral to borrow from the Fed. Here is an example of the Collateral Margins Table for the discount window. Next I'll discuss the solvency issues (not as easy to fix). http://www.calculatedriskblog.com/2009/04/bank-balance-sheet-liquidity-and.html

533 Krugman Worries about L-Shaped Recession by CalculatedRisk on 4/26/2009 10:15:00 AM From the Cincinnati Enquirer: Nobel-winning economist speaks at UC (ht Jonathan) The country may experience some economic growth in the latter half of this year, but don't expect the rate of job losses to abate anytime soon, noted economist and recent Nobel Prize laureate Paul Krugman told an audience of economists and area business leaders Friday at the University of Cincinnati. ... "There are two kinds of recessions that are bad - those that take place because of financial crises, and those that are synchronized around the world," he said. "In both cases, the recessions tend to last longer and be deeper. Right now, we've got both going on." And from a separate interview with the Enquirer: Q: What will it take to pull out of this crisis? Krugman: I'm in the camp that really worries about the L-shaped recession. We level off but we don't get the recovery. We hope it isn't, but it has all the markings of it. This looks like the kind of slump that has all the markings of where normal recovery forces are very, very weak. It's hard to see where recovery comes from. Almost always the way a country recovers from a financial crisis is with an export boom. The problem is that we have a global crisis this time. So who are we going to export to, unless we find another planet to take our stuff? http://www.calculatedriskblog.com/2009/04/krugman-worries-about-l-shaped- recovery.html

534

With Stress Test Results in Hand, Banks May Need to Boost Capital By Binyamin Appelbaum Washington Post Staff Writer Saturday, April 25, 2009 The nation's largest banks yesterday learned how much money the government projects they will lose over the next two years, the result of stress tests to determine whether they need more capital to survive those losses. The government hopes to reassure investors that most banks are in good shape. But at least one firm was told yesterday that it must raise more capital, according to a person with direct knowledge who spoke on condition of anonymity because of the sensitivity of the information. Banks required to raise money have several months to find private investors before they are forced to accept federal aid. Other banks may be required to improve the stability of their capital reserves by issuing common shares to preferred shareholders. In some cases, the efforts to buttress capital could force companies to sell the government a significant ownership stake. The public, however, remained largely in the dark. The government will not publicize its evaluations until the week of May 4. The Federal Reserve yesterday disappointed many investors by declining to disclose even the standards it is using to evaluate the banks. In the absence of clarity, financial analysts continue to release their own evaluations of which firms will need to raise capital. Concerns focus on banks that made large numbers of loans for commercial real estate development, because of a belief that losses on those loans will rise rapidly in the coming months. Such lending is a particularly important business for regional banks including Regions Financial of Alabama, BB&T of North Carolina and Ohio's Fifth Third. Bank of America and Citigroup, two of the nation's largest banks, also are viewed as candidates by many analysts. Both banks already have taken two rounds of federal aid, and Citigroup has received permission to convert the government's existing investment to less onerous terms. The stress tests have become an unwieldy challenge for the Obama administration, which hoped to calm investors simply by declaring that the banks were healthy. It has become clear, however, that calming investors will require evidence. And this has forced the government into an awkward bind: If it says too little, investors may distrust the results; if it says too much, the weakest banks could sustain an irreparable loss of public confidence. The proper calibration remains a subject of debate within the administration, even as regulators began yesterday to discuss the results with banks.

535 Meetings at the Federal Reserve Bank of New York began at 8 a.m. and ran into the late afternoon. Executives from seven banks were taken in turn to conference rooms where they sat across from regulators for about an hour, listening to the Fed's findings and then discussing the results. Other regional Federal Reserve banks hosted similar meetings. The 19 banks were given until Friday to contest the government's conclusions. The government had announced that it would release a detailed description of its methodology yesterday. Instead, the Federal Reserve published a 21-page narrative about the process of performing the tests. Numbers were notable by their absence. The report did not explain any of the specific assumptions used in the testing, save for repeating economic projections released previously. The report also did not answer the most critical question: What level of capital reserves must banks maintain to pass the test? "It was a little bit light on the details. They didn't convey loss projections. They didn't give any capital targets," said Jason Goldberg of Barclays Capital. "You still need more details to assess the impact." Regulators considered whether banks have enough money in their capital reserves to cover projected losses on loans and other assets over the next two years. Banks in general are required to maintain at least $6 in capital for every $100 in loans and other commitments. Fed officials said the 19 banks would be required to maintain a higher level of capital over the next few years, but they declined to say how much more. The banks also will be required to raise a minimum portion of their capital reserves from the most basic sources, such as quarterly profits or the sale of common shares. Fed officials declined yesterday to define this new secondary standard. In adopting it, regulators are bowing to criticism from investors that the government's definition of capital has overstated the ability of companies to absorb losses. "Lower overall levels of capital -- especially common equity -- along with the uncertain economic environment have eroded public confidence in the amount and quality of capital held by some firms, which is impairing the ability of the banking system to perform its critical role of credit intermediation," the Fed said. Staff writer Neil Irwin contributed to this story

536 COLUMNISTS Labour’s affair with bankers is to blame for this sorry state Published: April 24 2009 20:24 | Last updated: April 24 2009 20:24 In Wednesday’s Budget statement, Alistair Darling acknowledged that even on his optimistic assumptions a decade was needed to repair Britain’s public finances. The UK government’s reputation for economic competence was already in tatters; the chancellor of the exchequer has now laid it definitively to rest. How did the New Labour project end in such disaster? The answers lie not in unpredictable global events but closer to home. The government failed to deal effectively with the reform of public services and conducted an indecent love affair with the financial services industry. These two apparently unrelated errors, allied with hubris, proved to be a fatal combination. When Labour came to power in 1997, dissatisfaction with public services such as health, education and transport was widespread, and justified. For two decades not enough money had been spent, particularly on capital projects. This underspending had contributed to weak and demoralised management, reservations about which led to a fear that simply allocating more cash would provide poor value for money. There were two possible directions of reform. One – it might be described as Blairite – decentralised management authority and financial responsibility. The other – it might be described as Brownian – tightened centralised control and imposed performance targets on managers, with associated sticks and carrots. Both approaches were pursued, inconsistently, but overall with more Brown than Blair. When, by 2000, there was little to show in the way of beneficial results, the decision was made to spend lots more anyway. There were some service improvements, but the concern that the extra money would not be well spent proved largely justified. The reasons targets do not work are evident from any study of the failure of planned economies. You can require people to meet goals, but that is not at all the same as encouraging them to meet the objectives behind the goals. By emphasising targets you undermine both their motivation and their ability to achieve these more fundamental underlying goals. In a delicious irony, a major victim of this process would be the Treasury itself. Here is how it happened. The government’s principal fiscal target was to balance current expenditures with revenues over an economic cycle. This makes sense as a generalised objective: but not as a binding constraint. The financial services sector boomed from 1998 to 2000 and the government benefited from a surge of revenues. The tide then receded. But by mechanically averaging spending and receipts over the cycle, earlier revenues could be used to offset the later splurge in spending. When this resource started to run out, the Treasury redefined the economic cycle to claim compliance with the target. This is where the two stories become linked. We now know that many of the banking profits of that period were illusory. But they generated substantial revenues from

537 corporation tax and income tax on bonuses. The real funding gap was wider even than it appeared. But the illusion was at its most influential at the highest levels of government. Investment bankers had become the most powerful political lobby in the country and there was no vestige of political support for action to restrain City excess. Light touch regulation was not just a matter of policy but a matter of pride. What would have happened if the Financial Services Authority or Bank of England had sought to block the competing bids from RBS and Barclays for ABN Amro – a contest which, we now know, would bankrupt the bank that won the race? The phones in Downing Street would have been ringing insistently and it is easy to imagine the government’s response. Little has changed. The government continues to see financial services through the eyes of the financial services industry, for which the priority is to restore business as usual. For a time in 2008, it seemed possible to argue that a package of temporary support for the banking industry, combined with substantial recapitalisation of the weaker players, might stabilise the financial sector and prevent serious knock-on effects. But the problems of banks are much deeper than were then acknowledged and the destabilisation of the real economy has happened anyway. Government now provides taxpayers’ money to financial services businesses in previously unimaginable quantities. But there is no control over the use of the money, no insistence on structural reform or management reorganisation, no safeguarding of the essential economic functions of the financial services industry and no accountability for the damage that has been done. It is as though the teenage children and their friends were to wreck the house and then demand that the grown-ups clean up before the next party. Their parents are too intimidated to do anything more than ask Uncle Adair to keep an eye on them and excoriate the hapless Fred who made off with some of the silver. On Wednesday, Mr Darling gave the impression of an honest man who would have much preferred to have been somewhere else, as befits someone caught in a trap not of his own devising. We need a comprehensive reappraisal of both the fiscal framework and the economic and political role of the financial services sector. The crippling consequence of inability to admit error is the impossibility of learning from past mistakes.

John Kay, “Labour’s affair with bankers is to blame for this sorry state”, FT, April 24 2009: http://www.ft.com/cms/s/0/3f129b08-3104-11de-8196-00144feabdc0.html

538 Opinion

April 24, 2009 OP-ED COLUMNIST Reclaiming America’s Soul By PAUL KRUGMAN “Nothing will be gained by spending our time and energy laying blame for the past.” So declared President Obama, after his commendable decision to release the legal memos that his predecessor used to justify torture. Some people in the political and media establishments have echoed his position. We need to look forward, not backward, they say. No prosecutions, please; no investigations; we’re just too busy. And there are indeed immense challenges out there: an economic crisis, a health care crisis, an environmental crisis. Isn’t revisiting the abuses of the last eight years, no matter how bad they were, a luxury we can’t afford? No, it isn’t, because America is more than a collection of policies. We are, or at least we used to be, a nation of moral ideals. In the past, our government has sometimes done an imperfect job of upholding those ideals. But never before have our leaders so utterly betrayed everything our nation stands for. “This government does not torture people,” declared former President Bush, but it did, and all the world knows it. And the only way we can regain our moral compass, not just for the sake of our position in the world, but for the sake of our own national conscience, is to investigate how that happened, and, if necessary, to prosecute those responsible. What about the argument that investigating the Bush administration’s abuses will impede efforts to deal with the crises of today? Even if that were true — even if truth and justice came at a high price — that would arguably be a price we must pay: laws aren’t supposed to be enforced only when convenient. But is there any real reason to believe that the nation would pay a high price for accountability? For example, would investigating the crimes of the Bush era really divert time and energy needed elsewhere? Let’s be concrete: whose time and energy are we talking about? Tim Geithner, the Treasury secretary, wouldn’t be called away from his efforts to rescue the economy. Peter Orszag, the budget director, wouldn’t be called away from his efforts to reform health care. Steven Chu, the energy secretary, wouldn’t be called away from his efforts to limit climate change. Even the president needn’t, and indeed shouldn’t, be involved. All he would have to do is let the Justice Department do its job — which he’s supposed to do in any case — and not get in the way of any Congressional investigations. I don’t know about you, but I think America is capable of uncovering the truth and enforcing the law even while it goes about its other business. Still, you might argue — and many do — that revisiting the abuses of the Bush years would undermine the political consensus the president needs to pursue his agenda.

539 But the answer to that is, what political consensus? There are still, alas, a significant number of people in our political life who stand on the side of the torturers. But these are the same people who have been relentless in their efforts to block President Obama’s attempt to deal with our economic crisis and will be equally relentless in their opposition when he endeavors to deal with health care and climate change. The president cannot lose their good will, because they never offered any. That said, there are a lot of people in Washington who weren’t allied with the torturers but would nonetheless rather not revisit what happened in the Bush years. Some of them probably just don’t want an ugly scene; my guess is that the president, who clearly prefers visions of uplift to confrontation, is in that group. But the ugliness is already there, and pretending it isn’t won’t make it go away. Others, I suspect, would rather not revisit those years because they don’t want to be reminded of their own sins of omission. For the fact is that officials in the Bush administration instituted torture as a policy, misled the nation into a war they wanted to fight and, probably, tortured people in the attempt to extract “confessions” that would justify that war. And during the march to war, most of the political and media establishment looked the other way. It’s hard, then, not to be cynical when some of the people who should have spoken out against what was happening, but didn’t, now declare that we should forget the whole era — for the sake of the country, of course. Sorry, but what we really should do for the sake of the country is have investigations both of torture and of the march to war. These investigations should, where appropriate, be followed by prosecutions — not out of vindictiveness, but because this is a nation of laws. We need to do this for the sake of our future. For this isn’t about looking backward, it’s about looking forward — because it’s about reclaiming America’s soul.

April 22, 2009, 10:01 am Grand unified scandal From Jonathan Landay at McClatchy, one of the few reporters to get the story right during the march to war: The Bush administration put relentless pressure on interrogators to use harsh methods on detainees in part to find evidence of cooperation between al Qaida and the late Iraqi dictator Saddam Hussein’s regime, according to a former senior U.S. intelligence official and a former Army psychiatrist. Such information would’ve provided a foundation for one of former President George W. Bush’s main arguments for invading Iraq in 2003. No evidence has ever been found of operational ties between Osama bin Laden’s terrorist network and Saddam’s regime. The use of abusive interrogation — widely considered torture — as part of Bush’s quest for a rationale to invade Iraq came to light as the Senate issued a major report tracing the origin of the abuses and President Barack Obama opened the door to prosecuting former U.S. officials for approving them.

540 Let’s say this slowly: the Bush administration wanted to use 9/11 as a pretext to invade Iraq, even though Iraq had nothing to do with 9/11. So it tortured people to make them confess to the nonexistent link. There’s a word for this: it’s evil.

541 Economy

April 24, 2009 U.S. to Tell Big Banks the Results of Stress Test By ERIC DASH Wall Street is stressed out about stress tests. After a two-month wait, the nation’s 19 largest banks will start learning on Friday how they fared in important federal examinations — and which among them will need another bailout from the government or private investors. While many of the banks reported surprisingly strong first-quarter earnings, they are by no means out of the woods. A number of them are likely to need more capital to weather a prolonged recession, and the losses that might accompany it. The Federal Reserve intends to disclose, in general terms, how it conducted the stress tests on Friday afternoon, but the government will not publicly reveal the results until May 4. In between, Wall Street is bracing for a possible roller-coaster ride in financial stocks as investors scramble to do their own assessment of the financial industry’s strongest and the weakest players. “The headlines, not the details, seem to be driving the markets,” said Frederick Cannon, who is in charge of equity research at Keefe, Bruyette & Woods, a boutique investment bank. Analysts are already betting that the stress tests will show that banks need to raise significant amounts of new capital, as profits made in the first three months of the year give way to more losses, tied to credit card, commercial real estate and corporate loans. An assessment by Mr. Cannon’s firm, which calculated its own stress test for the industry, concluded Thursday that United States banks might need as much as an additional $1 trillion in capital. As part of their exam, regulators have been poring over bank balance sheets to spot financial problems that may not surface for months. Officials are assessing the financial condition of the banks based on their potential losses and earnings over the next two years. That is why some banks that recently announced blockbuster earnings may still need to raise sizable amounts of fresh money. As the dust settles from the shakeout on Wall Street, the 19 banks subject to stress tests are starting to divide into three groups: the strong that can weather the storm; the weak that will need new, perhaps significant, support; and the ones on the verge, whose fate will be decided by regulators. “Banks are starting to distance themselves from the pack,” said Gerard Cassidy, a longtime banking analyst at RBC Capital Markets. “The companies that pull away are going to be the companies that have the least amount of exposure to the riskiest areas, the strongest capital position and the best management teams.” Those poised to withstand potential worsening of the recession — with little or no new capital — include major banks like Goldman Sachs and Morgan Stanley, which already swallowed multibillion-dollar losses on toxic securities and cut dividends to shore up their financial position. Big custodial banks, like Bank of New York Mellon and the

542 State Street Corporation, which provide bookkeeping and securities lending to investment firms, also have probably put the bulk of their troubles behind them. A handful of well-run commercial banks are thought to be members of this group. JPMorgan Chase, for example, set aside several billion dollars from strong first-quarter profits in investment banking to protect against an onslaught of corporate and consumer loan losses. U.S. Bancorp of Minneapolis plans to rely on its fat lending margins and fee-generating businesses to weather the recession. At the other end of the spectrum are weaker banks, where ballooning losses threaten to overwhelm profits. Analysts say that some of these banks — including Bank of America and Citigroup, whose consumer and investment banking businesses have been pummeled — may need additional capital to shore up their finances. Although Bank of America announced a first-quarter profit that exceeded expectations, analysts say that rising loan losses across its portfolio may threaten its health. If so, the bank may be forced to convert part of the government’s investment into common stock, over the objections of its chief executive, Kenneth D. Lewis. Likewise, Citigroup’s credit card and consumer lending businesses are extremely vulnerable to a global downturn, although the bank still eked out a $1.6 billion first-quarter profit. In late February, it announced plans to convert a big part the government’s preferred shares into common stock to bolster its finances before its stress test. Even so, some analysts contend it still needs an additional stock infusion. And a number of regional banks are bracing for huge losses in their commercial loan books, making them strong candidates for needing additional money. Fifth Third Bank Ohio of Cincinnati has struggled to keep up with spiraling losses on corporate loan and real estate, the result of the worsening on its Rust Belt home turf and an ill-timed expansion into Florida. SunTrust Banks of Atlanta and Regions Financial of Alabama have been hard hit by the housing bust that has affected much of the Southeast, and their problems with commercial real estate and corporate loans have severely worsened. But Regions, for example, added a mere $34 million to its reserves for future loan losses, an amount analysts say may not be enough to cover a surge in its nonperforming loans. The rest of the lenders fit into a more uncertain category, where their need for capital depends on what federal officials decide. As unemployment rises, big credit card players like American Express and Capital One Financial are having a spike in the number of customers defaulting on their loans. But by reining in credit limits, and having set aside big pools of money to cushion the blow, they may end up better off than traditional bank lenders. Some large regional banks face a similar issue. BB&T Bank of North Carolina, PNC Financial of Pittsburgh, and Wells Fargo all posted surprisingly good first-quarter numbers, but some analysts have questioned their ability to cover future losses. Regulators are likely to make judgments on their capital needs. Correction: April 24, 2009 An earlier version of this article incorrectly included BlackRock, which is not believed to be under review.

543 Economy April 24, 2009 Bank Stocks Slid After Blogger Gave His ‘Scoop’ on Stress Tests By TIM ARANGO Harold C. Turner, an incendiary blogger and Internet radio host, would seem an unlikely market mover. But Mr. Turner, known as Hal, who has been labeled a white supremacist by some monitoring groups, once ran for Congress in New Jersey as a Republican and in 2005 supported an Aryan leader suspected of plotting the assassination of a federal judge in Chicago, apparently played a role in driving down bank stocks on Monday. Mr. Turner, writing on his Web site, the Turner Radio Network, claimed to have been leaked the results of stress tests the Treasury Department has been conducting on the nation’s banks. The results, which the federal government has promised to release on May 4, were troubling, according to Mr. Turner, who wrote Sunday night that “they are very bad.” Of the nation’s 19 top banks, 16, according to Mr. Turner, are “technically insolvent.” Andrew Williams, a spokesman for the Treasury, said, “There is no basis for that report. We do not even have the results yet.” But by the end of the day Monday, financial stocks in the Standard & Poor’s 500-stock index had fallen 11 percent. Individual stocks have often been sent reeling because of a fake press release or unfounded rumor. In September, United Airlines lost $1 billion in value when an old news item about bankruptcy resurfaced. But the broader sell-off in financial stocks after Mr. Turner’s report shows the velocity of news, true or not, in a market where jittery investors are wired to react quickly to information, positive or negative. Because Mr. Turner’s report seemed to be having an impact on the stock market, mainstream news organizations also took notice. A blog posting on the Web site of The Financial Times linked to it, which it called “something of a scoop,” while also describing Mr. Turner as a white supremacist. A second posting on The F.T.’s Web site said that Mr. Turner, who often writes about financial matters, was “widely derided as a racist crank.” Reuters and Bloomberg News wrote articles about the market reaction and the Treasury’s response, as did the DealBook blog of The New York Times. Meanwhile, investors were already fretting about the health of the country’s financial system, and bank stocks were falling. Many factors are to blame, but some traders said that Mr. Turner’s report fed in to already rampant fears about the banking system. “It really seemed that they did take it seriously, that this was a leak,” said Lou Brien, a market strategist at DRW Trading in Chicago, adding that the market had already taken a pessimistic view towards the outcome. “The story may have struck a chord with the market as regards to how the tests will look,” Mr. Brien said. “We reacted for about 20 minutes or a half hour.”

544 Mr. Turner, in an e-mail message Thursday, said, “My report was accurate.” He has declined to publish the actual documents he says were leaked. “I have the results,” he wrote in the message. “I will wait until the government releases whatever they release on or about May 4, then rebut the government ‘spin’ with facts.” Mr. Turner casts a long public shadow. In 2003 the Southern Poverty Law Center, which monitors hate groups, placed him on its list of prominent right-wing radicals, “a belligerent, foul-mouthed talk show host, Turner is the maestro of radio hate.” Referring to the report about the stress tests, Mark Potok, director of the intelligence project at the Southern Poverty Law Center, said, “People who bought in to this are real fools.”

April 21, 2009, 6:25 pm Vast majorities So the market was greatly reassured when Tim Geithner declared that the “vast majority” of banks are well capitalized. Count me as baffled. I mean, maybe he was actually giving us a hint about the stress tests — but I took it as a remark that was uninformative at best, ominous at worst. After all, there are a lot of banks in America. There are 1,722 institutions on the Fed’s list of “large commercial banks”. And I have no doubt that most of these banks — indeed, the vast majority — are in fine shape. That’s because they’re regional institutions that never got into the risky games played by the big guys. But the big guys are where the money is. The top 10 institutions on that list have 58 percent of the assets. (If we looked at bank holding companies rather than only commercial banks, assets would be even more concentrated.) So it’s perfectly possible that the “vast majority” of US banks are well-capitalized, but that banks with, say, a third of the system’s assets are insolvent. What Geithner said, then, was true but useless. If anything, his wording was cause for concern: Treasury knows the difference between raw numbers of banks and asset holdings, even if the press seemed to miss the distinction, and if he’d meant to say that the vast majority of assets are held by sound banks, he would have. Update: Brad DeLong had the same reaction: The failure to assure us that the vast majority of bank assets are in well- capitalized institutions seemed to me to speak volumes. Nobody ever thought that the vast majority of banks are not well capitalized–it’s the highly leveraged New York high flyers.

545 Economy

April 24, 2009 Plight of Carmakers Could Upset All Pension Plans By MARY WILLIAMS WALSH Decisions that the government will make soon on the future of General Motors and Chrysler could accelerate the decline of traditional pension plans, which have sheltered generations of workers from an impoverished old age. Pension experts predict that a government takeover of the two giant plans would spur other auto companies and all types of manufacturers to abandon such benefits for competitive reasons. For hundreds of thousands of retired auto workers, a federal pension takeover would mean sharply reduced benefits. For the federal agency that insures pensions, it would mean a logistical nightmare in the short term — and most likely a slow demise eventually as fewer and fewer small plans remain in the system and pay premiums. So far, the prospect of a grueling grind through bankruptcy court has been a major deterrent to companies that might want to rid themselves of pension obligations. But retirement and labor specialists are watching closely to see whether the administration’s auto task force will give either of the auto companies an easier way to shed their huge pension funds, blazing a simplified trail for others to follow. With or without a bankruptcy filing, the government is quietly making the preparations that would be needed to take over Chrysler’s pension plan, with its 255,000 participants, according to government officials. Even if Chrysler manages to strike a deal to sell many of its assets to Fiat, perhaps in conjunction with a bankruptcy filing, experts doubt Fiat will agree to take on its pension plan without extraordinary assistance. One possibility being considered is a cash infusion of $1 billion from Daimler, which previously owned Chrysler and had agreed to backstop a pension failure for several years. The future of General Motors’ pension plan is also unclear. G.M. has until June 1 to come up with an acceptable business plan. If it declares bankruptcy, it still may try to keep its pension plan afloat. G.M.’s plan for hourly workers, which covers 485,000 people, was in reasonably good shape until last fall’s market turmoil, and would not require cash contributions until 2013. If one or both of these plans collapse, the federal agency that insures pension benefits, the Pension Benefit Guaranty Corporation, will lose a big source of the premium revenue it collects from companies with pension funds. But more important, the demise of the bellwether auto plans might set a template for other companies seeking to cut costs and stay competitive. “If one of these companies solves its pension problem by shunting it off to the federal government, then for competitive reasons the others have to do the same thing,” said Zvi Bodie, a professor of finance at the Boston University School of

546 Management and longtime observer of the government’s pension insurance system. “That is the death spiral.” Though the automakers’ plans each have a gap between what they have on hand and what they owe their retirees over the years, if they failed, most of that shortfall would be made up by workers in the form of smaller benefits — not by the companies or the government. The government estimated that Chrysler’s plan was $9.3 billion short as of last November — but said it would be responsible for only about $2 billion of that. Most of the shortfall would be sliced from workers’ benefits. At G.M., the estimated shortfall was $20 billion as of last November, but the government would assume $4 billion of obligations and G.M.’s workers would lose the rest. When Daimler sold a majority stake in Chrysler in 2007 to a private equity firm, Cerberus, it promised to pay $1 billion into the government’s pension insurance program if the pension plan failed within five years. The Treasury could try to persuade Daimler to put some of that money into the plan to avoid a failure. For years, traditional pensions — those that shield workers from market risk — have been in a slow decline, with troubled sectors like aviation and steel shedding their plans in bankruptcy court as new types of individually managed benefits like 401(k) plans have taken hold. But big sectors, particularly manufacturing and financial services, have clung to the old plans. The Pension Rights Center, a consumer group in Washington, estimates that 18 million Americans are still building up such benefits every year, and millions more retirees are receiving guaranteed payments from their former employers. “Those that are fortunate enough to have those plans are sleeping soundly,” said Karen Ferguson, director of the center. The loss of the auto pensions would be devastating partly because Detroit sustains many other businesses and partly because of their history. It was the United Automobile Workers union, more than any other force, that pushed Congress to enact laws forcing companies to put money behind their pension promises and creating the federal guarantor. The failure of a major auto workers plan would be a blow to the whole system. Not only would Ford have reason to opt out of the expense of maintaining a pension plan, but so would Toyota and Honda, which also have pension plans at their American plants, said Teresa Ghilarducci, a professor of economics at the New School for Social Research and former member of the P.B.G.C.’s advisory board. Professor Ghilarducci said she believed the Obama White House had selected people for its auto task force who understood these stakes, and would strive to find some middle ground. The pension insurance agency, currently operating with an $11 billion deficit, has long viewed the automakers’ plans with anxiety, though its officials declined to discuss the situation. G.M.’s plan alone is bigger than the guarantor. The agency has roughly $67 billion in assets to cover the benefits of nearly 4,000 failed pension plans; G.M. has $84 billion in trust just to cover promises to its own workers. In a failure of that size, the agency’s immediate challenge would be logistical, not financial. Its insurance covers a simple benefit, not the much richer pensions negotiated

547 over the years by the U.A.W. It would have to process applications from thousands and thousands of workers, most of whom would get the bad news that they were going to get less than promised. The government’s maximum benefit is $42,660, but coverage falls off rapidly for workers who are younger when their plan fails. For a 55-year-old, the maximum is only $24,300. Calculating which workers would bear how much of the losses would be fiendishly complex. The government’s rules favor older participants and contain tripwires and arbitrary cutoffs that can leave similar workers with sharply different benefits. None of this can be sorted out in advance, because the calculations also depend on the amount of money in a pension fund on the day it terminates — something the pension benefits corporation does not yet know. Some pension specialists, aware of these difficulties, are hoping the Obama administration’s auto task force will spare at least the G.M. pension fund. Not only would that let laid off workers keep receiving full benefits, but it could also break the death spiral among other plans. For traditional pension plans, “maybe this is their last stand,” said Jeffrey B. Cohen, a partner with the law firm Ivins, Phillips & Barker in Washington who was chief counsel for the Pension Benefit Guaranty Corporation from 2005 to 2007. If the automakers’ plans fail, he added, “the biggest domino will have fallen for the P.B.G.C.”

548 Business

April 24, 2009 Tracking Loans Through a Firm That Holds Millions By MIKE McINTIRE Judge Walt Logan had seen enough. As a county judge in Florida, he had 28 cases pending in which an entity called MERS wanted to foreclose on homeowners even though it had never lent them any money. MERS, a tiny data-management company, claimed the right to foreclose, but would not explain how it came to possess the mortgage notes originally issued by banks. Judge Logan summoned a MERS lawyer to the Pinellas County courthouse and insisted that that fundamental question be answered before he permitted the drastic step of seizing someone’s home.

“You don’t think that’s reasonable?” the judge asked. “I don’t,” the lawyer replied. “And in fact, not only do I think it’s not reasonable, often that’s going to be impossible.” Judge Logan had entered the murky realm of MERS. Although the average person has never heard of it, MERS — short for Mortgage Electronic Registration Systems — holds 60 million mortgages on American homes, through a legal maneuver that has saved banks more than $1 billion over the last decade but made life maddeningly difficult for some troubled homeowners.

549 Created by lenders seeking to save millions of dollars on paperwork and public recording fees every time a loan changes hands, MERS is a confidential computer registry for trading mortgage loans. From an office in the Washington suburbs, it played an integral, if unsung, role in the proliferation of mortgage-backed securities that fueled the housing boom. But with the collapse of the housing market, the name of MERS has been popping up on foreclosure notices and on court dockets across the country, raising many questions about the way this controversial but legal process obscures the tortuous paths of mortgage ownership. If MERS began as a convenience, it has, in effect, become a corporate cloak: no matter how many times a mortgage is bundled, sliced up or resold, the public record often begins and ends with MERS. In the last few years, banks have initiated tens of thousands of foreclosures in the name of MERS — about 13,000 in the New York region alone since 2005 — confounding homeowners seeking relief directly from lenders and judges trying to help borrowers untangle loan ownership. What is more, the way MERS obscures loan ownership makes it difficult for communities to identify predatory lenders whose practices led to the high foreclosure rates that have blighted some neighborhoods. In Brooklyn, an elderly homeowner pursuing fraud claims had to go to court to learn the identity of the bank holding his mortgage note, which was concealed in the MERS system. In distressed neighborhoods of Atlanta, where MERS appeared as the most frequent filer of foreclosures, advocates wanting to engage lenders “face a challenge even finding someone with whom to begin the conversation,” according to a reportby NeighborWorks America, a community development group. To a number of critics, MERS has served to cushion banks from the fallout of their reckless lending practices. “I’m convinced that part of the scheme here is to exhaust the resources of consumers and their advocates,” said Marie McDonnell, a mortgage analyst in Orleans, Mass., who is a consultant for lawyers suing lenders. “This system removes transparency over what’s happening to these mortgage obligations and sows confusion, which can only benefit the banks.” A recent visitor to the MERS offices in Reston, Va., found the receptionist answering a telephone call from a befuddled borrower: “I’m sorry, ma’am, we can’t help you with your loan.” MERS officials say they frequently get such calls, and they offer a phone line and Web page where homeowners can look up the actual servicer of their mortgage. In an interview, the president of MERS, R. K. Arnold, said that his company had benefited not only banks, but also millions of borrowers who could not have obtained loans without the money-saving efficiencies it brought to the mortgage trade. He said that far from posing a hurdle for homeowners, MERS had helped reduce mortgage fraud and imposed order on a sprawling industry where, in the past, lenders might have gone out of business and left no contact information for borrowers seeking assistance. “We’re not this big bad animal,” Mr. Arnold said. “This crisis that we’ve had in the mortgage business would have been a lot worse without MERS.” About 3,000 financial services firms pay annual fees for access to MERS, which has 44 employees and is owned by two dozen of the nation’s largest lenders, including Citigroup, JPMorgan Chase and Wells Fargo. It was the brainchild of the Mortgage Bankers Association, along with Fannie Mae, Freddie Mac and Ginnie Mae, the

550 mortgage finance giants, who produced a white paper in 1993 on the need to modernize the trading of mortgages. At the time, the secondary market was gaining momentum, and Wall Street banks and institutional investors were making millions of dollars from the creative bundling and reselling of loans. But unlike common stocks, whose ownership has traditionally been hidden, mortgage-backed securities are based on loans whose details were long available in public land records kept by county clerks, who collect fees for each filing. The “tyranny of these forms,” the white paper said, was costing the industry $164 million a year. “Before MERS,” said John A. Courson, president of the Mortgage Bankers Association, “the problem was that every time those documents or a file changed hands, you had to file a paper assignment, and that becomes terribly debilitating.” Although several courts have raised questions over the years about the secrecy afforded mortgage owners by MERS, the legality has ultimately been upheld. The issue has surfaced again because so many homeowners facing foreclosure are dealing with MERS. Advocates for borrowers complain that the system’s secrecy makes it impossible to seek help from the unidentified investors who own their loans. Avi Shenkar, whose company, the GMA Modification Corporation in North Miami Beach, Fla., helps homeowners renegotiate mortgages, said loan servicers frequently argued that “investor guidelines” prevented them from modifying loan terms. “But when you ask what those guidelines are, or who the investor is so you can talk to them directly, you can’t find out,” he said. MERS has considered making information about secondary ownership of mortgages available to borrowers, Mr. Arnold said, but he expressed doubts that it would be useful. Banks appoint a servicer to manage individual mortgages so “investors are not in the business of dealing with borrowers,” he said. “It seems like anything that bypasses the servicer is counterproductive,” he added. When foreclosures do occur, MERS becomes responsible for initiating them as the mortgage holder of record. But because MERS occupies that role in name only, the bank actually servicing the loan deputizes its employees to act for MERS and has its lawyers file foreclosures in the name of MERS. The potential for confusion is multiplied when the high-tech MERS system collides with the paper-driven foreclosure process. Banks using MERS to consummate mortgage trades with “electronic handshakes” must later prove their legal standing to foreclose. But without the chain of title that MERS removed from the public record, banks sometimes recreate paper assignments long after the fact or try to replace mortgage notes lost in the securitization process. This maneuvering has been attacked by judges, who say it reflects a cavalier attitude toward legal safeguards for property owners, and exploited by borrowers hoping to delay foreclosure. Judge Logan in Florida, among the first to raise questions about the role of MERS, stopped accepting MERS foreclosures in 2005 after his colloquy with the company lawyer. MERS appealed and won two years later, although it has asked banks not to foreclose in its name in Florida because of lingering concerns. Last February, a State Supreme Court justice in Brooklyn, Arthur M. Schack, rejected a foreclosure based on a document in which a Bank of New York executive identified

551 herself as a vice president of MERS. Calling her “a milliner’s delight by virtue of the number of hats she wears,” Judge Schack wondered if the banker was “engaged in a subterfuge.” In Seattle, Ms. McDonnell has raised similar questions about bankers with dual identities and sloppily prepared documents, helping to delay foreclosure on the home of Darlene and Robert Blendheim, whose subprime lender went out of business and left a confusing paper trail. “I had never heard of MERS until this happened,” Mrs. Blendheim said. “It became an issue with us, because the bank didn’t have the paperwork to prove they owned the mortgage and basically recreated what they needed.” The avalanche of foreclosures — three million last year, up 81 percent from 2007 — has also caused unforeseen problems for the people who run MERS, who take obvious pride in their unheralded role as a fulcrum of the American mortgage industry. In Delaware, MERS is facing a class-action lawsuit by homeowners who contend it should be held accountable for fraudulent fees charged by banks that foreclose in MERS’s name. Sometimes, banks have held title to foreclosed homes in the name of MERS, rather than their own. When local officials call and complain about vacant properties falling into disrepair, MERS tries to track down the lender for them, and has also created a registry to locate property managers responsible for foreclosed homes. “But at the end of the day,” said Mr. Arnold, president of MERS, “if that lawn is not getting mowed and we cannot find the party who’s responsible for that, I have to get out there and mow that lawn.”

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Credit Card Reforms Pressed by Obama By Michael A. Fletcher and Nancy Trejos Washington Post Staff Writers Friday, April 24, 2009 President Obama met with executives from 13 of the nation's largest credit card issuers at the White House yesterday and pressed them to curb excessive fees and provide consumers with more straightforward contracts. Obama told the executives that he supports pending legislation to stamp out unfair practices, such as raising interest rates on outstanding balances even when consumers have paid their bills on time. "I think that there has to be strong and reliable protections for consumers -- protections that ban unfair rate increases and forbid abusive fees and penalties," Obama said after the meeting. "The days of anytime, any reason rate hikes and late fee traps have to end." Obama said plain language should be used in complicated credit card statements. "No more fine print, no more confusing terms and conditions," he said. "We want clarity and transparency from here on out." The meeting came as anger grows against credit card companies, whose practices have come under intense scrutiny by consumers and legislators. At the same time, the companies have been hit by fast-rising default rates, which have strapped their businesses and, the companies say, have made it harder for them to extend credit at favorable rates. Obama has been calling for tougher regulation of credit card lending since his days in the Senate. Yesterday's meeting is part of the White House's efforts to press middle-class issues with top financial executives. Several weeks ago, he met with banking executives, telling them to rein in bonuses and other extravagances. At yesterday's session, Obama cited letters he has received from Americans complaining about sudden changes in their credit card terms. "He often gets letters from people that discuss their credit card rate increasing overnight, their bill date changing, their being charged enormous fees, and then interest on top of those fees," White House press secretary Robert Gibbs said. White House officials said that while the meeting was cordial, industry officials told the president that pending Federal Reserve rules go far enough to protect consumers. The president disagreed. The executives also told Obama of the challenges they face, including raising money through securitization of their loans. "It was a meeting where the president was very frank in talking to the execs, that he had concerns about some of the practices the industry has been engaged in," said Edward L. Yingling, president and chief executive of American Bankers Association, who attended the meeting. "But at the same time . . . he recognizes the importance of the industry, and both sides indicated that they needed to work together, to work through this and move on." Other industry officials also struck a conciliatory tone.

553 "We are pleased and supportive of the president's message of increasing disclosures and consumer protection as well as recognizing the importance of credit cards as an important source of funding," said Scott Talbott, senior vice president at the Financial Services Roundtable, which represents large financial institutions. The Federal Reserve in December passed new rules that would ban such practices as raising interest rates on existing balances except under certain circumstances, assessing late fees if the borrower was not given 21 days to make a payment and applying payments over the minimum in a way that maximized interest charges. While the changes were sweeping, consumer advocates said they fell short because the card companies are not required to comply until July 1, 2010. Earlier this week, the House Financial Services Committee passed a Credit Cardholders' Bill of Rights that would codify the Fed's regulations. The measure is expected to reach the floor next week. The Senate is considering a stronger measure, which would prohibit companies from charging more than one over-limit fee per billing period, charge interest on fees, charge a fee to make a payment and raise interest rates at anytime for any reason. The bill would also limit aggressive marketing by card issuers to borrowers under 21. Obama told the credit card officials that he generally backs legislative action and that his administration would work with Congress to see that it becomes law. Asked whether there has to be a balance between protecting consumers and allowing credit companies to make money, Obama was quick to respond. "We think that it's been out of balance," he said. "And so we think we need to create a new equilibrium where credit is flowing, those who are issuing credit are able to make a reasonable profit -- but they're doing so in a way that is responsible and consumers are not finding themselves in a bad situation that they didn't anticipate."

554

24.04.2009 Is Fiat buying Chrysler or Opel or both?

It Sole 24 ore thinks Fiat could buy both, through a gradual built-up of a 51% stake in Chrysler in addition to buying GM’s European interests. Fiat’s chief Sergio Marchionne said Fiat could bring new technologies to Chrysler, but he was more circumspect on Opel. German media reported yesterday that GM and the German government were leaning in favour of a deal with Fiat – which is furiously opposed by German trade unions and workers’ representatives, as such an alliance could give rise to large-scale job losses. Those reports suggest that an Opel deal wiill end Fiat’s talks with Chrysler, which would face bankruptcy without a deal. (But in any case, it looks like the transatlantic car production capacity will be significantly reduced as a result of this extraordinary triage of deals).

A commentary in Frankfurter Allgemeine says Fiat might be an interesting choice for Opel, and Fiat might even be in a position to challenge VW and Toyota as global market leaders. But there should be no illusion about jobs. Such a merger will lead to thousands of job losses.

EU Commission favours caps on bonuses and golden parachutes The FT has the story that the European Commission is planning to issue a recommendation that member states should implement guidelines to limit bonus payments, allowing banks and companies to withhold bonus payments if performance criteria are not met. Furthermore, golden parachutes should be capped to two years of the fixed salary. There shall also be restrictions on the exercise of stock options.

555 Germany economics institutes favour British bank rescue model Germany’s economics institutes are calling on the German government to speed up efforts to fix the banking system, and in particular to introduce forced recapitalisation for institutions that do not meet stress test requirements. The plan currently considered by the German government consists of voluntary recapitalisation, as a result of which only some financial institutions will be covered, while most will continue to languish with insufficient capital ratios. According to FT Deutschland, the institutes favour the British model, which includes the possibility of nationalisation.

And here is what they are forecasting for the economy The institutes have also forecast a 6% decline in GDP this year, and a further decline in 2010. Here is the graph showing the further development. The line represents the quarter on quarter growth rates, and there is no recovery in sight even in 2010, during which growth will effectively stagnate.

Juppé ready to scrap tax limit for high income earners Former prime minister Alain Juppé signaled in an interview with Les Echos that one of the first measures of Sarkozy’s government, the limit of total taxes at 50% of income, is no longer sacrosanct to the French right. The tax limit was one of the key campaign promises of Sarkozy. Juppé said that it was right to introduce it in 2007, but that in the context of the crisis this measure is no longer explicable.

Brad Setser on global imbalances Brad Setser notes that global imbalances essentially boil down to US-China imbalances if one, as one should, aggregate European balances, which result in a small current

556 account deficit. Add to the US deficit, this offsets China’s surplus. Setser suspects, based on the latest IMF data, that China’s surplus will likely to remain high, as public investments replace private investments, and as falling commodity prices offset a fall in exports. Here is his chart on imbalances.

An Irish dispute about nationalisation Writing in the Irish Economy blog, Karl Whelan is critical of a statement by Alan Ahearne, now a special adviser to the Irish finance ministry, in which Ahearne argued against nationalisation. Ahearne’s argument is that nationalisation is not a good idea for Irish banks in particular, as they are dependent on international funds. Whelan makes the point that the debt of Irish banks was already guaranteed by the government, and so it should not make any difference from a funding viewpoint whether the bank is private or state-owned.

China’s dollar trap and what European history tells us about such a situation A very useful lesson in economic history was presented by Olivier Accominotti in Vox, who noted that China’s “dollar trap” has many analysts worried about its future resolution. His article discusses a similar situation in the in the 1920s when France held more than half the world’s foreign reserves. France’s “sterling trap” ended disastrously. Sterling suffered a major currency crisis, French authorities lost a lot of money, and subsequent policy reactions deepened the Great Depression.

557

Are Americans becoming European? The answer is, of course, not, but getting closer. Alberto Alesina and Paola Giuliano, writing in Vox, argue that the crisis may be a turning point towards more government intervention and redistribution in the US. More and more Americans believe that hard work is insufficient to climb the income ladder and are expressing anger against “unfairly” accumulated wealth. Politicians should prefer wise policies but may be tempted by populist outbursts.

How to sell a 10% cut in living standards Brendan Keenan in the Irish Independent says that the Irish government should get the grip on the fact that it has "to sell the people the idea that they must give up at least 10% of their living standards; and burden the next generation with as yet unknown debt; and that it is all in their own interests." The government must move now to counteract rising perception of injustice among ordinary people. This also means higher contributions for those who benefited throughout the fat years, and a removal of the bank management for a clean start with the government as majority shareholder.

Buiter on Weber versus the Commission Willem Buiter sides with Neelie Kroes in this dispute. He agrees with Charles Goodhart frequently quoted dictum that “banks are international in life, but national in death”, and concludes that banking in Europe is a complete mess. No bank is safe. It needs to be backed by the unholy trinity of the central bank, the treasury, and the supervisory authority, and the last two happen to be national. There is no single market for banking in Europe.

Wolf on what Germany has to do with the UK’s fiscal mess Martin Wolf looks behind the news that the UK is going to have a 12% budget deficit for two years running. He starts off by observing that the UK has the worst deterioration in the deficit, while Germany and Japan suffer the worst deterioration in economic growth. This is not surprising. If private demand in the US and the UK collapses, then either the current account deficit or the fiscal balance deteriorate in an offsetting direction. In the UK, the fiscal balance took the adjustment. In the surplus countries, exports take the hit – as they are faced with falling private-sector demand from abroad. So Britian’s deficit is consistent with Germany’s and Japan’s export crisis.

558 24.04.2009 “Catastrophic to Awful!” - The Banking Spin Cycle By: Satyajit Das

The recent rally in equity markets - the largest for decades - was predicated, in part, on the improving fortune of banks. Banks reported better than expected profits. U.S. banks seem likely to pass the “stress” test. Repayment of taxpayers’ funds by some institutions, at least, seemed imminent. Scrutiny suggests that the episode reflected Adlai Stevenson’s logic: “These are conclusions on which I base my facts.” Banks beat “well managed” low-ball expectations. In the last quarter of 2008, publicly traded banks lost $52 billion. Despite a return to profitability for some institutions, in the first quarter of 2009, banks are still expected to lose around $34 billion. For example, UBS and Morgan Stanley recorded losses. The quality of earnings was questionable. Core businesses declined by 20-30%. Trading revenues, especially fixed income, rose sharply at most big banks reflecting high volumes of bond issuance, especially investment grade corporate issues and government guaranteed bank debt. Corporate issuance was the result of the continued tightening in credit availability as banks reduced balance sheet. The issuance of government guaranteed bank debt provided underwriters with a “double subsidy” - the government guaranteed the debt but then allowed the banks to earn generous fees from underwriting government guaranteed debt. High volatility generated strong trading revenues. Key factors were increased client flows and increases in bid-offer spreads (by up to 300% in some products). High trading revenues also reflect principal position taking and trading. It will be interesting to see if trading revenues are sustainable. Questions remain about the impact of payments by AIG to major banks including Goldman Sachs ($12.9 billion), Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion) and Wachovia ($1.5 billion). Non U.S. banks also received substantial payments including Société Générale ($12 billion), Deutsche Bank ($12 billion), Barclays ($8.5 billion) and UBS ($5 billion). Conspiracy theories notwithstanding, it seems likely that these were collateral amounts due to the counterparty or settlement of positions that were terminated. At a minimum, the banks benefited from a one-off increase in trading volume and also larger than normal bid-offer spreads on these closeouts reflecting the distressed condition of AIG.

559 The banks also benefited from revaluing their own debt where credit spread widened. The theory is that the bank could currently purchase the debt at a value lower than face values and retire them to recognise the gain. Unfortunately, banks are not in position to realise this “paper” gain and ultimately if the debt is repaid at maturity then the “gain” disappears. If you are confused, then revaluation of issued debt worked differently at Morgan Stanley. The bank would have been profitable without a $1.5 billion accounting charge caused by an increase in the price of its debt from lower credit spreads. Earning were also helped by a series of one-off factors. Bank of America realised a large gain on the sale of its stake in China Construction Bank and also revalued some acquired assets as part of the closing of its Merrill Lynch acquisition. Goldman Sachs changed it balance date reporting results to the end of March rather than February. Given that its last financials were for the year to the end of November 2008, Goldman separately reported a loss for December 2008. It is not clear how much Goldman Sachs profit benefited from the change in the reporting dates. Effects of the change in mark-to-market accounting standards are also not clear. New guidance permits banks to exclude losses deemed “temporary” and also allows significant subjectivity in valuing positions. This may improve the financial position and overstate both earnings and capital. Some commentators believe that the changes could increase earnings by up to 10 to 15% and capital by up to 20%. The market ignored continuing increases in bad debts and provisions. After all “that’s so yesterday!” Further losses are likely in consumer lending (e.g. mortgages, credit cards and auto loans), corporate and commercial lending. In recent years, it has become an article of accepted faith that corporate debt levels have fallen. In aggregate, that is perfectly true. However, the debt has become concentrated in a number of sectors - commercial property, merger financing, private equity/ leveraged finance and infrastructure and resource financing. The overall quality of debt has deteriorated significantly. In 2008, over 70% of all rated debt were non-investment grade (“junk”). This is an increase from less than 30% in 1980 and around 50% in 1990. The debt is also heavily reliant on collateral; the loans are secured against financial assets (shares and property). Reduced ability to service the debt and falling collateral values may prove problematic. For example, the recent distressed sale of the John Hancock Tower produced around 50% of the value paid a few years earlier. In April 2009, the International Monetary Fund (“IMF”) estimated that banks and other financial institutions face aggregate losses of $4.1 trillion, an increase from $2.2 trillion in January 2009 and $1.4 trillion in October 2009. Around $2.7 trillion of the losses are expected to be borne by banks. The IMF estimated that in the United States banks had reported $510 billion in write-downs to date and face additional write downs of $550 billion. Euro zone banks had reported $154 billion in write-downs face a further $750 billion in losses. British banks had written down $110 billion and face an additional $200 billion in write offs. Banks may not be properly provisioned for these further write-downs. Recent accounting standards made it difficult for banks to dynamically provision whereby banks provided in low loss years for any eventual increase in loans losses when the economic cycle turns. Criticisms regarding income smoothing led to this practice

560 being discontinued. Increasing bad debt will flow directly into bank earnings as credit losses increase as the real economy slows. The stress tests do not provide comfort regarding the health of the banks. As Nouriel Roubini, Chairperson of RGE Monitor, has pointed out the likely macro- economic environment is likely to be significantly worse than the adverse scenarios used. Given that the test is to be the basis for setting solvency capital requirements, this is hardly reassuring or a guarantee that further taxpayer funded recapitilisation of the banking system is not going to be needed. The proposal floated by some banks to return taxpayer capital misses an essential point. The banks did not offer to waive the government/ FDIC guarantees, which have allowed them to fund in the capital markets. The suspicion is that the proposal had more to do with avoiding close public scrutiny of compensation and hiring practices. Goldman’s compensation costs increased 18% in the first Quarter while employee numbers were down around 7% translating into a 27% increase in employee costs. The reality is that the global economic system is de-leveraging and levels of debt must be reduced. As result, asset values are declining and sustainable growth levels have fallen significantly. In this environment, banks are likely to continue to suffer losses on assets (bad debts and further write offs) and earnings will remain sluggish (lower loan demand and lower levels of financial transactions). Higher funding costs and the need to raise capital compound the difficulties. For the banks currently: “On the liability side, some things aren’t right and on the asset side, nothing’s left.” Many major global bank shares are still, on average, trading at levels 70%-90% below their highs. Following the collapse of the “bubble” economy, Japanese banks staged a number of significant recoveries in share price before falling sharply necessitating government intervention to recapitalise and consolidate the banking system. Analysis of recent financial performance does not also take into account the underlying favourable current dynamics of the banking industry. Banks are currently beneficiaries of very low and, in some cases, zero cost of deposits. Banks also benefit from a sharply upward sloping that allows them to generate significant earnings from borrowing short and lending long. Banks have also benefited from subsidies and support from governments. They have also benefited from favourable changes in the fair value accounting treatment of securities. Banks have also benefited from sharply lower competition in most market segments. Adjusting for these factors, it is surprising that banks haven’t actually performed better. The truth is that bank remain in the ICU (intensive care unit). Even after around $900 billion in new capital, the global banking system remains short of capital by around $1-2 trillion. This translates into an effective reduction in available credit of around 20-30% from previous levels. Bank earnings and balance sheets remain under pressure. The financial system will need continued government support for some time to come. The performance of governments trying to rehabilitate the financial system has been problematic.

561 In April 2009, Elizabeth Warren, Chairperson of the TARP Oversight Panel Report questioned the very approach to resolving the problems of the financial system: “Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury’s [PPIP] approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from non-functioning markets for troubled assets. On the other hand, it is possible that Treasury’s approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth.” Richard Neiman (New York State Superintendent of Banks) and John Sununu (former New Hampshire Senator), two other panel members, issued dissenting findings noting: “We are concerned that the prominence of alternate approaches presented in the report, particularly reorganization through nationalization, could incorrectly imply both that the banking system is insolvent and that the new administration does not have a workable plan.” Constant changes in tack in the dealing with financial system problems do not suggest a consistent and well thought out strategy in dealing with the problem. Less than rigorous stress tests, using the PPIP to leverage FDIC funding into a lopsided subsidy for private investors or converting the preferred stock into shares to avoid having to seek additional congressional mandates also suggest political constraints in resolving the issues. Mancur Olson, the political economist, in his books (The Logic of Collective Action and The Rise and Decline of Nations), speculated that small distributional coalitions tend to form over time in developed nations and influence policies in their favour through intensive, well-funded lobbying. The policies result in benefits for the coalitions and its members but large costs borne by the rest of population. Over time, the incentive structure means that more distributional coalitions accumulate burdening and ultimately paralysing the economic system causing inevitable and irretrievable economic decline. Government attempts to deal with the problems of the financial system, especially in the US, Great Britain and other countries, illustrates Olson’s thesis. Active well funded lobbying efforts and “regulatory capture” is impeding necessary actions to make needed changes in the financial system. Urgent steps are necessary to accurately recognise losses on assets, remove toxic assets from balance sheets, recapitalise the banks and allow normal financial transactions to resume. If such actions are not taken then the broader economy and sustainable growth levels will be adversely affected. The solvency risk of major banks is now primarily a question of whether the sovereign can afford to and will support the institution. However, the health of the global financial system remains fragile. Banks have gone from catastrophic to just awful. By most standards, that condition does not constitute a necessary and sufficient condition for a recovery in the global economy. © 2009 Satyajit Das All Rights reserved. Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives> (2006, FT-Prentice Hall).

562 vox Research-based policy analysis and commentary from leading economists Methods to identify systemic financial risks

Brenda González-Hermosillo, Christian Capuano, Dale Gray, Heiko Hesse, Andreas Jobst, Paul Mills, Miguel Segoviano, Tao Sun 23 April 2009 http://www.voxeu.org/index.php?q=node/3495

As the recent G20 Communiqué emphasised, further progress is needed to identify and address systemic risks. This column summarises some of the research in the IMF’s latest Global Financial Stability Report aimed at identifying and measuring systemic events. Systemic events are intrinsically difficult to anticipate, though once they have occurred it is easier to look back and agree that a disruption was, in fact, systemic. Because of the severity and reach of the current crisis, renewed attention on what constitutes a systemic crisis and whether it can be uncovered, early or even concurrently, has come to the fore. The task of identifying warnings of impending systemic crises has become increasingly complex as global financial markets have become highly integrated and hence systemic shocks can cross national borders. Policymakers want to know when problems in financial institutions, and markets more broadly, are likely to become “systemic.” Being able to identify systemic events at an early stage enhances policymakers’ ability to take necessary (and perhaps exceptional) steps to contain the crisis. Similarly, being able to detect when those pressures may be easing would help to determine when to initiate exit strategies. Given that there are many facets and causes of systemic risks, the third chapter of the IMF’s recent Global Financial Stability Report present a range of measures to discern when events become systemic. Other recent influential work on systemic risk includes Acharya and Richardson (2009) and Brunnermeier et al (2009). Methodologies and key findings Firstly, the chapter reviews the basic information typically used to identify a financial institution’s vulnerability. These standard “financial soundness indicators” are examined to see if they could identify which financial institutions proved vulnerable in the current crisis. For the sample of global financial institutions examined, leverage ratios and return on assets proved the most reliable indicators, while risk-weighted capital-asset ratios and non-performing loan data lacked predictive power. In the current crisis, key vulnerabilities went unanticipated due to off-balance sheet exposures and lenders’ dependence on wholesale funding. Indeed, many “failed” institutions still met regulatory minimum capital requirements. While financial soundness indicators can still be helpful in assessing individual vulnerabilities when reliable market data may not be available – particularly in less developed financial markets – they should be complemented by other measures and systemic stress tests and broadened to better capture off-balance sheet exposures and liquidity mismatches. Secondly, several techniques also analyse (high-frequency) forward-looking market

563 data for groups of financial institutions in order to detect whether and when systemic risks became apparent. Starting from a simple correlation and cluster analysis, market-based measures are then calculated to capture joint tail risks – the risk that multiple financial institutions become distressed simultaneously – which seem to have given prior indications of impending stress for the overall financial system. Specifically, some of the more advanced tools examined include: • Contingent Claims Analysis (CCA): This approach explicitly accounts for the inherent uncertainty in the value of assets, and links the market value of equity, assets, and debt in an integrated way. This approach permits the estimation of asset values and asset volatility (that are otherwise not directly observable), which are used to provide an equity market-based assessment of default risk (see Gray and Malone, 2008). • The option-implied probability of default (option iPoD): This approaches uses equity option prices to infer default probabilities on individual financial institutions, with the advantage that determining when the institution goes into default (the default barrier) is also derived within the model in line with the observation that the value of debt moves with market conditions (see Capuano, 2008). • Multivariate Dependence and Equity Options: Equity option information is used to calculate tail-risk indicators for individual institutions as well as between institutions. These tail risks encompass both the skewness and the kurtosis and thus adjust to stressful conditions (see Gray and Jobst, 2009). • Joint of probability of defaults, distress dependence and cascade effects: Based on credit default swap prices, joint probabilities of distress and then a matrix of (pairwise) distress dependencies are estimated. The probability of cascade effects whereby the distress of a particular financial institution affects another is also calculated (see Segoviano, 2006; Segoviano and Goodhart, 2009). Regime-switching techniques are then employed to examine the different states of the multivariate stability indicators (see Hesse and Segoviano, 2009). Thirdly, proxies for “market conditions,” such as variables used to measure investors’ risk appetite, that influence (and reflect) the risks facing financial institutions are also examined to capture the bigger picture of system-wide stress (see González-Hermosillo, 2008). The signalling capacity of these indicators is explored by observing whether and when they move from low, to medium, and to high volatility “states,” with the high state associated with systemic crisis (see González- Hermosillo and Hesse, 2009, and summarised on Vox). Several measures suggest that letting Lehman Brothers collapse on 15 September 2008 aggravated what appeared to be a global systemic financial crisis already in the making. The various techniques used in the chapter clearly identify major stress events, such as those associated with the assisted merger of Bear Stearns and JPMorgan in March 2008, as well as the failure of Lehman Brothers a few months later, as systemic. Some indicators, as early as February 2007, also signalled rising systemic pressures. However, advance notice of systemic stress using market-based data can be relatively brief at times. Policy implications and conclusion

564 The analysis presented could help calibrate the marginal contribution of a financial institution to systemic risk conditional on the state of global markets (as reflected in, for example, the level of global liquidity and interest rates, the degree of volatility and uncertainty in capital markets, and the general price of risk). The tools presented in the chapter could be useful to financial regulators as the basis for additional regulatory measures to encourage behaviour that mitigates systemic risk. In particular, macro-prudential regulation should aim to require institutions to enhance their stress tests and hold additional capital to take account of the build-up of systemic risk and their contribution to it. Since the practical utility of measures to identify systemic risk depends on their ability to reliably predict stress events, which may only become apparent concurrently in some cases, policymakers should monitor a wide range of market indicators tuned to systemic risk and combine these indicators with more thorough information from financial institutions. More public information on key data, especially on off-balance derivative exposures and measures of market liquidity, is needed. Due to the difficulties in predicting systemic events, policy makers should develop comprehensive contingency plans that can be implemented quickly if needed. Having such a scheme in place may help diminish uncertainty, which is often a key factor in the transition of a “contained” financial crisis to one that is systemic. Note: The views expressed in this article are those of the authors and should not be attributed to the IMF, its Executive Board, or its management. Any errors are the responsibility of the authors. References Acharya, Viral and Matthew Richardson (eds). Restoring Financial Stability: How to Repair a Failed System, Wiley, March 2009. Brunnermeier, Markus, Andrew Crockett, Charles Goodhart, Avi Persaud, and Hyun Shin, 2009, “The Fundamental Principles of Financial Regulation,” Geneva Reports on the World Economy 11. Capuano Christian, 2008. “The option-iPoD. The Probability of Default Implied by Option Prices Based on Entropy,” IMF Working Paper 08/194 (Washington: International Monetary Fund). González-Hermosillo, Brenda (2008), “Investors’ Risk Appetite and Global Financial Market Conditions,” IMF Working Paper 08/85 (Washington: International Monetary Fund). González-Hermosillo, Brenda and Heiko Hesse, 2009 (forthcoming), “Global Market Conditions and Systemic Risk,” IMF Working Paper (Washington: International Monetary Fund). Gray, Dale F. and S. Malone, 2008, Macrofinancial Risk Analysis, by Dale F. Gray and Samuel Malone, John Wiley & Sons. Gray, Dale and Jobst, Andreas A., 2009 (forthcoming), “Tail Dependence Measures of Systemic Risk Using Equity Options Data – Implications for Financial Stability,” IMF Working Paper (Washington: International Monetary Fund). Hesse, Heiko and Miguel Segoviano, 2009 (forthcoming), “Distress Dependence, Tail Risk and Regime Changes,” IMF Working Paper (Washington: International Monetary Fund). International Monetary Fund, 2009, Global Financial Stability Report, Spring 2009 (Washington: International Monetary Fund).

565 Segoviano, Miguel, 2006, “The Consistent Information Multivariate Density Optimizing Methodology,” Financial Markets Group, London School of Economics, Discussion Paper 557. Segoviano, Miguel and Charles Goodhart, 2009, “Banking Stability Measures”, IMF Working Paper 09/04 (Washington: International Monetary Fund).

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VOLUME 56, NUMBER 8 · MAY 14, 2009 How to Understand the Disaster By Robert M. Solow

A FAILURE OF CAPITALISM: THE CRISIS OF '08 AND THE DESCENT INTO DEPRESSION

BY RICHARD A. POSNER

Harvard University Press, 346 pp., $23.95 No one can possibly know how long the current recession will last or how deep it will go. That is because the dangerous combination of the "real" recession—the unemployment and idle productive capacity that come from lack of demand—and the financial breakdown, each being both cause and effect of the other, makes the situation more complex, more unstable, more vulnerable to psychological imponderables, and more distant from previous experience. Whenever the US economy returns to some sort of normality, or preferably before then, it will be necessary to improve and extend the oversight and regulation of the financial system. The main goal should be to make another such episode much less likely, and to limit the damage if one occurs. To make progress in that direction requires some understanding of the origins of the current mess. I once saw a hospital discharge diagnosis that read "sepsis of unknown etiology"; that sort of thing will not help in this case. The need is not only for a clear picture of what happened but for an assessment of the motives and actions of the main players, the causes and consequences of what they did, and the ideas and institutions that encouraged, inhibited, and shaped the outcomes. Richard Posner's book is intended to fill that need, in clear and understandable language. I think it is at best a partial success; it gets some things right and some things wrong, and the items on both sides of the ledger are important. More striking than what the book says is who says it. Posner is a judge of the US Court of Appeals for the Seventh Circuit, and so preeminently a lawyer. In addition, he is an apparently inexhaustible writer on...nearly everything. To call him a polymath would be a gross understatement. A partial list of his publications in the past ten years alone includes How Judges Think; Law, Pragmatism and Democracy; Frontiers of Legal Theory; the seventh edition of his Economic Analysis of Law (first published in 1973); the third edition of Law and Literature; three volumes of essays on The Economic Structure of Law; and books on plagiarism, constitutional aspects of national emergencies, the election of 2000, the US domestic intelligence system, countering terrorism, public responses to the risk of catastrophe, the Clinton impeachment, dealing with the AIDS epidemic, and, significantly, Public Intellectuals: A Study of Decline. There is a prehistory of still more books, and many articles in legal and other periodicals. Judge Posner evidently writes the way other men breathe. I have to say that the prose in this book often reads as if it were written, or maybe dictated, in a great hurry. There is

567 some unnecessary repetition, and many paragraphs spend more time than they should on digressions that seem to have occurred to the author in mid-thought. If not exactly chiseled, the prose is nevertheless lively, readable, and plainspoken. The haste may have been justified by the pace of the events he aims to describe and explain. Posner has an extraordinarily sharp mind, and what I take to be a lawyerly skill in argument. But I also have to say that, in some respects, his grasp of economic ideas is precarious. In his book on public intellectuals, Posner blames the decline of the species on the universities and their encouragement of specialization. I may be acting out that conflict. Remember that even hairsplitting is not so bad if what is inside the hair turns out to be important. The plainspokenness I mentioned is what makes this book an event. There is no doubt that Posner has been an independent thinker, never a passive follower of a party line. Neither is there any doubt that his independent thoughts have usually led him to a position well to the right of the political economy spectrum. The Seventh Circuit is based in Chicago, and Posner has taught at the University of Chicago. Much of his thought exhibits an affinity to Chicago school economics: libertarian, monetarist, sensitive to even small matters of economic efficiency, dismissive of large matters of equity, and therefore protective of property rights even at the expense of larger and softer "human" rights. But not this time, at least not at one central point, the main point of this book. Here is one of several statements he makes: Some conservatives believe that the depression is the result of unwise government policies. I believe it is a market failure. The government's myopia, passivity, and blunders played a critical role in allowing the recession to balloon into a depression, and so have several fortuitous factors. But without any government regulation of the financial industry, the economy would still, in all likelihood, be in a depression; what we have learned from the depression has shown that we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails. The movement to deregulate the financial industry went too far by exaggerating the resilience—the self-healing powers—of laissez-faire capitalism. If I had written that, it would not be news. From Richard Posner, it is. The underlying argument—it is not novel but it is sound—goes something like this. A modern capitalist economy with a modern financial system can probably adapt to minor shocks—positive or negative—with just a little help from monetary policy and mostly automatic fiscal stabilizers: for example, the lower tax revenues and higher spending on unemployment insurance and social assistance that occur in a weakening economy without any need for deliberate action. It is easy to be lulled into the comfortable belief that the system can take care of itself if only do-gooders will leave it alone. But that same financial system has intrinsic characteristics that can make it self-destructively unstable when it meets a large shock. One such characteristic is asymmetric information: some market participants know things that others don't, and can turn that knowledge into profit. Another is the capacity of financial engineering to produce securities so complicated and opaque—for example, collateralized debt obligations and other exotic derivatives—that almost no one in the market can understand their implications. (Insiders still have an exploitable advantage.) Yet another characteristic is the inevitability of market imperfections, so that what is essentially the same object can sell for two or more different prices; or so that some

568 market prices can be manipulated by large, informed operators; or so that some markets take a long time to match supply and demand. And yet another is the possibility that large financial institutions can raise large sums of credit, in amounts and ways that can affect the whole system, without anyone taking account of, or feeling responsible for, the systemwide effects. In that kind of world, imagine a period of low interest rates. Once a set of profit opportunities is found, big operators will be tempted to borrow so that they can play with much more than their own capital, and thus make very large profits. This has come to be called "leverage." Suppose I have $100,000 of my own, and I see an opportunity to earn a 10 percent return. If it pans out, I make $10,000; if it earns nothing, I have my original stake. If it loses money, that comes out of my initial capital. But I have a shot at something bigger. I can borrow $900,000 at, say, 5 percent interest, and invest the whole million. If it earns the expected 10 percent, I have $1,100,000; I can pay off my debt, plus interest of $45,000, and have $155,000 left. I have earned 55 percent on my money. Only in America! Of course, if the investment earns zero, I must still pay back my borrowing, with interest, which leaves me with $55,000. I have lost almost half of my capital; and it could be worse. Risk cuts both ways. What I have just described is 10-to-1 leverage; the size of the total bet is ten times my equity. In the past, 10-to-1 leverage would have been about par for a bank. More recently, during the housing bubble that preceded the current crisis, many large financial institutions, including now-defunct investment banks such as Bear Stearns and Lehman Brothers, reached for 30-to-1 leverage, sometimes even more. So suppose I borrow $2.9 million to go with my very own $100,000—leverage of 29 to 1. I can buy $3 million of whatever asset I fancy. If it earns 10 percent, I repay the $2.9 million plus $145,000 in interest and go home with $255,000, having earned a mere 155 percent on my own capital. But now, if the investment earns zero, I have an asset worth $3 million and liabilities of $3.045 million. I am, to coin a phrase, bankrupt. And this is when I have invested in an asset that is worth, at the end of the year, exactly what I paid for it at the beginning. If I had bought a piece of a complicated package of subprime mortgages, as many investors did, it might be worth less than I paid for it a year ago. In fact, there might be no takers at all. There is no way of knowing what the package of mortgages might be worth in a couple of years; when it comes to raising more cash to cover my debt, it is worth essentially nothing, i.e., it can neither be sold nor used as collateral. Whoever lent me the $3.045 million, including interest, has lost the whole thing. Why did I do such a risky and, as it turned out, stupid thing? Well, it had worked in the past, and made a lot of money for many people. If I had backed off, others would probably have continued to make money for a while. I would have looked like a fool, and very likely an unemployed fool. This sob story is just the beginning. Many highly leveraged financial institutions— banks, hedge funds, and insurance companies among them—have dug themselves into similar, interconnected holes. They have borrowed from other financial institutions to make complicated bets on risky assets, and they have lent to other leveraged financial institutions so that those institutions could make complicated, risky asset bets. These are the "toxic assets" that weigh down the balance sheets of banks. No one knows for sure what anyone else is worth: they own assets of uncertain value, including the debts of other institutions that own assets of uncertain value. All those banks and others are now unwilling to lend to one another because they fear that the potential borrower is already broke and will be unable to repay. And so the

569 credit markets freeze up and ordinary businesses that need credit for ordinary business purposes find that they cannot get it on any reasonable terms. This is what happened in September 2008 when the commercial paper market—the market for daily business borrowing—ceased to work. The breakdown of the financial system exacerbates the recession; many who want to buy or build cannot get credit with which to do so. The recession then endangers the solvency of more financial and nonfinancial borrowers and worsens the state of the financial system. I have deliberately kept this story stylized, omitting the juicy details about complicated derivative securities that seem to bear only the most tenuous connection to the everyday economic realities of production, employment, consumption, and so on. I have also ignored the even juicier details of greed, stupidity, and corruption. Posner does not ignore those things. They provide an irresistible target for amusement and contempt. I wanted instead to focus on the central role of leverage, because it is leverage that turns large banks and financial institutions into ninepins that cannot fall without knocking down others that cannot fall without knocking down still others. That seems to be the key to the potential instability of an unregulated financial system. It happens without any of the private actors violating the canons of self-interested rationality. Those canons would have been different if the SEC, the Fed, and other institutions charged with regulation had insisted both that all transactions be made public and that there be some limits on leverage. It is a noteworthy intellectual event that Posner has come to this understanding and expressed it forcefully and fearlessly. This same understanding must then also be the key to designing regulations that can reduce the frequency of financial crises like the current one, and limit the collateral damage to the real economy that they entail. Regulation should require that the uses and amounts of leverage, still largely hidden, be made public and that limits be set on the amounts of leverage that financial institutions can bring into play. Now let me turn to the recession itself. Posner prefers to label it a "depression"—see his subtitle—as if there is some unambiguous dividing line that has been crossed. He defines a depression as a "steep reduction in output that causes or threatens to cause deflation and creates widespread public anxiety and, among the political and economic elites, a sense of crisis that evokes extremely costly efforts at remediation." All sorts of obvious questions arise. How steep? How many prices must fall for how long to qualify as deflation? "Core" consumer prices—meaning prices for all consumer goods and services exclusive of energy and food—had not fallen at all at the end of 2008. Even more recently, decreases in the price indexes have been few and sporadic. Wage rates have not fallen either, still less so when benefits are added in. Anyhow, one should mean by "deflation" a cumulative, sustained fall in prices, not a scattered episode. Deflation is certainly a "threat." In a time of roughly stable price level, any recession entails a threat. My guess is that Posner overstates it. Finally, a "sense of crisis" seems merely to replace one vague word by another. I am going to stick with "recession." Posner thinks this is a euphemism in aid of denial. No: we are in a long and serious recession. When it is over we will be able to estimate roughly how much production was lost in the course of it. But I want to avoid the suggestion that something qualitative happened at the end of 2007 or sometime in 2008, over and above the combination of recession and the financial breakdown, or that we are on our way to the 1930s, which is grossly unlikely. What is important is the interaction

570 of the "real" recession and the financial crisis. I mentioned at the beginning that they are reciprocally cause and effect, and that is what I want to clarify, at least broadly. Posner starts the story, reasonably enough, with the period of easy money and low interest rates that began in 2001 as the Fed's normal response to the recession of that year, and lasted until the middle of 2004. There was plenty of liquidity—money, or assets that can be readily turned into money—and one result was a housing boom. In fact, construction had already increased pretty sharply during the prosperous 1990s, in spite of generally unfavorable demographics, such as the aging of the population and the corresponding slowdown in family formation, both of which diminish the need for living space. But there was certainly a further spurt. About 1.2 million private housing units were started in 1990, 1.6 million in 2000, and 2.1 million in 2005. Posner emphasizes the corresponding run-up in house prices, and he is right to do so. But the housing boom was not just a financial fact. By 2005 the country had clearly built many more houses, maybe two or three million more, than it could afford to occupy and finance. There would have been a housing slump in any case. We have had housing booms and slumps before, with consequences no worse than an interval of slow growth or a brief downturn, met with normal monetary policy and automatic fiscal stabilizers such as changes in tax rates or in public spending. What made this housing boom different, of course, was the mix of low interest rates and the ability of the original lenders to package many thousands of mortgages into mortgage-backed securities that could be sold off to the broad capital markets, where the buyers could have no real grasp of how risky the underlying mortgages were. (The rating agencies that were supposed to figure it out for them were waist-deep in conflicts of interest. Moody's and Standard and Poor's were paid by the same institutions whose securities they were supposed to be judging.) As a result, trillions of dollars of mortgages were sold, unscrupulously and deceptively, to buyers whose only chance of meeting their obligations was a continued rise in prices. (I remember a ubiquitous TV commercial for a mortgage finance company whose punch line was: "When others say No, Champion says Yes." I haven't seen it lately.) So this housing boom was enhanced by riskier and more opaque financial products that entangled a wider variety of highly leveraged financial institutions. The word "bubble" is often misused; but there was a housing bubble. Rising house prices induced many people to buy houses simply because they expected prices to rise; those purchases drove prices still higher, and confirmed the expectation. Prices rose because they had been rising. To make matters worse, the fever spread to other assets: stock prices doubled in the five years 2003–2007. When the implosion came in 2007, enormous amounts of what had been perceived as wealth—true, eventually spendable wealth—simply disappeared. According to data compiled by the Federal Reserve, household wealth in the US peaked at $64.4 trillion in mid-2007, and had plummeted to $51.5 trillion at the end of 2008. Something like $13 trillion of perceived wealth vanished in not much more than a year. Nothing concrete had changed. Buildings still stood; factories were still just as capable of functioning; people had not lost their ability to work or their skills or their knowledge of technology. But a population that thought in 2007 that they had $64.4 trillion with which to plan their lives discovered in 2008 that they had lost 20 percent of that. A standard, empirically tested rule of thumb is that an additional dollar of wealth induces the average consumer to increase annual spending by an amount between four and six

571 cents. So we are looking at a potential drop in consumer spending of something like $650 billion a year (5 percent of $13 trillion). To see how big this is, remember that President Obama's stimulus package amounted to less than $800 billion, spread over two or more years. If every dollar of stimulus were translated into a dollar of spending, this particular consumer-spending gap would still not be filled. And not every dollar of stimulus will be spent; nor is the consumer- spending gap the only demand failure we have to worry about. But this is one very important route by which the financial collapse damages the real economy. Another, of course, is the paralysis of credit markets, limiting the ability of legitimate businesses and families to borrow and spend. Much the same thing seems to be happening in Europe and in Asia, with national differences in detail. Judge Posner does not quite get the role of the consumer right. He says that among the "immediate causes of the depression were the confluence of risky lending with inadequate personal savings...so that people couldn't reallocate savings to consumption." He is referring to the fact that American families, who were saving 7 or 8 percent of their after-tax income not so long ago, had brought their saving rate down to less than 2 percent on average in the years between 2001 and 2008. If they had saved more they would find it easier to maintain their consumption spending in hard times. But from the rational individual's point of view, the goal of saving is to add to one's wealth, to be used eventually in whatever way seems best. If your wealth is increasing anyway—as it was—there is less need to save from current income. The problem was that bubble-generated wealth is very unreliable, to put it mildly. Judge Posner is much too smart to expect the average household to see exactly how much of its apparent wealth was at risk in an unregulated, highly leveraged, deeply opaque, generally shortsighted financial system. Besides, there is plenty of evidence that many people rarely, if ever, alter their 401(k) allocations and, when they do, are very likely to alter them unwisely. Most commentary, at large, in Posner's book, and in this review, has been about how the financial collapse damages the real economy. It might be thought that somehow fixing the financial mess would automatically fix the real economy. That is not so, for at least two reasons worth mentioning. In the first place, all that vanished wealth cannot be restored; much of it was fluff, as we now know. American families are not worth $64.4 trillion. There is no way to know now whether they are worth more than $51.5 trillion or less. When all that shakes itself out, both the real economy and the financial system will be different. Secondly, the restoration of credit flows is not just a matter of clarifying and strengthening the balance sheets of banks and other lenders. It takes two to make a loan: a solvent and willing lender and a credible borrower. In a deep recession, there are not enough credible borrowers, meaning businesses and individuals with excellent prospects of being able to repay a loan on time, with interest. That is why direct stimulus has to accompany the necessary work of cleaning up the debris cluttering the financial system, by removing those toxic assets from the balance sheets of banks and replacing them with clean capital. There are other weaknesses in Posner's remarks on the real economy. For example, more than once he says that the various antirecessionary measures—like fiscal stimulus, bailouts—are very "costly" and "may do long-term damage to the economy." He does not explain what these costs and damages are. Sometimes he seems to have budgetary costs in mind. But bailouts are mostly transfers from one group in society to another, for

572 example from taxpayers to financial institutions and their owners. They are certainly not ethically satisfying transfers, but it is not clear how they do long-term damage to the economy. The components of a fiscal stimulus package are costs to the federal budget; but to the extent that they put otherwise unemployed labor and idle industrial capacity to work, they do not impoverish the economy; in fact, they enrich it. (Of course, one would prefer useful projects to wasteful ones.) If fiscal stimulus works, even imperfectly, there is no doubt which way the benefit–cost ratio goes. Posner is on much firmer ground in worrying about the very large increases in the money supply and in the interest-bearing public debt that are left behind by antirecessionary policy. Even there, we do not know how skillful and lucky the Federal Reserve will be at mopping up excess liquidity when the economy recovers, whether by arranging repayment of loans it has made to the private sector, or by selling off the assets it has acquired along with Treasury debt. And if the economy can be restored to normal growth and sensible fiscal policy, the ratio of debt to GDP, which is what matters, can eventually be brought down. Without some analysis, this sort of talk does not spread light. There is an even odder chapter called "A Silver Lining?" In it Posner flirts with the idea that a recession, even a depression, has a good side. It weeds out inefficient firms and practices. This is a little like saying that a plague is not all bad: it cleans up the gene pool. No doubt there is some truth to this idea of a purifying effect. But the notion that it could possibly compensate for years of lost output and lost jobs seems wholly implausible. There is certainly no calculation of economic costs and benefits behind the thought of a "silver lining." I think it is another example of overemphasis on minor gains in efficiency and neglect of first-order facts. Posner's chapter on "The Way Forward" is all of sixteen pages long, and fairly disorganized pages at that. This means he does not seriously try to imagine what an effective regulatory regime for financial markets would look like or, above all, how it could be designed to protect the real economy as much as possible from damage inflicted by financial breakdown. Nevertheless he says some useful things; and it is especially significant that they come from a leading conservative (even if never a tamely doctrinaire one). Here is a representative statement: Other regulatory changes might be desirable, such as limiting leverage; raising credit-rating standards and changing how credit-rating agencies are compensated; forbidding proprietary trading by banks (that is, trading of their equity capital, which puts that capital at risk); adjusting reserve requirements to take more realistic account of the riskiness of bank's capital structures; requiring greater disclosure by hedge funds and private equity funds; requiring that credit-default swaps be traded on exchanges and fully collateralized; and even resurrecting usury laws. In addition, he is clear that the enormous collection of federal and state agencies with various regulatory responsibilities over financial institutions has to be somehow consolidated and unified. Also, though he is unnecessarily ambiguous, a new streamlined regulatory apparatus has to apply to most of the financial sector, including hedge funds, not just the proper banks. If this is not done, new but just as dangerously risky and opaque practices will find their way between the cracks; and no agency will have the capacity or the responsibility to detect oncoming trouble. Obviously that laundry list is not a blueprint for reform. It seems to me that effective limits on leverage, even if they have to be different for different classes of institutions,

573 are basic to controlling the potential instability of the financial system. Even with more transparency, extreme leverage is what generates extreme uncertainty and systemic risk. And it also encourages the dangerous compensation practices that Posner pillories. Leverage allows a clever player to manage enormous sums; it is then irresistible to focus on the short run and skim off mind-boggling paychecks and bonuses before the opportunity goes away. The Obama administration has been trying to inject enough clarity and capital into the balance sheets of banks so that they can resume providing credit for businesses and consumers. The job of regulatory reform has had to wait. The hints we have had suggest that the administration understands the need to include the unregulated institutions, and to set up at least an early warning system to detect major risks before they arrive. But there is no way yet to know what form the new system will take. One would like to establish some principles before we forget how bad it can get. The financial system does have a useful social function to perform, and that is to make the real economy operate more efficiently. Some human institution has to collect a nation's savings and put them at the disposal of those who have productive ways to use them. Risks arise in the everyday business of economic life, and some human institution has to transfer them to those who are most willing to bear them. When it goes much beyond that, the financial system is likely to cause more trouble than it averts. I find it hard to believe, and I suspect that Judge Posner shares my disbelief, that our overgrown, largely unregulated financial sector was actually fully engaged in improving the allocation of real economic resources. It was using modern financial technology to create fresh risks, to borrow more money, and to gamble it away. Posner writes: As far as I know, no one has a clear sense of the social value of our deregulated financial industry, with its free-wheeling banks and hedge funds and private equity funds and all the rest. That is already a hint that he thinks its social value is limited. As Posner sees it, talk about greed and foolhardiness is comforting but not useful. Greed and foolhardiness were not invented just recently. The problem is rather that Panglossian ideas about "free markets" encouraged, on one hand, lax regulation, or no regulation, of a potentially unstable financial apparatus and, on the other, the elaboration of compensation mechanisms that positively encouraged risk-taking and short-term opportunism. When the environment was right, as it eventually would be, the disaster hit. April 16, 2009 http://www.nybooks.com/articles/22655

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Fundamentally Different That's what American capitalism will be once Obama's done with it. John B. Judis, The New Republic Published: Thursday, April 23, 2009

Getty Images My colleagues Frank Foer and have written a compelling account of the Obama administration's approach to economic policy. And although I don't pretend to know the president's mind, I might agree with their summary statement that "Obama has no intention of changing the nature of capitalism." Still, I want to make what may seem to be a paradoxical argument: that regardless of the president's intentions, he will change American capitalism in fundamental ways--in particular, he will alter the relationship between the government and the economy. My argument rests on what he has actually proposed to do and how his proposals, if enacted, would situate his administration in the history of American economic reform. Americans have been notoriously loath to undertake reforms that increase the role of government. That goes back partly to our Lockean liberal heritage of minimal government that marks us off from Europe with its absolutist past. The only times that Americans have permitted major changes in government's role have been during economic crises, social upheavals, and war--that is to say, during the Civil War, the Progressive Era and World War I, the New Deal and World War II, and the Sixties (circa 1961-1974). If you look at these periods, and at the intervals between them, you find certain patterns that may help explain what is going on today. Reform and reaction: Periods of major reform have invariably been followed by periods of reaction: the Civil War by the era of Robber Barons and Social Darwinism; the Progressive Era and World War I by the Twenties of Calvin Coolidge and Andrew Mellon; the New Deal and World War II by the Robert Taft Congresses and the Eisenhower presidency; and the Sixties by Ronald Reagan, Newt Gingrich, and George W. Bush. The limits of reaction: In these periods of reaction, attempts were made to undo and reverse prior reforms, but the efforts always fell short, and the reforms were

575 preserved, if in weakened form. The Robert Taft Congresses failed to eliminate collective bargaining; Eisenhower, to the distress of conservative GOPers, kept social security in place; Reagan, Gingrich, and G. W. Bush tried, but failed, to eliminate the regulatory reforms of the Sixties. In addition, during these periods of reaction, the government's share in the gross domestic product never fell below the plateau established, except during the world wars, by the prior reform era. Reform builds on reform: Each of the reform eras picked up on the unfinished agenda of the prior era, and in some respects, went beyond it and into uncharted waters. The New Deal nationalized the state reforms of the Progressive Era (such as unemployment compensation), but also radically expanded the sheer quantitative role of government in the economy. The Sixties expanded social security and added Medicare and Medicaid, but it also radically widened the definition of what government could do to include things like worker safety and environmental protection (which is different from Progressive Era conservation). Now how does this apply to the Obama administration? Its relationship to the Sixties is similar to the Sixties' relationship to the New Deal. It is reviving and expanding the regulatory state of the Sixties, particularly in the areas of the environment, consumer protection, worker safety, and financial regulation. It is attempting to make good on the promise of universal health insurance that failed in Congress in 1971. It is also committed to tax reforms and social programs that will redress post-Sixties inequality. The Obama budget, for instance, contains $100 billion in tax increases on the wealthy and tax cuts for everyone else. It would also make college more accessible to lower- and middle-income students. But the Obama proposals also go well beyond the Sixties in certain respects. First, they pick up on an approach to industrial policy that began circulating among Democrats in the early Eighties, but has never been successfully implemented. That is, its proposals seek to change not merely the pace of production, investment, and consumption, but what is produced and consumed. Most notably, it is using the budget to shift the locus of industrial production toward "green" jobs and products. It is making dramatic changes in transportation with its intervention in the auto industry and in its funding of high-speed rail. Of course, the Eisenhower administration invested in transportation through its massive highway program, but there is a subtle difference here. The Eisenhower administration's intervention was largely in response to pressure from the auto, construction, and real estate and developer (suburban housing, malls) lobbies. Obama's proposals aim to alter and reverse existing trends. They are an effort at national planning. And it doesn't matter, incidentally, whether the administration tries to get its way through manipulating the market or through outright control of investment; what matters is that it is using its governmental power to change the American economy in basic ways. Finally, there is the sheer size of Obama's intervention. Obama's stimulus program and its budget are going to lift overall government spending from the 30s to well over 40 percent of GDP. Its 2009 budget, along with other public spending, could reach 45 percent of GDP. That's in response to a crisis, but as has happened before, the extent of government intervention is likely to remain permanent . At the least, the Obama budgets will shift even more dramatically the balance of economic power away from the private and toward the public sector. The American relationship of state to economy will begin to look more like that of France and Sweden,

576 whose non-crisis budgets total over 45 percent of GDP. And our politics may change accordingly--shifting public opinion on regulation, spending, and taxes well to the left. On the relationship of the state to the economy, European "conservatives" (say, Nicolas Sarkozy) are well to the left of our "moderates" and even occasionally our "liberals." It's hard to imagine, but the Republicans of the next decade could begin to sound like moderate Democrats today when discussing certain domestic policies. Of course, what I have described are largely proposals rather than accomplishments. Obama has the perverse benefit of a crisis to spur reform, but not to the extent that, say, Franklin Roosevelt did. Roosevelt took office after four years of a Depression, with unemployment nearing 25 percent and with bankers, businessmen, and their Republican backers thoroughly discredited. Obama is being forced to battle bankers and corporate execs; and the Democratic leadership in Congress faces filibusters from irresponsible or deeply ignorant--take your pick--Republicans and even from some so-called centrist Democrats. It won't be easy for Obama to get national health insurance or to finally put the financial sector in its place. And if his opponents are victorious or if he is too timid, the United States could head in an entirely different and more unpleasant direction than it would head if he were successful. There will probably be a return to deregulation and capital gains tax cuts--but when they don't work (and they won't), we might be forced to venture even deeper into the dark recesses of the American right John B. Judis is a senior editor of The New Republic and a visiting scholar at the Carnegie Endowment for International Peace.

577 U.S.

April 23, 2009 As Housing Market Dips, More in U.S. Are Staying Put By SAM ROBERTS Stranded by the nationwide slump in housing and jobs, fewer Americans are moving, the Census Bureau said Wednesday. The bureau found that the number of people who changed residences declined to 35.2 million from March 2007 to March 2008, the lowest number since 1962, when the nation had 120 million fewer people.

Experts said the lack of mobility was of concern on two fronts. It suggests that Americans were unable or unwilling to follow any job opportunities that may have existed around the country, as they have in the past. And the lack of movement itself, they said, could have an impact on the economy, reducing the economic activity generated by moves. Joseph S. Tracy, research director of the Federal Reserve Bank of New York, said the lack of mobility meant less income for movers and the people they employ and less spending on renovation and on durable goods like appliances. But, Dr. Tracy said, the most troubling prospect is that people were no longer able to relocate for work. “The thing that would be of deeper concern is if job-related moves are getting suppressed and workers are not getting re- sorted to the jobs that best use their skills,” he said. “As the labor market started to improve, if mobility stays low, you can worry about the allocation of workers.”

How long will the downturn in mobility last? Michael J. Hicks, director of the Center for Business and Economic Research at Ball State University in Indiana, said, “I think it will be well into next year before we see any growth in migration, and that still may be optimistic.” “If the stock market rebounds before the housing market, we might see a scramble for retirement housing,” Professor Hicks added.

578 The American Moving and Storage Association said the number of people changing residences had been dropping for four years and fell 17.7 percent from 2007 to 2008. The first quarter of 2009 is likely to be even worse, the trade group said. “We saw a standstill in new home construction, so there was no domino effect from people moving,” John Bisney, a spokesman, said. “People are a little nervous about getting a mortgage. And the recession is so broad-based it’s not as if you can pull up stakes and move to a part of the country that’s growing.” Jed Smith, a research director for the National Association of Realtors, said that on average it took a homeowner 10.5 months to sell a house in 2008 compared with 8.9 months in 2007. “Generally speaking, people move based on the economy,” Dr. Smith said, “and obviously the economy in 2008 was mediocre to bad. That would tend to have a negative impact on people’s desire, ability or need to move.” In its report Wednesday, the Census Bureau said that Americans’ mobility rate, which has been declining for decades, fell to 11.9 percent in 2008, down from 13.2 percent the year before and setting a post-World War II record low. Moves between states dropped the most, to half the rate recorded at the beginning of this decade. In addition, immigration from overseas was the lowest in more than a decade, which experts attributed to the lack of jobs. Over all, movers were more likely than nonmovers to be unemployed, renters, poor and black. For decades, several trends have driven a decline in American wanderlust. Home ownership rates have risen, and owners are typically less likely to move than renters. Two-earner families have become more common, and finding employment for both spouses in a new location can be challenging. Americans’ median age has been climbing, and it is younger people who usually move most often. “It does show that the U.S. population, often thought of as the most mobile in the developed world, seems to have been stopped dead in its tracks due a confluence of constraints posed by a tough economic spell,” said William H. Frey, a demographer with the Brookings Institution. Dr. Frey predicted that the foreclosure crisis might spur more local mobility, within or between counties, as families shift to rented quarters or move in with relatives. Robin Camacho, a Las Vegas real estate agent, expressed surprise at the census mobility figures, given the high foreclosure rates in his city. “If people are losing their homes and tenants are being forced to vacate,” Ms. Camacho said, “then this just doesn’t jibe with what I intuitively think. I see people moving constantly because they have no choice.” Patrick Bonnema, sales manager for Anderson Brothers Moving and Storage in Chicago, said local residential moves were “down drastically over the last six months.” “I’m not surprised this has happened,” Mr. Bonnema said. “Look at the economy, look at the banking industry, look at the credit industry. People can’t move, what are they going to do? Their homes are now worth less than what they originally paid, and they don’t want to take a loss.” Those surveyed by the census said they moved for housing, family and job reasons, in that order.

579 Suburbs gained 2.2 million movers while major cities lost 2 million. Immigrants, though, appeared less likely to settle in the suburbs in 2008, compared with recent years. “The housing crunch and its impact on employment in construction, plus the demise of sub-prime lending, gave immigrants fewer opportunities for living and working in the suburbs than in the immediately preceding years,” Dr. Frey said. The influx of 1.1 million overseas foreigners was the lowest since the 780,000 in 1995. Among movers, the South recorded the largest net gain, but the gain was the smallest in five years. Steve Freiss contributed reporting from Las Vegas; Rebecca Cathcart from Los Angeles; and Lori Rotenberk from Chicago.

580

Accounting Change Boosts Wells Fargo New Rules Let Bank Increase Capital Reserves By $4 Billion By Binyamin Appelbaum Washington Post Staff Writer Thursday, April 23, 2009 Wells Fargo yesterday showed the potentially dramatic impact of the recent loosening of accounting rules as it reported a first-quarter profit of $3.05 billion. The San Francisco company said the accounting change, which has generated controversy, allowed it to increase capital reserves by more than $4 billion. The increase could make a critical difference in the federal government's evaluation of the company's ability to withstand a deepening recession, accounting experts said. "This makes them look a lot healthier in the eyes of the government and presumably other observers as well," said Robert Willens, who advises financial companies on tax and accounting issues. "And you would think therefore that they will have passed the stress test with flying colors." Wells Fargo reported that first-quarter earnings fell 7 percent to 56 cents a share, from 60 cents a share or $2 billion during the first quarter of last year. The company had issued an unusual statement two weeks ago disclosing its bottom line but offering little explanation of how the result was achieved. Yesterday, the company said its retail banking operations had outperformed those of its major rivals, Bank of America and J.P. Morgan Chase, in significant part because of Wells Fargo's position as the nation's largest mortgage lender. The company's income from mortgage lending surged fourfold to $2.5 billion as it benefited from a refinancing boom driven by federal efforts to hold down interest rates. Wells Fargo took an investment of $25 billion from the Treasury Department. It also is the major beneficiary of a change in federal tax law last fall that shelters billions of dollars of its own profits from taxes based on losses incurred by Wachovia, the troubled bank it bought in December. The deal made Wells Fargo the largest banking firm in the Washington region by number of branches. The Financial Accounting Standards Board, under intense pressure from banks and Congress, agreed in early April to let banks report higher values for some assets. Most large banks have made a point of saying that their results were achieved without this kind of accounting adjustment. Wells Fargo's action, however, underscored the room for maneuver available to other banks in future quarters. Wells Fargo had set aside almost $10 billion from its capital, the pool of money banks are required to maintain as a reserve, to reflect a decline in the value of its investments. The decline was based on the prices that buyers were paying for similar assets. After the FASB change, which allows banks to substitute their own judgment in some cases, Wells Fargo decided market prices were too low by more than $4 billion, and it returned that amount to its capital pool.

581

Forget global imbalances, it is now a Sino-American imbalance – Posted on Wednesday, April 22nd, 2009 By bsetser Or perhaps a Sino-North Atlantic or Sino-Euramerican imbalance. Europe plays a supporting role in the drama. If oil averages $50 or so this year and $60 or so next year – and if intra-European surpluses and deficits are netted out – the world’s macroeconomic imbalances reduce to the United States external deficit (which the IMF estimates will be under 3% of US GDP in 09), a somewhat smaller EU deficit and China’s 10% of GDP surplus. On the surplus side of the global ledger, the IMF forecasts that there will soon be China – and almost no one else.

Stacking Europe on top of the US makes it hard to see Europe’s contribution to offsetting Asia’s surplus over the past two years. The US deficit peaked in 06; if Europe’s deficit hadn’t increased dramatically since then, Asia couldn’t have run such a large surplus (remember that from 06 on, most Asian currencies were deeply undervalued v Europe) at the same time as the oil exporters. Deficits and surpluses have to add up globally.

582 The IMF doesn’t current expect China’s stimulus to bring China’s current account surplus down. From a savings and investment view, I suspect the IMF expects a rise in public investment to offset a fall in private investment, not increase total investment – and the swing in the fiscal deficit to partially be offset by a rise in household savings. Just a guess though. And on the trade side, the fall in exports will be offset by the impact of lower commodity prices. The fact that China’s current account surplus is expected to stay large over time also suggests that the IMF continues to believe that the RMB is undervalued. The bigger question though is whether or not China will still be willing to accumulate the very large claims on the world implied by the IMF’s forecast. China is already worried about the long-term value of its $2.3 trillion or so in reserves and hidden reserves. The current account surpluses in the IMF’s forecast implies that Chinese claims on the world would rise by another $2.3 trillion over the next 4 years. If private Chinese savers don’t want to add to their dollar and euros, the government would need to resume buying – on a large scale. One last point: The IMF doesn’t attribute the current crisis directly to global imbalances. Fair enough. The proximate trigger for the global downturn was a collapse in private financial intermediation, not a collapse in net demand for US financial assets. It wasn’t linked to a dollar crisis — at least not directly (more on this later). The subprime crisis of August 07 proved bad for the dollar; but Lehman’s crisis unleashed a bout of deleveraging the supported the dollar. The US consumer - -and US financial sector — gave out before the rest of the world’s willingness to finance the US. At the same time, as Martin Wolf and others have emphasized, the capital outflow from the emerging world to the US and Europe – a flow that was necessary to support large household deficits in a country like the US where neither the government nor business was savings – wasn’t a private flow. The scale of emerging market reserve growth was far far larger than ever in the past. And that includes the period immediately after the Asian crisis when a host of countries added to their reserves on a large scale. I usually plot reserve growth with a positive sign. But an increase in reserves produces a capital outflow. Plotting the outflow from emerging market governments to the advanced economies over the past several years highlights just how much money emerging market governments moved into the financial markets of the advanced economies.*

583 Private investors in the emerging world didn’t, generally speaking, want dollars or euros. That is why reserve growth topped the emerging world’s current account surplus. The IMF seems to expect a return to this pattern – just with a smaller number of players, smaller aggregate flows and smaller deficits in the US (scaled to GDP). China’s surplus would continue to fuel Chinese reserve growth and thus the buildup of Chinese government claims on the US and Europe. And, implicitly, China’s government would risk ever larger losses on its ever growing foreign portfolio – at least so long as China finances the world by buying dollars and euros, not making yuan-denominated loans. * The IMF’s data includes SAMA but it excludes the Asian NIEs (Korea, Taiwan, Singapore and HK) and leaves out China’s non-reserve foreign assets. It thus understates headline emerging market reserve growth. On the other hand, I am not sure if it is adjusted for valuation effects, so it may overstate reserve growth when the dollar is falling. Data all comes from the IMF WEO’s interactive data base. This entry was posted on Wednesday, April 22nd, 2009 at 9:58 pm and is filed under China, U.S. trade deficit and external debt, central bank reserves. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site. http://blogs.cfr.org/setser/2009/04/22/forget-global-imbalances-it-is-now-a-sino- american-imbalance-%e2%80%93/#more-5262

584 COLUMNISTS A chancellor flying on a wing and a prayer By Martin Wolf Published: April 22 2009 14:37 | Last updated: April 22 2009 14:37 Only Alistair Darling, most emollient of politicians, could manage to make this Budget boring. He is telling his country that its prosperity was as fraudulent as a collateralised debt obligation, that Gordon Brown’s boasts of “no more Tory boom and bust” are a joke, that the forecasts he gave only last November were nonsense, that the public finances are deteriorating at a rate never seen in peacetime and that, to cover these failures, he is indulging in populist attacks on the highly paid. To make this feel boring is an achievement Yet is the government at last being realistic about the scale of this disaster? Can Labour hope to get away with it, economically or politically? Does it deserve to do so? These are the questions for markets and analysts now, and for voters at some point in the next 12 months. My answers are, briefly: No, No and No.

585 In terms of the overall picture, the salient figures were already well known: instead of an economic contraction of 1 per cent this year forecast in the pre-Budget report, the Treasury now forecasts a decline of 3.5 per cent; instead of public sector net borrowing of 8 per cent of gross domestic product this financial year and 6.8 per cent next year, falling to 2.9 per cent in 2013-14, we now have 12.4 per cent this year, followed by 11.9 per cent next year and 5.5 per cent in 2013-14; and instead of net debt at 57 per cent of GDP in 2013-14, we now have net debt at 79 per cent. This is a horror story. But it could, of course, be worse: the economy may not recover as hoped; losses on support for the banks could, as the International Monetary Fund suggests, be far bigger than the 3.5 per cent of GDP now expected; and, above all, the creditworthiness of the British government could come into question, with devastating consequences. The government is flying on a wing and a prayer. Can it – or its successor – land the aircraft? As a British citizen, I do hope so. But nobody can now be sure of this. Can a government that made large claims for the quality of its stewardship survive such a debacle? Perhaps the most striking single figure in the Budget is that the Treasury now believes cyclically adjusted net borrowing will be 9.8 per cent of gross domestic product this financial year (see chart). In other words, virtually all of the overall net borrowing requirement of 12.4 per cent of GDP is structural. The Treasury’s implicit view is that this is a sudden and unexpected event, consequent on the collapse of corporate profitability, particularly in the financial sector, and of the housing market: it shows the structural net borrowing requirement at only 2.7 per cent in 2007-08 and 5.7 per cent in 2008-09. But this view is highly implausible. More realistic is that, as happened in the boom of the late 1980s, but on a bigger scale, the Treasury confused a super-boom with a sustainable economic position. Now, after the collapse, the Treasury admits that the structural fiscal position is far worse than it thought. If it – and, we must admit, many others – had realised how fragile the economic and fiscal position was, they would have recognised that deficits and net public debt were far too high. So the big question is how – and how quickly – the Treasury expects this appalling structural position to improve. The answer is: very slowly. By 2013-14, structural net borrowing is still expected to be 4.5 per cent of GDP and the structural current budget (supposed to be in balance “over the cycle” under now discarded fiscal rules) will still run a deficit of 3.2 per cent of GDP. In this Budget, the cyclically adjusted current budget returns to balance only in 2017-18, instead of 2015-16, the date chosen in the November pre-Budget report. Yet any notion of the structural as opposed to the cyclical position is heroic guesswork. It may be sensible, therefore, to ignore the distinction and focus on the plausibility of actual numbers. In essence, the Budget forecasts that, as a result of the collapse in GDP and the recession, particularly the huge rise in spending on benefits, total spending will peak at 48.1 per cent of GDP next year, but then fall to 39 per cent by 2017-18. Meanwhile, receipts make a modest recovery, from a crisis-hit 35.1 per cent of GDP this financial year and 36.2 per cent next year, to 38 per cent in 2013-14 and, presumably, thereafter. Behind this forecast is a promise and a hope: the promise is that real public spending will remain roughly constant between 2010-11 and 2013-14 and then rise at only about 0.5 per cent a year over the rest of that parliament and, implicitly, well into the next; the hope is that the economy will recover vigorously, with GDP already growing at 3.5 per

586 cent in 2011, after 1.25 per cent next year. These are not impossible forecasts. But they imply a resolution that can hardly be expected of any UK elected government, a vigour that can no longer be assumed of the storm-tossed British economy and an amount of luck, on the world economy and losses in the raddled banking system, that cannot be taken for granted. The horrible truth is that the government’s forecasts are still very far from the worst imaginable. I have no idea whether the government can both get away with this optimism and postpone the moment of truth at least until after the general election. Markets have been forgiving. The difficulty with assuming that this will continue is that this is how markets tend to behave – until they cease to do so. Should investors decide that a return to fiscal stability has become a remote prospect, they may turn against the UK suddenly and brutally. The populism of the Budget, with its fiscally futile attack on relatively high earners, makes this even more likely. Finally, does the government deserve to get away with it? It is true that this is a global crisis in which many economies have been as hard hit as the UK. But, according to the Organisation for Economic Co-operation and Development, no other big member has suffered as large a deterioration in its structural fiscal position as the UK. In retrospect, the government was far too optimistic about the structural solidity of the UK economy and its finances. While many others were equally blind, it is hard for a government to escape responsibility for so huge a mistake. I have sympathy for the decision not to tighten fiscal policy during the worst of a recession. But I would also want to see determination to take the measures needed to return the fiscal position to health by the end of the next parliament. This will require action on both revenue and spending. Understandably, perhaps, the chancellor failed to spell out the scale of the challenges that lie ahead even if the economy were to recover robustly. Yet what is in prospect is year after miserable year of austerity. The challenge for both government and the opposition is to show how they will bring the budget back under control. Neither side is being honest about what this means. If this failure leads to a collapse of confidence, that will prove the worst mistake of all. http://www.ft.com/cms/s/0/28796910-2f3f-11de-b52f-00144feabdc0.html

587 Economy

April 22, 2009 Economic Scene For Housing Crisis, the End Probably Isn’t Near By DAVID LEONHARDT The closest thing to a real estate crystal ball in the last few years has been the house auctions that are regularly held around the country. In 2006 and early 2007, the official housing statistics were still showing that house prices were holding up. But that was largely because so many sellers were refusing to sell. The auctions, made up mostly of foreclosed homes, showed the truth: house values were starting to plummet in many places. So a few weeks ago, I decided to go to an auction at a hotel ballroom in Washington — and to study the results of several others elsewhere — with an eye to figuring out whether prices may now be close to bottoming out. That’s clearly a huge economic question. Last week, JPMorgan’s chief financial officer told Eric Dash of The New York Times that JPMorgan, and presumably other banks, would be under pressure “until home prices stabilize and unemployment peaks.” As long as home prices are falling, foreclosures are likely to keep rising and the toxic assets polluting bank balance sheets are likely to stay toxic. There are reasons, though, to think that prices may be on the verge of stabilizing. Relative to fundamentals, like household incomes and rents, houses nationwide now appear to be overvalued by only about 5 percent. You can make an argument that the end of the housing crash is near. But that’s not what I found at the auctions. • “This is a perfect storm of opportunity,” Bob Michaelis, goateed with a shaved head, told the 300 or so people who had come to downtown Washington for the auction. Mr. Michaelis, the auction manager, spoke from a lectern on stage, and his goal seemed to be to persuade people that they might never see a buyers’ market as good as this one. Prices have plunged, and interest rates, he said, are at “generational lows.” (The National Association of Realtors has been running a radio commercial this spring making a similar case.) “Look around to your left and your right, and you’ll see someone who sees an opportunity just like you do,” Mr. Michaelis said. “We’re approaching the bottom of the market, I think. We’re approaching the bottom of the market, if we’re not there already.” He then told the audience that, in the last 100 years, house prices have recovered from every downturn and gone on to reach record highs. Oh, and Wells Fargo and Countrywide were standing by, ready to offer financing to qualified auction buyers.

588 If nothing else, this sales pitch certainly had chutzpah. It combined the old bubble-era notion that house prices always rise over time (ignoring the fact that incomes, stock values and the price of bread do, too) with the new postcrash idea that houses must be a bargain because they’re a lot cheaper than they used to be. Even Countrywide, which was taken over by Bank of America after so many of its subprime mortgages went bad, is still part of the housing pitch. Yet as soon as the auction began, it was clear that the pitch wasn’t working. The winning bid on the first home auctioned off, a two-bedroom townhouse in Virginia Beach, was $115,000. Just last July, it sold for $182,000, according to property records. A four-bedroom brick house with a two-car garage in Upper Marlboro, Md., went for $375,000. Last year, it sold for $563,000. Throughout the evening, such low-ball prices continued to win the bidding. At one point, the auctioneer, Wayne Wheat, interrupted his sing-song auction call to cheerfully ask, “Where are my investors?” The tables that had been set up around the edges of the ballroom, reserved for people planning to buy multiple houses, were mostly empty. Many audience members, like the man in a camouflage baseball cap just in front of me, were attending their first auction. On Sunday, my colleague Carmen Gentile went to a larger auction, in Miami, to see if my experience had been unusual. It wasn’t. The homes there also sold for just a fraction of what they would have even a year ago. The rate of decline in Miami hasn’t even slowed noticeably in recent months, according to data kept by Real Estate Disposition Corporation, known as R.E.D.C., which runs the auctions. A recently transplanted New Yorker named Michael Houtkin won the bidding on a one- bedroom condominium on the outskirts of Boca Raton, a few blocks from three golf courses, for the incredible price of $30,000. “Things were almost being given away,” he said later. As is often the case at these auctions, the seller of the condo — Fannie Mae — retained the right to refuse the winning bid and keep the property. But Mr. Houtkin told me he was optimistic his bid would be accepted. An R.E.D.C. employee suggested to him that $30,000 wasn’t much below the minimum price that Fannie Mae had hoped to receive. How could that be? Because Fannie Mae, like many banks, is inundated with foreclosed properties. In recent weeks, banks have begun accelerating foreclosures again, after having held off while waiting to find out which homeowners would be eligible for the Obama administration’s assistance program. The glut of foreclosed homes creates a self-reinforcing cycle. Falling prices lead to more foreclosures. Foreclosures lead to an excess supply of homes for sale. The excess supply then leads to further price declines. Jan Hatzius, the chief economist at Goldman Sachs, says that the “massive amount of excess supply” means that home prices nationwide will probably fall an additional 15 percent. This estimate hides a lot of variation, too. In Miami, Goldman forecasts, prices could drop an additional 33 percent, which is pretty amazing since they’ve already fallen 50 percent from their 2006 peak. Nor is excess supply the only reason prices still have a way to fall. Nationwide, homes may not be overvalued by much. But in some cities, including New York, San Francisco, Los Angeles, Boston, Chicago and Miami, they remain very expensive.

589 So while Mr. Hatzius and his Goldman colleagues are somewhat more pessimistic than most forecasters, but the difference isn’t enormous. I’ll confess that this bearish picture isn’t exactly what I had hoped to find. A year ago, as part of a move from New York to Washington, my wife and I bought our first house. We did so fully expecting prices to continue falling (though perhaps not as much as they ultimately will, given the severity of the financial crisis). But we decided they had fallen enough for us to take the plunge. We preferred buying before the bottom of the market instead of renting and having to move again in a year or two. Still, when I wrote about that decision last spring, I argued that anyone who didn’t have to probably should not buy yet. Prices still had a way to fall. They don’t have as far to fall today, but the great real estate crash is not over, either. So if you are part of the 30 percent of American households who rent and you’re trying to decide when to buy, relax. The market is still coming your way.

590

22.04.2009 IMF says crisis will last many years

This is something you should read unfiltered. No news organisation has done justice to the IMF’s excellent global financial stability report. What caught the headline writers is that the total of global bad assets is currently estimated by $4.1 trillion, a number that is undoubted going to be revised upwards again. The report also contains an excellent and deeply troubling analysis of emergent markets, including Eastern Europe, which are likely to suffer capital outflows of a scale much larger than during the Asian financial crisis. The IMF criticises governments for not doing enough to sort out the problem of bad assets, and to recapitalise the banking sector. Most troubling of all, the IMF forecasts that the credit crisis will be deep and long lasting, even if government were to take all the right decisions, which they are not. (It is interesting that both the IMF and the OECD have been getting a lot more gloomy of late, while the financial markets and politicians are getting more optimistic)

Don’t be complacent now Writing in FT Deutschland, Wolfgang Munchau warns against too much optimism regarding the cyclical recovery. Of course, the growth rates for industrial production are getting a little better, and there is a good chance that the recession will end some time later this year. But there are as yet no indications that we can avoid a Japanese-style scenario, of a crash followed by a decade of stagnation. The financial sector is still in a much worse shape than is officially acknowledged. Those, like Angela Merkel, who now confidently predict the end of the crisis show that they do not understand what is going on, and their complacency is likely to aggravate the situation further. Martin Wolf, in his FT column, also makes the point that complacency is dangerous. He says there is no question of a recovery, not even on the horizon. All we are seeing is a deceleration of extreme rates of economic decline. Here is the core of his analysis: “The danger is that a turnround, however shallow, will convince the world things are soon going to be the way they were before. They will not be. It will merely show that collapse does not last for ever once substantial stimulus is applied. The brutal truth is that the financial system is still far from healthy, the deleveraging of the private sectors of highly indebted countries has not begun, the needed rebalancing of global demand has barely even started and, for all these reasons, a return to

591 sustained, private-sector-led growth probably remains a long way in the future.”

German government to implement bad bank concept The German cabinet decided in favour of a bad bank approach to bank rescue, consisting of government support for structures that takes toxic assets of the banks’ balance sheets. There will be more than one single bad bank. There are still two models under discussion. A decision is due sometime in May. The first model includes the creation of several government-supported special purpose vehicles that buy toxic assets at book value in exchange of a government-guaranteed loan of the same amount. At the same, the bank has to make a provision of the gap between book value and an estimated fair value, which it has to pay back to the SPV at the end of the 20-year duration of the bond. The government guarantee is kept off-balance sheet (which means it does not affect Germany’s deficit-to-GDP ratio, and which allows politicians to claim that it does not cost the taxpayer a penny, as they did yesterday). But it will cost money if and when these losses are realised. FT Deutschland says the total amount expected to be incorporated into these new SPVs is estimated to be between €150bn to €300bn, but this excludes loans that have turned sour due to the recession. The problem with this concept was well analysed by Holger Stelzner in Frankfurter Allgemeine this morning. Deutsche Bank will not have a bad bank, nor will the majority of private and public owned banks. This model will apply mainly to Landesbanken (which have bought the bulk of bad assets in Germany), and a few other banks in trouble. An estimate by the banking supervisor from 17 balance sheets is that the amount of toxic waste is €853bn (which suggests that the government’s €150bn to €300bn scheme may be insufficient). Stelzner says this can only work if the government is ready to unwind some of these banks.

Axel Weber attacks European Commission In an FT interview Axel Weber criticises the European Commission for enacting policies that make the credit crisis even worse. “Some of the demands coming out of the competition department of the Commission have been aimed at refocusing banks on their national credit and lending operations rather than fostering their pan-European endeavours... I find it surprising – to say the least – that European institutions view crossborder operations within the EU as foreign operations. For me, the euro area is the domestic economy.” The Commission insists that banks that receive state aid must restructure. Mr Weber said these demands might deter banks from using government help. “If banks are forced to sell off profitable businesses . . . I think this creates a problem. Dealing with rescue operations in that way, the probability of a credit crunch in the euro area increases rather than decreases due to these restructuring conditions.”

Greece to post much higher budget deficit It would be real news if Greece for once posted a lower deficit than expected, but the scale of the latest overshoot is quite extraordinary nevertheless. The FT reports that Eurostat will estimate Greece’s budget deficit at 4.8% of GDP, against the Greek’s government own estimate of 3.7%. The article quotes Yannis Papathanassious, the Greek finance minister, as saying that the country will undertaking a stringent course of savings, and that there will be no stimulus.

592 Austria too Austrian finance minister Josef Proell presents his budget plan until 2012 to parliament today. According to this first draft, public deficit will be 3.5% this year and 4.7% annually in the three following years until 2012, much higher and persistent than expected. Public debt is expected to rise to 78.5% by 2013. Der Standard writes that the crisis is not alone to blame. While the banking rescue package (€9.3bn up to date) is a main factor, there are also generous pension top-ups agreed upon in the past that will increase pension expenditures by one forth to €9.7bn until 2013. Also the structural deficit worsened dramatically from plus 2.1% in 2008 to minus 1.7% in 2009.

Published: April 21 2009 23:31 | Last updated: April 21 2009 23:31 Weber hits out at Brussels

By James Wilson and Ralph Atkins in Frankfurt and Nikki Tait in Brussels Europe’s competition authorities risk throwing the continent’s economic integration into reverse with their response to the financial crisis, the head of Germany’s Bundesbank has warned in rare public criticism of Brussels.

In a Financial Times interview, Axel Weber said policymakers were “at a crossroads” and might harm Europe’s growth prospects if they insisted on making lenders withdraw from foreign markets and become more nationally focused. His warning comes as competition authorities decide what concessions banks will have to make in return for state aid. Commerzbank, Germany’s second largest lender, which has been offered €18.2bn of state aid, is in talks with the European Commission over remedies, which may include disposals of businesses in other Warning: Axel Weber EU countries. The comments by Mr Weber – one of the most powerful figures in European banking – reflect his fears that the crisis in financial markets will set back the economic integration deemed essential for the eurozone to thrive. “Some of the demands coming out of the competition department of the Commission have been aimed at refocusing banks on their national credit and lending operations rather than fostering their pan-European endeavours,” Mr Weber said. “I find it surprising – to say the least – that European institutions view crossborder operations within the EU as foreign operations. For me, the euro area is the domestic economy.”

593 Neelie Kroes, competition commissioner, has insisted that if banks get state aid they must restructure to compensate for the anti-competitive distortions created. Mr Weber said these “side effects” were “more pronounced than was originally envisaged” and might deter banks from using government help. “If banks are forced to sell off profitable businesses . . . I think this creates a problem. Dealing with rescue operations in that way, the probability of a credit crunch in the euro area increases rather than decreases due to these restructuring conditions.” Some national governments have also insisted banks become more domestically focused in return for state help. If banking did become more nationally focused “I think Europe would forgo a lot of its growth potential”, Mr Weber said. The Commission defended state aid rules and said they had been “precisely adapted . . . to the current circumstances”. New guidelines on bank restructuring aid were likely to be published next month and would take account of current exceptional circumstances, it said. But the Commission said “it is important banks restructure to avoid a repetition of the mistakes made so far”. Asked about Mr Weber’s comments on the impact of restructuring, the Commission said: “It all depends on how you require banks to downsize and which activities you make them get rid of.” Mr Weber said UK suggestions for a European banking regulator were welcome and a “good vision to have”. But he said an “evolutionary approach” – increasing co-ordination among national supervisors over time – was more likely to succeed.

Published: April 21 2009 23:31 | Last updated: April 21 2009 23:31 Transcript of FT interview with Axel Weber, president of the Bundesbank Ralph Atkins, Frankfurt bureau chief, and James Wilson, German financial correspondent, spoke with Mr Weber on Monday April 20 2009 in Frankfurt FT: It’s a beautiful sunny day in Frankfurt, do you see economic green shoots? Axel Weber: In terms of the global economy we are still in the midst of a sharp downturn, which is pretty much synchronised across all regions, including emerging markets. When it comes to Europe, the decline in the first quarter has probably been somewhat stronger than the decline in the fourth quarter of last year. For Germany, pretty much the same holds. In the wake of global downturn and plunge in world trade, the German economy in my view has been affected more than other countries as it is relatively vulnerable to foreign demand shocks because of its very high degree openness and high share of capital goods in exports that are orientated towards emerging markets.

594 If you are looking for green shoots: my view is that a deceleration of the downward pressure can be expected, but up to now there are no clear signs of a levelling off in Germany and Europe. I think developments in Germany in particular will depend on the recovery in the global economy, and there are some positive signs in the latest data but no firm indication of a cyclical turning point at this moment. FT: So Germany and Europe are going to lag behind the US at least for a few moments? AW: I would say that our recovery, like that of the US, depends crucially on the restoration of the health of the banking system. On that front, we have seen some encouraging signs over the first quarter. January and February were pretty good month for the banking industry. March was more mixed, but the general sentiment in the market is that the first quarter was quite a bit better than the previous very difficult quarter, when the immediate impact of the demise of Lehman Brothers was felt. The other area where I see some signs of green shoots is that we have a lot of positive stimulus coming now both from monetary and fiscal policy, which will over the rest of this year and into 2010 develop a sizable stabilising influence. That is true for the US, Europe and Germany. FT: In Germany, companies appear to have hoarded labour, for instance, by taking advantage of short-time working arrangements. Is there not a danger that the worse may yet be to come if they decide to lay off workers permanently later this year? AW: Unlike in similar economic circumstances in the past, firms have been holding onto their core labour force. A large part of the initial adjustment was done through running down excess labour accounts. The initial perception was that it was a short- lived economic downturn that could have rebounded relatively quickly. But as over time employers realise that we are in a much more substantial downturn that could last longer than initially expected, they will react not just with these short term measures but we will see some firing and adjustment in the labour force itself. So unemployment rates are likely to go up. We expect a noticeable increase in the unemployment rate over the course this year. FT: …. by which time you expect some stabilising influence from the stimulus packages … AW: … exactly by that time you would expect some stabilising counter balancing forces from monetary and fiscal policy. The only measure that took immediate effect was the “scrapping premium” (abwrackpraemie) for cars, and that has helped in the last month or two. But over the course of the year we expect the structural adjustment in the labour market to be counteracted but not completely offset by the forces of the fiscal of the monetary stimulus. FT: What do you expect for German growth this year? The OECD is forecasting a 5.3 per cent contraction. AW: Currently the consensus of projections tends to be centred in the range of -4 and -5 per cent for average growth in 2009. We will update our projections in June. FT: Do you think it is desirable or possible for Germany to reduce its dependence on exports? AW: The vulnerability of the German economy to international demand shocks is something that is not a desirable feature of any economy. Like many of the surplus

595 countries, Germany has to engineer a structural change in its economic model towards more a balanced growth pattern, in which domestic demand and net exports both provide a solid foundation for future growth. In the short term, it is very hard for an economy to move away from such an export orientation. But I think that the vulnerabilities that we have seen in recent months make the point even clearer. Whether it is achievable is a different issue. In any case it has to be flanked by targeted economic policy measures. Germany is probably, when you compare it with the UK, too focused on industrial production. More than 24 per cent of GDP is manufacturing. The comparable number in the UK is less than 10 per cent. Manufacturing is not a very labour intensive process. In that view a more balance composition between services and manufacturing is desirable. I would question whether this could be engineered in this downturn. FT: Wouldn’t a bigger fiscal stimulus help? If you want more fiscal stimulus, you have to make up your mind about how, in the long term, you are going to finance it. The German fiscal programmes are relatively sizable – their size is usually underestimated in international discussions. If one compares the Germany economy with the US economy, automatic stabilisers – built-in stability features such as our employment support schemes, like our health insurance, unemployment insurance or pension insurance schemes – contribute much more to automatic stabilisation. If one adds together the automatic stabilisers and the discretionary fiscal programmes one probably gets as much bang for the buck as in the US. But have in mind that if the public loses its confidence in the long run sustainability of the fiscal system, any discretionary short term expansion of fiscal policy will have counterproductive effects. The German government has chosen a reasonable compromise between stimulus and sustainability. FT: At the ECB, are we moving into a different chapter? You have exhausted the use of the interest rate weapon and you need now to find news ways of stimulating growth because inflation is below the price stability target? AW: What our monetary policy focuses on is medium term inflation. In that sense, a lot of the disinflation effects that we have seen over recent months, and will see until the middle of the summer, are almost the one-to-one by-products produced by the excessive rise in oil prices last year. I actually expect inflation rates to move into negative territory during the summer months as a result of this “base effect”. In Germany, we may be in negative territory for quite a few more months. But this has only limited implications for medium term inflation pressures, which I think monetary policy should look at, and it has nothing to do with deflationary forces. I see no indication whatsoever at this stage that the risks of deflation are materialising. What I see is a steep drop in oil prices and a welcome – I repeat welcome – relief for consumers’ purchasing power that will last through the summer. FT: How strong are those medium term inflation pressures – are they in line with your price stability target? AW: If you look at financial market contracts that give you an indication of implied inflation expectations two years out, which is the relevant policy horizon – even if you have to take these readings with a pinch of salt – they are still signalling that inflation

596 expectations over the medium term are relatively robustly anchored in line with price stability that is at around 2 per cent, or slightly below. The recent surveys of professional forecasters also have not signalled a sizable decline in inflation expectations that goes beyond what seems to me a reasonable response of expectations to the base effects that are impacting on actual inflation readings. FT: So what does this mean for monetary policy? That you don’t need to do anything more? AW: It means that our main concern continues to be an anchoring of inflation expectations consistent with our medium term price stability objective. Our focus is not on long-term inflation risks, which is being discussed frequently and concerns the possible long-term inflation impact of the excess liquidity that is currently in the market. Nor is our focus on short term deflationary risks. I have said in the past that we have room for cutting interest rates in line with our mandate. We have used this room and we will continue to use the marginal room for manoeuvre that we have. I stick with my statement that I consider a reasonable lower bound for the main financing rate to be 1 per cent. FT: You said last week that the direct intervention in financial markets should have a lower priority compared with the bank-based measures that the ECB is taking. Were you ruling out the outright purchases of assets? AW: The Eurosystem has already taken a broad range of non-standard measures which have led to a substantial increase in the size of its balance sheet and has effectively lowered and flattened the money market yield curve. With regard to additional non- standard measures, I didn’t rule anything out but I said that we have to look at the specific characteristics of the euro area. And the euro area financial system is a bank- based system and therefore, foremost, our focus should be on alleviating to a further degree the re-financing costs and improving the refinancing conditions of banks through which monetary policy operates. President Trichet has referred to the fact that 70 per cent of the financing of the euro area is done through the banking system and only 30 per cent goes through the capital markets. But let me remind you that even that 30 per cent capital market access in the euro area is organised by banks and through banks. We will discuss this in the governing council but I have a clear preference for continuing to focus our attention on the bank financing channel. FT: Would you rule out purchases? AW: I would rule out any activity of the eurosystem (eurozone central banks) that is not consistent with the Treaty. In the Treaty we have a clear prohibition of direct purchases in primary markets of government papers. Even for secondary markets there is only a very limited scope for the eurosystem to be involved in the purchase of government papers, so in my view this is not a desirable option. FT: Because it blurs the boundary between fiscal and monetary? AW: No, it crosses this boundary. But more fundamentally: any additional measures would have to be based on the judgment that our past focus on re-igniting lending through the banking system has failed or is about to fail. We will discuss all the pros and cons but if anything, recent months have given me some comfort that there is a rebound in the banking industry and its ability to channel funds to corporates. Lending conditions

597 have stabilised somewhat. The spreads in the interbank market have come down quite sizably, and volumes have moved up somewhat. Our impact on the interbank market – despite a higher main refinancing rate – has been such that for example our 12 month interbank rates are below the 12 month interbank rates in the UK or US. This underscores that our policy action is so far has been quite effective FT: Do you think you represent a majority view on the ECB governing council? AW: I leave the interpretation of such majority views solely to the president of the ECB. FT: There is a lot of speculation about splits on the council … AW: Like President Trichet, I am convinced that when it comes to these decisions the council will be united. FT: Do you agree with Jurgen Stark, ECB executive board member, who has worried about the inflationary impact of the recent decision to increased the IMF’s Special Drawing Rights? AW: I don’t comment on remarks by colleagues. What is true is that in the long run the excess liquidity that we are creating as central banks around the world has to be withdrawn from the market as soon as financial market conditions have stabilised and economic conditions start to show some improvement. One of the lessons of the past has been that leaving rates too low for too long can contribute to macroeconomic and financial imbalances down the road. So our main task, while being proactive with loose monetary policy at this point, will be to change this expansionary stance once conditions have improved. And central banks will have to do this at a time when both the executive branches of governments and possibly market observers will judge that we should not take a risk in withdrawing liquidity too early. But European citizens can rest assured that we will not miss this exit. Independent central banks were created to fulfil just this task. FT: You seem to be already planning the first interest rate increase of the upturn! But surely the problem is that although you have stressed the focus on the banking system, the scale of the downturn means the ECB is going to have to find other ways to stop this recession becoming even worse? You could extend period over which you give liquidity – maybe to 12 months – but is that going to be enough? AW: Don’t forget that we have already done a lot in terms of expanding the balance sheet of the central bank. And don’t forget that after we will have had an additional “measured” decrease in [the main refinancing] rate, our term structure for inter-bank lending will not look that different from in the US and the UK. What is important is that once we are at point where we think policy rates have reached a level where there will remain for a foreseeable time, we have to combine this rates signal with a clear signal that banks’ financing costs and conditions are going to remain as they are for some time and give refinancing security for a longer time than is currently the case. The power of these two measures should not be underestimated. Currently, there is some hesitancy in the banking system, due to banks are not entering into longer term refinancing because they expect central banks borrowing costs to come down or borrowing horizons to be prolonged. FT: Do you think the UK is pursuing an exchange rate policy that is not in the common interest of the EU? AW: I am firmly convinced that the governments and leaders of the G20 governments meant what they said when they agreed in London that competitive exchange rate

598 policies, and artificial competition policies and beggar-thy-neighbour policies will not be part of resolving the economic problems. Swings in exchange rates that are market driven are a normal process, but I don’t see any policy-driven exchange rates and deliberate beggar-thy neighbour policies as part of the policy responses we are seeing now. FT: What is your position on the issue of how, and whether, Germany should create a ‘bad bank’ or banks to deal with toxic and illiquid assets? How far will the proposals we have heard do the job? AW: In designing the German financial stability fund, we said from the outset that the first and second pillars – guarantees, and capital injections – are both measures that address only the liability side of the balance sheet. They have to be supplemented by measures aimed at the asset side of the balance sheet. What we in Germany have embarked on is a three-pronged approach. The UK has tried to insure some assets within banks’ balance sheets. In the US, the discussion has focused primarily on taking assets off balance sheets, but the key issue within both of these approaches is the fair value at which to price the assets. That is very hard to judge in the current environment. The German solution will not focus on insuring assets within the balance sheet, nor on engineering the ownership change from banks to taxpayer but on placing some of these assets in special long-term vehicles where the capital losses, to the largest extent possible, will have to be borne by the banks which remain ultimately in charge of these vehicles. The government can be of help in securing liquidity and funding for these vehicles. But the government is very reluctant to take part in loss tranches, in terms of capital losses. There are two major advantages of such a deconsolidation. If the administration of such assets is placed with a public institution, it is possible to use German accounting rules, which look at the underlying long-term value of the assets rather than having to account for market fluctuations. If you also move it outside the banking sector, you can avoid holding regulatory capital for these assets and free up capital to provide a first-loss tranche to cover potential losses from the assets. FT: Is it too simplistic to try to divide between toxic and illiquid assets, as has been suggested? AW: We have to take into account the fact that the view of what is illiquid changes day to day. A few weeks ago, with government spreads at an all-time high, many would have said some government bonds were quite illiquid. Now, spreads have come down and markets have improved. We are talking about assets with maturities of five to 20 years. No one can judge now, amid the crisis, how the liquidity of these markets will develop over those long time horizons. FT: Is there a risk that the desire not to burden taxpayers will detract from an optimal solution, in terms of preserving banks’ capital and restoring confidence? AW: I don’t think there is a big risk. The German rescue package has €400bn of guarantees, of which less than 40 per cent are used; and €80bn of capital to inject, of which less than 20 per cent is being used. I don’t expect more banks to experience similar problems. So I think that means mending banks balance sheets can be done within this overall headline figure, if we focus the discussion primarily on structured

599 finance products, which are the most impaired assets and illiquid market segments. It is about using the money committed in the most efficient way. A politically viable solution on the asset side of banks balance sheets has to focus on allowing the banks to work off potential losses over time without forcing them to immediately write off these assets upon sale at a price that is in part a reflection of the illiquidity of markets. FT: You expressed concern recently about Jacques de Larosiere’s proposals for beefing up the so-called “level three” committees into European Union institutions. The UK also shares your concerns but appears to favour a super, pan-national regulator: do you agree? AW: The point I tried to make is that one cannot have a imbalanced situation in which fiscal responsibilities and decision-making powers remain with national institutions but legally-binding powers are with supernational bodies. The UK proposal is to have the legal binding powers with a supernational institution, meaning you have to have a microprudential supernational regulator. I think that in the long run that is a good vision to have. In the short term, we favour a more evolutionary approach that harmonises and increases the coordination of national supervisors for cross-border institutions and evolves over time towards supernational institutions. The issue is more about the time horizon over which you can achieve this internationalisation of supervision, not about the ultimate objective. I’m positively surprised and take note that the UK prefers pan-European institutions. I take that as a welcome suggestion, but let’s remain reasonable as regards the timeframe. An evolutionary approach is more likely to be successful. If you overload the process, you may stall it. FT: Isn’t it ironic that Germany, a federal, pro-European nation, is against a pan- European solution? AW: I am not against it. What I say is that we need to have a process to get there. I was very much involved in advising on European monetary union. After a ten year process, we came to an institutional decision that was a pan-European central bank.. This process could be speeded up – because we have done it already once for central banking – for banking supervision. But there are a lot of details on the road to leading to that objective. Let me remind you that when we reached monetary union, we found ourselves without our British friends. So let’s make sure that this time, when we embark on a pan-European supervision landscape, it is joint endeavour. It would help the emergence of pan-European banking groups a lot. We have not seen much pan-European dynamics in cross-border banking recently. And I fear that, in this crisis, some of the demands coming out of the competition department of the European Commission have been aimed at refocusing banks on their national credit and lending operations rather than fostering their pan-European endeavours. For a European bank, foreign subsidiaries are non-EU subsidiaries. I find it surprising – to say the least – that European institutions view cross-border operations within the EU as foreign operations. For me, the euro area is the domestic economy. There should be no discrimination whatsoever in terms of banking organisations or banking industry investment decisions taking place anywhere within this domestic economy called the euro area.

600 In a world of a global capital markets I would also question whether asking European banks to focus only on European operations is such a good strategy in terms of both risk clusters or undermining diversification. FT: Is the German government making these arguments robustly enough in Brussels? AW: All member countries that have used bank rescue programmes to save systemically relevant banks will come to this point of discussion. We have had some of these discussions already in Germany, because we embarked very early on the process of having to rescue some victims of the crisis; the same discussion will come in the UK, in the Netherlands, in France, Spain and elsewhere. We have had to move on a much larger scale than we envisaged to rescue banks. This is a clear signal that we are not dealing with a “single institution” issue but a systemic crisis. And I think competition concerns in a systemic crisis have to be different from competition concerns in a non-systemic event. If banks are forced to sell off profitable businesses and also pressed to downsize their balance sheet by roughly half, I think this creates a problem. Dealing with rescue operations in that way, the probability of a credit crunch in the euro area increases rather than decreases due to these restructuring conditions. There is already a strong tendency, from governments that have led bank rescue operations, to get banks to focus their lending activity on the domestic economy. If, in addition, European institutions focus these banks on their domestic operations, there is a big risk that we get a double impact of national interests and maybe European conditions that will lead to a stronger than necessary renationalisation of banking markets and lending activity in the EU. FT: Banks that come through the crisis under their own steam might see it differently – they might view it as a just opportunity to gain market share if rivals that have needed help were required by competition law to be scaled back. AW: I fully agree. It is only a matter of proportions. If 90 per cent of the European banking industry gets through this crisis on its own feet, I believe that is the right answer. If only a few banks make it through on a standalone basis, and many have to be rescued, then there is a deep problem.. There are some countries in Europe where more than 50 per cent of the banking market has been subject to state aid. In such circumstances, we are a long way from a “single institution” event and in a more systemic crisis. The real issue is then whether all banks have access to government programmes at conditions that are the same for all banks. If the answer is yes then I cannot see a deep distortion. Whether such a level playing field is used or not depends upon the side effects that some of these capital injections from governments have – and in my view these side effects, like the restructuring requests after half a year, are more pronounced than was originally envisaged. We are at a crossroads, and we have to get it right: Where do we we want the European banking industry to go? Do we want it to become more and more pan-European – which is my interest – in which case I think regulation would then follow? Or do we risk the pan-European banking industry becoming more nationally focused, which will throw us back in this pan-European integration process?

601 If the crisis is a catalyst for such a development, I think Europe would forgo a lot of its growth potential. One of the key growth-enhancing factors has been the availability of financial funds at a pan-European level. FT: The crisis has caused many people to believe banks became too big to be allowed to fail and therefore should be restricted: if not exactly to national markets, then certainly made to be smaller. AW: It has some truth in it. In the future banking industry risks will be smaller, balance sheets will be smaller, leverage will be smaller. But it should happen in a pan-European, integrated space. It should not happen by downsizing the banking industry along national borders or by increasing its national focus. For me, to have many competitive banks at a pan-European level is more desirable to achieve integrated, and sound, financial market. FT: So you think things could be going the wrong way at the moment? AW: There is a risk of that at this point. I fully share the de Larosière vision of a pan-European banking industry that ultimately needs to be regulated at a pan-European level. http://www.ft.com/cms/s/0/085d83b4-2e9f-11de-b7d3-00144feabdc0,s01=1.html

602 COLUMNISTS How economics lost sight of real world By John Kay Published: April 21 2009 20:51 | Last updated: April 21 2009 20:51 The past two years have not enhanced the reputation of economists. Mostly they failed to point out fundamental weaknesses of financial markets and did not foresee the crisis, and now they disagree on appropriate policies and on the likely future course of events. Although more economic research has been done in the past 25 years than ever before, the economists whose names are most frequently referenced today, such as Hyman Minsky and John Maynard Keynes, are from earlier generations. Since the 1970s economists have been engaged in a grand project. The project’s objective is that macroeconomics should have microeconomic foundations. In everyday language, that means that what we say about big policy issues – growth and inflation, boom and bust – should be grounded in the study of individual behaviour. Put like that, the project sounds obviously desirable, even essential. I confess I was long seduced by it. Most economists would claim that the project has been a success. But the criteria are the self-referential criteria of modern academic life. The greatest compliment you can now pay an economic argument is to say it is rigorous. Today’s macroeconomic models are certainly that. But policymakers and the public at large are, rightly, not interested in whether models are rigorous. They are interested in whether the models are useful and illuminating – and these rigorous models do not score well here. Indeed, at an early stage of the project Robert Lucas, one of its principal architects, who received the Nobel prize for his contributions, developed what is known as the Lucas critique. He argued that ordinary standards of statistical validity should not be applied to the project’s predictions. According to his colleague Thomas Sargent, Lucas was concerned that such tests rejected “too many really good models”. Economists, like physicists, have been searching for a theory of everything. If there were to be such an economic theory, there is really only one candidate, based on extreme rationality and market efficiency. Any other theory would have to account for the evolution of individual beliefs and the advance of human knowledge, and no one imagines that there could be a single theory of all human behaviour. Not quite no one: a few deranged practitioners of the project believe that their theory really does account for all human behaviour, and that concepts such as goodness, beauty and truth are sloppy sociological constructs. But these people discredit themselves by opening their mouths. That people respond rationally to incentives, and that market prices incorporate information about the world, are not terrible assumptions. But they are not universal truths either. Much of what creates profit opportunities and causes instability in the global economy results from the failure of these assumptions. Herd behaviour, asset mispricing and grossly imperfect information have led us to where we are today.

603 There is not, and never will be, an economic theory of everything. Physics may, or may not, be different. But the knowledge we can hope to have in economics is piecemeal and provisional, and different theories will illuminate different but particular situations. We should observe empirical regularities and – as in other applied subjects such as medicine and engineering – we will often find pragmatic solutions that work even though our understanding of why they work is incomplete. Max Planck, the physicist, said he had eschewed economics because it was too difficult. Planck, Keynes observed, could have mastered the corpus of mathematical economics in a few days – it might now have taken him a few weeks. Keynes went on to explain that economic understanding required an amalgam of logic and intuition and a wide knowledge of facts, most of which are not precise: “a requirement overwhelmingly difficult for those whose gift mainly consists in the power to imagine and pursue to their furthest points the implications and prior conditions of comparatively simple facts which are known with a high degree of precision”. On this, as on much else, Keynes was right. More columns at www.ft.com/kay

Comentario de Brad DeLong:

John Kay Weighs in, Calling for a Practical Macroeconomics

Me? I think that we ought to be turning out a lot of macroeconomic historians and historians of economic thought, and that only they should be allowed to serve in government or comment on public affairs at least as far as the business cycle is concerned.

John Kay, “How economics lost sight of real world”, Financial Times, 21, Abril, 2009 , disponible en: http://www.ft.com/cms/s/0/35301d06-2eaa-11de-b7d3- 00144feabdc0.html

604 COLUMNISTS Why the ‘green shoots’ of recovery could yet wither

Published: April 21 2009 20:24 | Last updated: April 21 2009 20:24

Spring has arrived and policymakers see “green shoots”. Barack Obama’s economic adviser, Lawrence Summers, says the “sense of freefall” in the US economy should end in a few months. The president himself spies “glimmers of hope”. Ben Bernanke, chairman of the Federal Reserve, said last week “recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, homebuilding and consumer spending, including sales of new motor vehicles”. Is the worst behind us? In a word, No. The rate of economic decline is decelerating. But it is too soon even to be sure of a turnround, let alone of a return to rapid growth. Yet more remote is elimination of excess capacity. Most remote of all is an end to deleveraging. Complacency is perilous. These are still early days. As the Organisation for Economic Co-operation and Development noted in its recent Interim Economic Outlook, “the world economy is in the midst of its deepest and most synchronised recession in our lifetimes, caused by a global financial crisis and deepened by a collapse in world trade”. In the OECD area as a whole, output is forecast to contract by 4.3 per cent this year and 0.1 per cent in 2010, with unemployment rising to 9.9 per cent of the labour force next year. By the end of 2010, the “output gap” – a measure of excess capacity – is forecast to be 8 per cent, twice as large as in the recession of the early 1980s. In the US, the rate of decline of manufactured output compares with that of the Great Depression. Japan’s output of manufactures has already fallen by almost as much as in the US during the 1930s (see chart). The disintegration of the financial system is, arguably, worse than it was then. If the world experiences a “Great Recession”, rather than a Great Depression, the scale of policy support will be the explanation. Three of the world’s most important central banks – the Federal Reserve, the Bank of Japan and the Bank of England – have official

605 rates close to zero and have adopted unconventional policies. The real OECD-wide fiscal deficit is forecast at 8.7 per cent of gross domestic product next year, with a structural deficit of 5.2 per cent. In the US, the corresponding figures are 11.9 and 8.2 per cent. Governments of wealthy countries have also put their healthy credit ratings at the disposal of their misbehaving financial systems in the most far-reaching socialisation of market risk in world history. It would be impossible for such activism to have had no effect. We can indeed see partial normalisation of financial markets, with a marked reduction in spreads between riskier and less risky assets (see charts). The FTSE All-World index has jumped by 24 per cent and the S&P 500 by 23 per cent since March 9 2009. Purchasing managers’ indices are picking up (see chart). More broadly, the chances of a manufacturing turnround are high: big falls in demand generate inventory build-ups and collapses in output. The latter are sure to reverse. China’s growth is also rebounding. We can say with some confidence that the financial system is stabilising and the rate of decline in demand is slowing. But this global recession is different from any other since the second world war. Its salient characteristic is uncertainty. Consider obvious perils: given huge excess capacity, a risk of deflation remains, with potentially dire results for overindebted borrowers; given the rising unemployment and huge losses in wealth, indebted households in low-saving countries may raise their savings rates to exceptional levels; given the collapse in demand and profits, cutbacks in investment may be exceptionally prolonged and severe; given massive and persistent fiscal deficits and soaring debt, risk aversion may lead to higher interest rates on government borrowing; and given the flight from riskier borrowers, a number of emerging economies may find themselves in a vicious downward spiral of weakening capital inflow, falling output and reductions in the quality of assets. In short, as Stephen King and Stuart Green of HSBC note in a recent report, the exceptional dynamics of this crisis suggest a healthy scepticism about the timing and speed of recovery. What is most disturbing, moreover, is the scale of the policy action required to halt this downward spiral. This raises the big question: how and when might the world return to normality, with sustainable fiscal positions, strongly positive short- term official interest rates and solvent financial systems? That Japan has failed to achieve this over 20 years is surely frightening. What I find most disturbing of all is the reluctance to admit the nature of the challenge. In its policy advice, even the OECD seems to believe this is largely a financial crisis and one that may be overcome in quite short order. Even the latter looks ever more implausible: in its latest Global Financial Stability Report, the International Monetary Fund now estimates overall losses in the financial sector at $4,100bn (€3,200bn, £2,800bn). The next estimate will presumably be higher. Above all, the financial crisis is itself a symptom of a balance-sheet disorder. That, in turn, is partly the consequence of structural current account imbalances. Thus, neither short-term macroeconomic stimulus nor restructuring of balance sheets of financial institutions will generate sustained and healthy global growth. Consider the salient example of the US, on whose final demand so much has for so long depended. Total private sector debt rose from 112 per cent of GDP in 1976 to 295 per cent at the end of 2008. Financial sector debt alone jumped from 16 per cent to 121 per cent of GDP over this period. How much of a reduction in these measures of leverage occurred in the crisis year of 2008? None. On the contrary, leverage rose still further.

606 The danger is that a turnround, however shallow, will convince the world things are soon going to be the way they were before. They will not be. It will merely show that collapse does not last for ever once substantial stimulus is applied. The brutal truth is that the financial system is still far from healthy, the deleveraging of the private sectors of highly indebted countries has not begun, the needed rebalancing of global demand has barely even started and, for all these reasons, a return to sustained, private-sector-led growth probably remains a long way in the future. The world economy cannot go back to where it was before the crisis, because that was demonstrably unsustainable. It is at the early stages of a long and painful deleveraging and restructuring. Fortunately, policymakers have eliminated the worst possible outcomes. But there is much more yet to be done before fragile shoots become healthy plants.

Martin Wolf, “Why the ‘green shoots’ of recovery could yet wither”, 21, Abril, 2009, en: http://www.ft.com/cms/s/0/1ed88b70-2ea9-11de-b7d3-00144feabdc0.html

607

Banks in Europe Lag in Recovery Huge Capital Infusions Needed, IMF Says By Anthony Faiola Washington Post Staff Writer Wednesday, April 22, 2009 European banks are far behind those in the United States in clearing bad loans off their books and may need additional capital injections of up to $1.2 trillion, according to a major International Monetary Fund report released yesterday. The IMF's global financial stability report -- seen as a key measure of the financial crisis -- suggests that while the downturn may have started in the United States, it could take longer to run its course in Europe and ultimately prove more costly for Europeans to fix. Overall, the report said, financial institutions and investors worldwide stand to lose $4 trillion from bad debt and toxic assets, their biggest hit since the Great Depression. The single biggest sting is to banks, which are set to absorb about two-thirds of all losses. The fund also warned of growing credit woes in emerging markets. Addressing that concern, the World Bank said yesterday it would triple its spending to help developing countries withstand the crisis, allocating $12 billion in loans over the next two years for food, health and education programs. The bank spent $4 billion on such social programs in the past two years. "Most attention in the current crisis has been focused on developed countries where people face the loss of homes, assets and jobs," World Bank president Robert B. Zoellick said. "People in developing countries have much less cushion: no savings, no insurance, no unemployment benefits and often no food." The IMF sought to quantify the scope of the crisis, saying the weak financial sectors in the United States and Europe are likely to need billions of dollars more in cash injections and signaling that Europe in particular needed to boost its efforts to prop up ailing banks. U.S. banks have written about half the estimated $1.1 trillion in troubled loans and toxic assets off their books, the IMF noted. But European banks have moved much slower, so far writing down less than 25 percent of the $1.4 trillion in bad debts. Although the financial crisis originated largely with the subprime mortgage bubble in the United States, the global pool of bad assets has been augmented by a surge in troubled loans in Europe stemming from a string of corporate failures and depressed housing and commercial real estate markets. The report raised its estimate of troubled assets originating in the United States to $2.7 billion, up from $2.2 billion in January. For the first time, it also measured the size of troubled loans and assets overseas, placing them at about $1.3 billion. "Europe may be in as bad shape, if not in worse shape," said Martin Baily, senior fellow at the Washington-based Brookings Institution, and former chairman of the Council of Economic Advisers under former president Bill Clinton. "They are holding quite a lot

608 U.S. troubled assets, but they are also getting defaults themselves as their own economies turn down sharply. In terms of the housing market, with the exception of Germany, their bubble was in many cases bigger than the United States." The delayed response in Europe, officials note, is tied to the fact that the crisis began in the United States, giving U.S. financial institutions more time to identify and deal with its scope. The report indicates global lending may not fully recover until 2011. Although lending may have bounced back some in recent months, the credit crunch continues to make it harder and more expensive for businesses worldwide to obtain financing, the report said. The credit crunch has been particularly pronounced and worrisome in the developing world. In addition, the report notes that taxpayers in many nations are growing weary of bailout efforts when more may be needed for a sustained global recovery. "The political support for such action is waning as the public is becoming disillusioned by what it perceives as abuses of taxpayer funds in some headline cases," the report said. "There is a real risk that governments will be reluctant to allocate enough resources to solve the problem." The IMF nevertheless advised governments to "take bolder steps" to reinforce the fragile financial system through bailouts, even if it means nationalization of specific banks. It urged, however, that such steps be temporary and that banks be strengthened and returned to the private sector ownership as soon as possible. Many nations, including the United States, have poured billions of dollars into financial institutions, though mostly avoiding full nationalization. In London this month, the group of 20 industrialized and developing nations agreed in principle to combat the financial crisis in part by beefing up resources at the IMF and World Bank by more than $1 trillion -- though they have not yet agreed where all of that money will come from. That will be one of the chief topics discussed over the next several days during a number of major meetings in Washington. Finance ministers from the Group of Seven industrialized nations, as well as from the larger G20, will meet Friday. The World Bank and IMF will host their annual spring meetings Saturday and Sunday. http://www.washingtonpost.com/wp- dyn/content/article/2009/04/21/AR2009042101241_pf.html

609

How the U.S. Will Save GM and Chrysler By Steven Pearlstein Wednesday, April 22, 2009 Negotiations over the government's bailout of Chrysler and General Motors have shifted into high gear in recent days, and from this point until the end of June, things are likely to get more tense and more complicated. My guess is that when it's all over, both companies will have been run through a quickie bankruptcy process and will emerge smaller, with less debt, a lower cost structure and Uncle Sam as the majority owner. The process is now being driven largely by Steven Rattner and Ron Bloom, the Obama administration's auto czars. Over the past month, they have laid down the parameters for talks among the companies; the United Auto Workers; the banks and bondholders; and, in the case of Chrysler, Italy's Fiat, which seeks to integrate Chrysler with its newly revived European operations. The Obama team understands that it will get only one good shot at a rescue and that if its plan doesn't work, the companies will be shut down and sold off in pieces. Its priorities are to minimize damage to an already weak economy, protect workers and pensioners, and get the government out of the deal as quickly as possible with all of its money back. The government has the upper hand here for the simple reason that all the parties know they would be better off with almost any restructuring that involves $40 billion of federal financing than with the normal bankruptcy process, which would almost certainly result in the liquidation of the companies. But the government's leverage has its limits. As a legal matter, if the plan tilts too much in favor of unionized workers, the bankers and bondholders can demand that the judge reject it, based on a bankruptcy law requirement that all unsecured creditors be treated equally. And as a political matter, a Democratic administration may be reluctant to ask a bankruptcy court to impose an overly onerous labor contract on an unwilling union. So what is the final rescue plan likely to look like? For starters, it will certainly require that workers accept a wage and benefit package that would bring labor costs down to the levels of Toyota and Honda plants in the United States. In February, the UAW took a big step in that direction by accepting a two-tiered wage structure that cut the pay of new hires roughly in half. But with the government insisting that labor costs come down immediately, unionized workers will have to accept immediate reductions in base pay, along with increased cost sharing for their health insurance. Even that's probably not enough, however. The generous defined-benefit pension plan that UAW workers have always gotten will need to be replaced by company contributions to individual 401(k) plans. And to reduce the tens of billions of dollars that both GM and Chrysler have committed to fund a new retiree health plan, the government is likely to insist that benefits be trimmed and that half of the money come in the form of stock in the new companies.

610 Both companies will also have to lay off tens of thousands of additional employees as they eliminate brands, close more plants and outsource more non-core functions. Chrysler's product line will be reduced to Jeeps, minivans and trucks, along with a new line of passenger cars using Fiat-designed platforms and engines. GM, meanwhile, will be left with its Chevrolet, Cadillac and Buick nameplates, along with GMC trucks. Going through bankruptcy would allow both companies to bypass state laws and dramatically reduce the number of dealerships without having to take the time and bear the expense of buying back the franchises from their owners. Still unresolved, however, will be the tricky question of what to do about the hundreds of thousands of cars now on those dealers' lots. The worst outcome would be to force the dealers to dump them on an already depressed market at deep discounts. The toughest negotiations will be with the GM bondholders and Chrysler bankers, who have already been told by Rattner & Co. that nearly all of what they get will be in the form of stock in the new company, rather than cash (which they don't have) or new debt (which the Treasury is eager to minimize). The only question now is how much of the new companies they will own. Given the amount of money it is likely to put into the automakers, the government will be entitled to more than half of the stock of the reorganized companies. Then there is the union's health fund, which will probably be entitled to stakes of 20 to 25 percent, reflecting not only the reduced cash payments it will receive but also all the other concessions made by active and retired workers. At Chrysler, there's also the matter of Fiat's contribution of technology and management services, which it offered for a 20 percent share. That leaves only about 10 to 15 percent of each company. Bankers and bondholders will kick and scream and call it unfair, but in the end they'll take it because, like everyone else in this adventure, they'll conclude that it's better than the alternative. And that's the way GM and Chrysler will be saved. http://www.washingtonpost.com/wp- dyn/content/article/2009/04/21/AR2009042103538_pf.html

611 Business

April 22, 2009 Quadrangle Is Facing Questions Over Pension Funds By LOUISE STORY

Left, Jay Mallin/Bloomberg News; Louis Lanzano/Associated Press The authorities contend the firm of Steven Rattner, left, has had pension dealings with Hank Morris, right. Two months after Steven Rattner left Wall Street for Washington, his private investment company is facing a widening investigation into corruption in public pension funds — and fighting for its future.

As state and federal authorities examine Mr. Rattner’s dealings with the New York State retirement fund, questions are emerging about his efforts to gain business from several other public funds, including ones in New Mexico and New York City. His private investment firm, the Quadrangle Group, is moving to calm anxious pension managers, who have entrusted the firm with hundreds of millions of dollars.

Mr. Rattner, who is leading the Obama administration’s efforts to revamp the auto industry, has left his small but prominent firm in a bind. Because he was integral to Quadrangle, investors can try to withhold additional money that they have pledged to the firm now that he has left.

The deadline for their decision is Friday, according to four people familiar with the matter. For Quadrangle, the stakes are high. If its investors balk, the amount of fees that it collects annually on its funds would fall to about $19 million, from $35 million, according to a Quadrangle investor. Mr. Rattner’s firm also would lose its ability to make investments in new companies.

No charges have been filed against Mr. Rattner, who did not respond to e-mail messages on Tuesday, or against Quadrangle, whose executives declined to comment.

While Quadrangle’s funds have not suffered as much as some other private equity funds, its investors have suffered losses in other parts of their portfolios. Some of them might try to capitalize on the inquiry to avoid making good on their pledges.

Another crucial question, however, is whether money from one Quadrangle fund was used to lure investors to a second fund. That possibility that might expose Quadrangle to investor lawsuits.

612 Quadrangle hired a firm that had been run by Hank Morris, a now-indicted associate of New York’s former comptroller, to help gain business in New York, state and federal authorities contend. While the New York fund accounted for a only a small portion of Quadrangle’s investments, the prestige associated with it helped the firm lure other big investors.

Quadrangle also hired Mr. Morris’s firm, Searle, to help raise money from pension funds in New York City, New Mexico and Los Angeles, according to a person with knowledge of the arrangement.

Mr. Rattner was personally involved in discussions about using Mr. Morris to gain pension business. In 2005, for instance, Mr. Rattner discussed hiring Mr. Morris with the head of the New Jersey pension fund, who told him such a move would not benefit Quadrangle, according to a person briefed on the investigation, which is being led by the attorney general of New York and the Securities and Exchange Commission.

Mr. Rattner, a major Democratic fund-raiser, has social and political connections. He is friends with the mayor of New York City, Michael R. Bloomberg, and Quadrangle manages the mayor’s personal fortune. Mr. Bloomberg said in a statement on Tuesday that he had no plans to move his money and that Quadrangle was doing “a great job.”

Mr. Rattner headed much of Quadrangle’s effort to raise money from pension funds in 2005, when the firm attracted money from the New York fund and others.

Mr. Rattner forged close personal ties in New Mexico, which invested $20 million in Quadrangle. He met with Senator Jeff Bingaman, a Democrat from that state, on at least one occasion, according to a person with knowledge of the meeting. From about 2004 until early this year, Quadrangle also employed the senator’s son as an associate.

A spokeswoman for Senator Bingaman said that the senator’s son did not raise money for Quadrangle, but instead helped make investments. Senator Bingaman was not involved in the pension process, she said.

The accusations involving Quadrangle were included in an S.E.C. complaint last week that detailed a three-year-long investigation into corruption in New York state’s pension plan. Quadrangle and several other private equity funds, among them the Carlyle Group, were named in the complaint.

Mr. Rattner turned to Mr. Morris after meeting Josh Wolf-Powers, then managing director of private markets for the New York City comptroller, about the beginning of 2005. Mr. Wolf-Powers told Mr. Rattner that he could not think of any investment firm that had persuaded the city’s pension fund to invest without using a placement agent.

Mr. Rattner left the meeting irritated that his own considerable connections did not seem to be enough. He soon hired Mr. Morris.

Payments to placement advisers like Mr. Morris, can be legal but often raise questions about conflicts of interest and would be illegal if used to bribe public officials.

After Mr. Rattner left, Quadrangle executives flew to California to try to persuade three pension funds to stick with the firm.

613 Before Mr. Rattner left, Quadrangle stood to earn about $60 million more in management fees on its second fund, which is allowed to make new investments through the end of 2010. The partners at the firm are now offering to cut about $5 million of those fees. In early April, Quadrangle organized a conference call for its investors. Calpers, the big California pension fund, pushed other investors to demand that Quadrangle reduce its fees, according to two investors who were on the call. The Pennsylvania teachers’ pension fund was among those willing to support the firm without any concessions.

One investor, Amos Hostetter, who made a fortune in the cable business, said some Quadrangle investors have committed too much money to such private equity investors and are pushing to reduce fees. But he said it would be unwise to cut fees drastically, because such a move would force Quadrangle to dismiss some employees who are managing its investments.

“It would hurt everyone’s financial interest to see the fund reduced in size,” Mr. Hostetter said.

614 COMMENT Bank tests we should get stressed about

By Mohamed El-Erian

Published: April 21 2009 20:46 | Last updated: April 21 2009 20:46 With the banking system still under stress, financial markets are waiting with great anticipation for the release by Washington of the results of stress tests for major US banks. Some believe the tests, scheduled to be released in early May, are excessively hyped. They are wrong. The stress tests will accelerate the redefinition of the financial landscape, with a meaningful impact on future economic growth and welfare. However, whether the impact is for good or ill depends on how the results of the tests, and policies that flow from them, are pursued. Rightly or wrongly, the February stress-test announcement was interpreted by markets as signalling a comprehensive process through which the government would evaluate the soundness of banks and decide on sustainable solutions for the sector – a sector critical to the economy’s prospects. In particular, the tests suggested a concrete way to differentiate between the solid institutions that can raise private capital, and those that will (and must) feel a heavy government hand. They could also lead to a way to reconcile the multiple initiatives designed to stabilise a highly disrupted sector that is contaminating many sources of job creation, nationally and internationally. The US government now has to deliver on those expectations; and it will not be easy. The outcome will be decided by more than the design and execution of the stress tests for the 19 selected institutions. It also depends critically on the announcement, context and follow-up. To maximise the prospects for a good outcome, or at least minimise the risk of damage, it would be prudent for US policymakers to take seriously the following five factors: First, transparency is key. Whether the government likes it or not, hundreds of analysts around the world will reverse engineer the stress tests. The government would be well advised to assist the process through clarity. Obfuscation would result in damaging market noise and further derail the real economy. At the minimum, policymakers need to provide credible details on the methodology, the underlying assumptions and scenario analyses. Second, the results of the stress tests must be part of a comprehensive, forward-looking package to resolve problems at banks. Out-performing banks should be provided with exit mechanisms from the exceptional government support that they have been receiving and, presumably, no longer need. At the other end, there must be clarity as to how capital-deficient banks that no longer have access to private capital will be handled. Third, the banks’ recovery and rehabilitation efforts must be co-ordinated closely with other efforts to put the banking system back on a viable road. In particular, they need to

615 work together with the implementation of initiatives aimed at lowering funding costs (such as federally-guaranteed borrowings and Federal Reserve facilities), and facilitating the removal of the overhang of toxic assets. This will require a level of co- operation among US agencies that, historically, has not come easily or effectively. Fourth, the government should arrest and counter the recent erosion in key parameters of the market system. Specifically, it must work hard to resist the temptation to override contracts, to undermine the sanctity of the capital structure and to treat differently stakeholders with similar legal rights. Indeed, seemingly attractive and politically expedient financial engineering, such as that used in the third Citigroup bail-out, risks undermining long-standing principles that have served the US well for years. Finally, the US must never lose sight of the international dimensions of its policies. Its response must be consistent with efforts to upgrade a deeply challenged infrastructure for cross-border harmonisation of regulation and bank capital. The aim is to ensure a degree of global consistency that clarifies accountability and responsibility. These are stringent requirements. Yet there is really no alternative. The US is already embarked on a journey to a “new normal” that includes reduced private credit intermediation and lower capacity for sustained, non-inflationary growth. Adherence to these five principles would help to ensure that the damage caused by past market failures is not compounded further by stress-test policy failures. The writer is chief executive of Pimco and author of ‘When Markets Collide: Investment Strategies for the Age of Global Economic Change’, winner of the 2008 FT/Goldman Sachs Business Book of the Year

Mohamed El-Erian, Bank tests we should get stressed about, 21, abril, 2009 http://www.ft.com/cms/s/0/b4e9b93e-2eab-11de-b7d3-00144feabdc0.html?nclick_check=1

616 Apr 21, 2009 IMF Boosts Global Loss Estimate To $4.1 Trillion: $2.7T U.S.-Originated; $1.2T in EU; $150bn in Japan Overview: April 21: IMF estimates toxic loans and securities around the world could reach $4.1 trillion by the end of 2010. Of these, the IMF has raised loss estimates on U.S. originated assets to $2.7 trillion from $2.2T in January 2009. European originated loans and securities losses are set to amount to $1.2T and Japan originated loans and securities losses to a further $150bn. Banks and insurers have so far owned up to $1.29 trillion in writedowns (about $800bn in U.S., $400bn in Europe, remainder in Asia). Loss Estimates: o Apr 21: IMF-->Worldwide losses tied to bad loans and securitized assets may reach $4.1 trillion by the end of 2010 as the recession and credit crisis exact a higher toll on financial institutions. Banks will shoulder about 61% of the writedowns, with insurers, pension funds and other non-banks assuming the rest. Losses of $2.7 trillion at U.S. financial institutions, an increase from its estimates of $2.2 trillion in January and $1.4 trillion in October o The $4.1 trillion estimate is the first by the IMF to include loans and securities originating in Europe and Japan. Pension funds and insurance companies are also exposed to such losses. Bank losses in the euro area in 2009 and 2010 are forecast to climb to $750 billion, from $154 billion at the end of 2008. Losses at European financial institutions are projected to reach $1.2 trillion (Bloomberg) o Jan 20 Roubini/Parisi (RGE): Assuming a further 20% fall in house prices and unemployment peaking at 9-10%, we project total loan and securities losses amount to $3.6T, half of which accrue to the U.S. banking system, or $1.8T (of which $1.1 T in loan losses/ $600-700bn in securities writedowns). o Capitalization of FDIC banks is $1.4T, that of investment banks as of Q3 $110bn. If projected loan and securities losses materialize, the U.S. banking system is close to insolvency despite TARP 1 of $230bn and private capital of $200bn. o Outstanding loans are $12.4T. Of these, RGE estimates $1.6T to turn bad. Of these, U.S banks and brokers are assumed to carry $1.1T o Mark-to-market prices as of December imply around $2T in writedowns on $10.8T U.S. originated securities outstanding. Flow of funds data show that 40% of U.S. originated securities are held abroad. U.S. banks' share of writedowns is about 30- 35%, or $600-700bn for U.S. banks/brokers according to weights in IMF GFSR October 2008, table 1.1 o Chris Whalen (IRA): The bad news is that estimates that put aggregate loan charge- offs for all US banks over the next 12-18 months above $1 trillion are probably in

617 the right neighborhood. The entire banking industry only has $1.5 trillion in capital, so new equity must obviously be provided by Washington and/or private investors. o Jan 25 Goldman (via Zero Hedge): Total loan losses will reach $2 trillion of which $1 trillion are carried by the U.S. banking system (50% mortgage losses and 50% other loan losses). Banks need a minimum of $300bn additional capital but most likely more. o Roubini: In order to restore healthy credit conditions, the banking system needs about $1-1.5T in public or private capital. This calls for a comprehensive solution along the lines of a 'bad bank' or RTC. Loss Estimates For European Banks: o Fed Board: Flow of funds data show that 40% of U.S. originated securitizations are held abroad--> about $4.4T out of $10.8T securitizations held abroad, assume $4 T in Europe. Average writedown rate on securitization is 17% as calculated by RGE, so about $680bn writedowns apply for Europe. Assume about half to 75% fall on eurozone banks, or $400 - 500bn. o Goldman Sachs: Domestic loan and securities losses in the eurozone are estimated at 6% of GDP in baseline scenario (in ugly scenario this could double)--> 6% of eurozone GDP in dollars is $730bn (eurozone 2008 GDP=EUR9.3T=$12.2T) o The IMF puts expected losses on European/Asian loans at $900bn, rather than $1.1T estimated above. o Danske: European banks have $1.3T in claims on Central and Eastern European countries. Assuming that 20% of these loans turn bad, EU banks incur about $270bn in CEE-related losses, of which $30bn occur in Sweden (non-eurozone) which leaves writedowns of $240bn. --> Adding all up, expected losses among European banks amount to about $450bn exposure to U.S. securities +$730+ domestic&foreign loan losses+240 CEE=$1.4T. -->Compare with RGE's expected losses among U.S. banks and brokers of $1.8T. --> If the domestic loans and securities loss share is assumed to approach the U.S. loss share of around 12%, then eurozone expected losses add up to about the same dollar value as in U.S.

618 Apr 21, 2009 Stress Tests Underway: IMF Says U.S. Banks Need $275-500bn Capital Injections For Tangible Equity/Asset Ratio of 4-6% Overview: Stress test results are expected by the end of April. Banks then have six months to raise private capital if found to be undercapitalized. Meanwhile, Treasury plans to have the PPIP for toxic assets in place in order to facilitate the quest for private capital (application deadline extended to April 24 to include smaller asset managers and hedge funds) before government injects preferred shares as a last resort (see Geithner's Financial Stability Plan). Critics of the stress tests say that the Treasury's stress scenario looks more like the unfolding baseline scenario (i.e. unemployment rising to 10.3 percent by next year, home prices falling an additional 22 percent this year, and the economy contracting by 3.3 percent this year and staying flat in 2010.) o IMF Global Financial Stability Report April 2009: for 4% tangible common equity/tangible assets ratio, U.S. banks would need some $275bn in capital injections (incl. conversion from preferred shares). For 6% TCE/TA ratio, U.S. banks would need $500bn o April 15 NYT: The Treasury Department says it has $134.5 billion in TARP funds left after PPIP, incl. a conservative estimate that the banks would pay back $25 billion. o NYT: Administration plans to convert preferred shares issued under the TARP Capital Purchase program (=218bn) into Tangible Common Equity--> saves banks 5% interest payment, reduces leverage, saves Treasury from going back to Congress for additional TARP funds.Moreover, substantial voting rights: nationalization through the backdoor? o April 16 Bloomberg: Stress test results to be released May 4, paper on methodology on April 24. The results will include any plans for boosting capital to weather a deeper economic downturn. o April 8 Dash NYT: Insiders say that at the recent meeting with top executives, Geithner said that unrealistic loan values on banks' books are unacceptable. Geithner warned he would take a tough stance and force banks to sell these assets at prices investors are willing to pay. These banks must be prepared to take further write-downs o Eichengreen/ O'Rourke (Vox): The world economy is now plummeting as it did in the Great Depression; indeed, world industrial production, trade and stock markets are diving faster now than during 1929-30. Fortunately, the policy response to date is much better. Wether this will be enough to make a difference we'll see.

619 o April 6, Mike Mayo (via Bloomberg): Loan losses may exceed Great Depression levels and the government may be forced to take over large lenders. “New government actions might not help as much as expected, especially given that loans have been marked down to only 98 cents on the dollar, on average.”--> FASB Eases Mark-To-Market Rules For Toxic Assets: Will Banks Prefer To Keep Them? o cont.: Mayo said he expects loan losses to increase to 3.5 percent, and as high as 5.5 percent in a stress scenario, by the end of 2010. The highest level of loan losses in the Great Depression was 3.4 percent in 1934, according to the report. In the 3.5% loss rate scenario, Mr. Mayo said banks will lose between $600 billion and $1 trillion over the next three years, more than the roughly $400 billion in write-downs they've taken on risky investments. Total losses to the industry could amount to $1- 1.5T, most of which will be compensate by an expected pre-tax, pre-provision earnings (PPP) of $1T over next 6 years. o cont.: Mortgage-related losses are about halfway to their peak, while credit-card and consumer losses are only a third of the way to their expected highest levels, according to Mayo--> IMF Boosts Global Loss Estimate To $4.1 Trillion: $2.7T U.S.-Originated; $1.2T in EU; $150bn in Japan o Among the banks Mr. Mayo rates "underperform" are: Bank of America Corp., Citigroup Inc., Comerica Inc., J.P. Morgan Chase & Co., PNC Financial Services Inc. and Wells Fargo & Co. An "underperform" rating means the stock is expected to perform up to 10% worse than the broader market over the next year. o cont.: The U.S. government cannot provide much relief because its actions will lead to either banks having to raise new capital or toxic assets remaining on banks’ balance sheets. Solutions to the banking crisis will take time, as the increase in risk happened over a decade or more. o cont.: "Nationalization of banks remains a possibility because government policy remains unclear." o cont.: The "seven deadly sins" of banking include greedy loan growth, gluttony of real estate, lust for high yields, sloth-like risk management, pride of low capital, envy of exotic fees, and anger of regulators. o April 6, Meredith Whitney: Banks will continue to write down their mortgage assets as home prices decline further than lenders expected. The unemployment rate also has exceeded banks’ projections and could lead to further loan losses o March 30: Bank stocks plunge as Geithner says that some banks will need “large amounts” of assistance o March 25 FT Guha/Guerrera: The government’s toxic assets plan will force banks such as Citigroup, Bank of America and Wells Fargo to take large writedowns on their loans, requiring them to raise more capital from taxpayers or investors, executives and analysts have warned--> see Geithner presents new insolvency regime for holding companies and non-banks o March 20 Greenspan (via Bloomberg): “Restoration of normal bank lending will require a very large capital infusion from private or public sources.” The need is “north of $750 billion” and can’t be met just from banks’ cash flows, he said. o March 13 IRA (Whalen): "Remember that the maximum probably loss ("MPL") shown in The IRA Bank Monitor for the top US banks with assets above $10 billion,

620 also known as Economic Capital, is a cash number representing the amount of incremental capital the banks may require to absorb the losses from a 3-4 standard deviation economic slump, such as the one we have today. If you include the subsidy required for the GSEs and AIG, the US Treasury could face a collective funding requirement of $4 trillion through the cycle. Do Ben Bernanke and Tim Geithner really believe that they can sell such a program to the Congress? To put it in perspective, the $250 billion in the Obama Budget for additional TARP funds will not quite cover Citigroup" o Feb 25 DealBook: Stress Test specifics: the government appears to be aiming for banks to have a Tier 1 (=common stock, preferred stock and hybrid debt-equity instruments) capital ratio of 6% and a total common equity ratio of 3%. These are the baseline amounts and could be increased depending on how the financial markets react going forward. o Feb 22 WSJ: As part of those stress tests, the Federal Reserve is expected to dwell on the 'tangible common equity' (TCE) measurement as a gauge of bank health. Bankers and regulators generally prefer to use what is known as “Tier 1″ ratio of a bank’s capital adequacy. o cont.: By Tier 1 measurements, most big banks, including Citigroup, appear healthy. Citigroup’s Tier 1 ratio is 11.8%, well above the level needed to be classified as well-capitalized. By contrast, most banks’ TCE ratios indicate severe weakness. Citigroup’s TCE ratio stood at about 1.5% of assets at Dec. 31, well below the 3% level that investors regard as safe.--> see Hybrid Capital All But Discredited o DealBook: If Citigroup and Bank of America are forced to dole out common stock to get to the 3 percent level, the government could end up owning 59 percent of Citigroup and 19 percent of Bank of America, according to BreakingViews’ nationalization calculator. That is a whole lot more than the maximum 40 percent ownership stake of Citi that has been talked about in Washington. o Feb 25 Treasury: Regulators set a six-month deadline for the biggest 19 U.S. banks to raise any new capital deemed necessary after a review of their balance sheets. The regulators will complete their so-called stress tests by the end of March (now April). Banks with less than $100 billion of assets will also be eligible to participate in the Treasury’s new capital-raising plan. o Feb 24 Ben Bernanke: The Treasury will buy convertible preferred stock in the 19 largest U.S. banks if stress tests determine they need more capital to weather a deeper-than-forecast recession. The shares would be converted to common equity stakes only as extraordinary losses materialize, stress tests are no pretext to nationalize banks. While the U.S. government may take “substantial” stakes in Citigroup Inc. and other banks, it doesn’t plan a full-scale nationalization that wipes out stockholders. o Feb 23: Joint statement: Stress Tests begin February 25. In case of undercapitalization try private capital first. Afterwards, "any government capital will be in the form of mandatory convertible preferred shares, which would be converted into common equity shares only as needed over time to keep banks in a well- capitalized position and can be retired under improved financial conditions before the conversion becomes mandatory."

621 o As details about the current legacy loan valuations on banks' books emerge, doubts increase about the viability of matching buyer and seller interest without a huge subsidy--> Sifting Through Past FDIC Troubled Asset Auctions: Average 56 Cents on Dollar Value Implies Additional $1 Trillion Writedowns. The public and Congress are increasingly concerned about too many incentives to private investors, whereas Treasury has only $50bn in TARP money left after PPIP and TALF to make it work without resorting to Congress or nationalization--> see Are Banks To Buy Toxic Assets From Each Other?

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04/21/2009 01:19 PM GERMANY PONDERS BAD BANKS

Toxic Waste Urgently Seeking Dump By Beat Balzli The German government is hosting talks with banking supervisors about what to do about the hundreds of billions of euros of toxic assets still left in the banks' balance sheets. It sounds like a mission impossible -- saving the banks without bankrupting taxpayers. DDP Bank skyscrapers in Frankfurt, Germany's financial capital. The president of the German central bank, Axel Weber, was at pains last week to stress how hard it will be to recover from the current economic slump. "The paths out of the crisis will be stony and hard," he told a conference of the Hamburg Chamber of Commerce last Wednesday. "We'll need good boots and we'll have to push obstacles out of our way." The biggest obstacles are lurking in the banks' balance sheets. "Uncertainty about the solidity of the banks" hasn't been removed yet, said Weber. The International Monetary Fund estimates that banks worldwide hold more than €3 trillion ($3.88 trillion) worth of toxic assets which could yet cause a collapse of the financial system. German banks have just under €300 billion of that total on their books. The aim is to remove that toxic waste from balance sheets. This Tuesday, Chancellor Angela Merkel will host a meeting of top representatives from the German central bank, or Bundesbank, the Soffin bank bailout fund and government officials to discuss what to do with the toxic assets. Their task sounds impossible -- saving the banks without bankrupting taxpayers. The aim is to set up a national network of state-guaranteed waste dumps for financial products, so-called Bad Banks. These banks will take the risk of asset writedowns out of the banks' books. Josef Ackermann, the CEO of Deutsche Bank, Germany's biggest commercial bank, says such a plan would help restore confidence in the financial system. He said earlier this year that his own bank didn't need a Bad Bank. But its rivals do, urgently. Commerzbank has toxic assets of €55 billion since its takeover of Dresdner Bank. Publicly owned regional banks such as HSH Nordbank have similarly alarming holdings of toxic assets. No Central Bad Bank for Toxic Assets So far, no rubbish dump has been found for their toxic waste. Merkel's coalition has been arguing about a solution for months. Only one thing seems clear -- there is unlikely to be one central toxic waste dump because that would be too big, too risky, and too

623 expensive. It's also unlikely that private investors will be drawn in to the process, like in the United States, or that there will be a government insurance against losses, like in the United Kingdom. Finance Minister Peer Steinbrück agrees with Bundesbank President Weber that separate waste dumps are needed on a bank-by-bank basis. Steinbrück wants the process of cleaning up balance sheets to be transparent and practicable, and sufficiently plausible for politicians to explain it to the public. They also want it to be simple and quick because the crisis is continuing to eat its way into the supporting pillars of the financial system. In the US, so-called monoline bond insurance companies that guarantee bond repayments are starting to look wobbly. According to a new study by Britain's Royal Bank of Scotland, banks worldwide now face writedowns of a further $80 billion. Deutsche Bank alone has €36 billion worth of investments secured by "monoliners" on its books. At Commerzbank, such investments also run into the billions. News earlier this month illustrated how serious the situation has become -- rating agency Moody's cut its ratings on a mighty US bond insurer, Ambac Assurance, to junk territory. Despite Encouraging Bank Results, No Sign of Turnaround There are virtually no indications of a sustained recovery even though financial stocks have recently been rising. The latest profits being reported by Wall Street banks largely result from changes in accounting rules. Wells Fargo only managed to shine because it was suddenly allowed to book its share in a joint venture with insurance giant Prudential as an asset. The balance sheet jugglers of Goldman Sachs were allowed to make similarly profitable accounting changes. A change in its accounting period allowed it to keep a major loss out of its recently published quarterly results. In the classic investment banking business, Goldman Sachs earned even less than in the previous quarter. The only area where Goldman made serious profits was in the crisis-driven government and corporate bond business where its rivals J.P. Morgan and Deutsche Bank have been delivering similarly strong profits. "One swallow doesn't make a summer," Manfred Weber, president of the Association of German Banks, warned recently. "We're experiencing such a sharp economic downturn that the banks' credit risks will increase massively in the coming quarters." This would sap banks' equity capital and could "in the worst case lead to a general credit crunch." Lingering Risk of Credit Crunch Weber has proposed placing the toxic assets in separate accounts in a fund held by Soffin. In return, the banks would receive state-guaranteed, interest-paying bonds issued by the new fund. Any losses would be divided up "fairly" between the banks and the taxpayers at the end of the bonds' expiration, he proposes. But Weber hasn't said how those losses should be divided up. Will the taxpayer have to foot the bill for all the losses in 10 years' time when certain banks have long gone bust, have merged or remain too weak to cover the losses? It's a risky business given that the losses could run into hundreds of billions of euros.

624 Valuing the assets remains the biggest problem. Banking federation chief Weber argues that because the price question can't be answered, the assets should be priced at their current balance sheet values. But insiders believe that up to 90 percent of securities held in bank balance sheets are overvalued. It's also unclear what Steinbrück's plan for the private commercial banks entails. He wants to demand a high fee for guaranteeing the rotten assets. He recently proposed that the various bad banks should only be allowed to hold illiquid -- untradable -- securities. He wants the banks themselves to handle toxic assets such as securitized US mortgage loans. But where should the dividing line be between illiquid and toxic? Banking supervisors are already scratching their heads about whether securitized US credit card debt is just illiquid or toxic. Credit Suisse has come up with a particularly original idea for getting rid of its junk assets. Instead of paying out bonuses to its investment bankers, it gave them shares in the bank's own bad bank. The German government wants to decide by the summer recess what to do with the toxic assets. This Tuesday's meeting is unlikely to produce any decisions, said government spokesman Thomas Steg.

Beat Balzli, “Germany Ponders Bad Banks. Toxic Waste Urgently Seeking Dump”, Spiegel online, 21/04/2009, disponible en: http://www.spiegel.de/international/business/0,1518,620181,00.html

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21.04.2009 Socialists want to turn hedge fund regulation into election issue

The elections to the European Parliament are beginning, and the Socialists appear to have picked the Commission’s draft proposal on hedge funds and private equity groups as the key election issue. Poul Nyrop Rasmussen, the leader of the Socialists, wrote an angry letter to Jose Manual Barroso, accusing him of falling short of his own commitments given to the G20. Rasmussen promised to turn this into a prominent issue in June's election, the FT reports. The Socialists are particularly outraged by the €250m threshold in assets under management, above which the regulation is applied. Italy and the Euribor Il Sole 24 ore has the story this morning the one-month Euribor fell below 1% for the first time ever, and it looks as though this is becoming a big boost to the national property market as 42% of new mortgages are based on one-month Euribor. Last autumn, the trend was exactly reversed. The savings in mortgage payments to Italian mortgage holders are indeed substantial (the same applies almost to the same extent to the 3-month Euribor based mortgages, which are popular in Spain).

German government credit guarantees fail to work FT Deutschland leads this morning with a story that the programme of credit guarantees by the government to industry has failed to work, as the rules of the scheme are too complicated, and onerous. Companies have to prove that they only got into trouble after the start of the crisis, and they also have to be subject to a rating process. So far only 640 applications have been received for credits totalling €2bn. (This is typical for those micro-managed stimulus programmes. The infrastructure component of Germany’s stimulus is also not coming off the ground)

626 Majority of Swedes want to introduce euro An opinion poll in Sweden has produced a narrow majority in favour of the euro for the first time. 47% are in favour, 45% against, according to a poll for Swedish television. FT Deutschland reports that the Swedish poll is representative of an increasing popularity of euro membership in the periphery. One particular factor in Sweden may have been the 15% devaluation of the Swedish krone since the beginning of last year. Remember Segolene? After Nicholas Sarkozy memorably called Zapatero not very intelligent (we think he is probably right, for once), Segolene Royal apologised to the Spanish premier, who is widely admired by French Socialists. But her appology backfired, according to a report in Le Monde (which seems to be the biggest political issue in France this morning). A poll suggests that the majority of Frenchmen do not think it is a good idea to apologise for the president, and some observers do not like the idea that she appears to create the office of a shadow presidency. Most commentators seem to think that her strategy could backfire. Remember Joschka? In an interview with Le Monde, Daniel Cohn Bendit made a few interesting remarks. He talked about a lunch he had with Joschka Fischer recently, in which Fischer expressed deep uncertainty about the future of Europe, drawing parallels with 1929, and saying that Europe’s failure to act jointly in the current crisis would threaten European integration in the long run. Cohn Bendit also made the point that he is no longer as certain about the irreversibility of European integration as he once was. Why are banks hoarding cash? Writing in the FT Douglas Diamond and Raghuram Rajan dismiss the standard theories about why banks are not lending, such as concerns about credit risk. It is fear of being short of funds when credit opportunities get better. In particular, if financial institutions expect that those with liquidity could make a killing in the future, they will restrict their lending today to very short maturities. This also explains why some asset markets dried up completely. Paul Krugman on Ireland and the US In his NY Times column, Paul Krugman wonders whether the US might turn Irish in this crisis, ending up in a position where they need to pursue pro-cyclical fiscal policies merely to survive, or as Krugman puts it: you don’t want to put yourself in a position where you have to punish your economy in order to save your banks. He said he is worried about the Geithner plan because it might exhaust the available resources of the US to fix the problem, as the debt-to-GDP ratio grows by 30 to 40pp, at which point the freedom for manoeuvre may not be a lot greater than for Ireland today.

APRIL 21, 2009, 1:11 PM Signs of the times The local Sovereign Bank has posters in the window advertising the fact that it’s owned by Spain’s Santander. “Part of one of the world’s safest banks”, the posters boast.

627

April 21, 2009 Spain’s Falling Prices Fuel Deflation Fears in Europe By NELSON D. SCHWARTZ VALENCIA, Spain — Faced with plunging orders, merchants across this recession- wracked country are starting to do something that many of them have never done: cut retail prices. Prices dipped everywhere, from restaurants and fashion retailers to pharmacies and supermarkets in March. Hoping to increase sales, Fernando Maestre reduced prices by a third on the video intercoms his company makes for homes and apartment buildings. But that has not helped, so, along with many other Spanish employers, he is continuing to fire workers. The nation’s jobless rate, already a painful 15.5 percent, could soon reach 20 percent, a troubling number for a major industrialized country. With the combination of rising unemployment and falling prices, economists fear Spain may be in the early grip of deflation, a hallmark of both the Great Depression and Japan’s lost decade of the 1990s, and a major concern since the financial crisis went global last year. Deflation can result in a downward spiral that can be difficult to reverse. As unemployment rises sharply and consumers cut spending, companies cut prices. But if sales do not pick up, then revenue can decline further, forcing more cuts in workers or wages. Mr. Maestre is already contemplating additional job and wage cuts for his 250 employees. Nowhere is this cycle more evident than in Spain. Last month, it became the first of the 16 nations that use the euro to record a negative inflation rate. The drop, though just 0.1 percent, had not happened since the government began tracking inflation in 1961, and Spanish officials have said prices could keep dropping through the summer. Some of the decline came as volatile food prices sank; the cost of fish fell 6.2 percent, and sugar was down 5.7 percent. But even prices in normally stable sectors like drugs and medical treatments fell 0.7 percent in March, and there were slight declines in footwear, clothing and prices for household electronics. “Alarm bells are going off,” said Lorenzo Amor, president of the Association of Autonomous Workers, which represents small businesses and self-employed people. “Economies can recover from deceleration, but it’s harder to recover from a deflationary situation. This could be a catastrophe for the Spanish economy.” Deflation is not just a Spanish concern. Luxembourg, Portugal and Ireland have reported price drops, too. While the declines have been slight — and prices rose modestly after factoring out food and energy prices, which can fluctuate widely — other figures released this month suggest the risk of deflation is growing. In Germany, wholesale prices dropped 8 percent in March from a year ago, the steepest fall since 1987. In Japan, wholesale prices fell 2.2 percent on an annual basis. In the United States, the Consumer Price Index fell 0.1 percent in March, year over year, the

628 first decline of its kind since 1955, though prices rose 0.2 percent excluding food and energy. “It doesn’t mean it will spread here to the U.S., but we need to look closely at Spain and other places to understand the dynamic,” says Simon Johnson, a professor at the Sloan School of Management at the Massachusetts Institute of Technology and a former chief economist for the International Monetary Fund. “It’s like the front line of a new virus outbreak.” The trends have unnerved even well-established businesses. “There is such a huge lack of confidence in the politicians, in the European Union and in the banks,” said Arturo Virosque, 79, president of Valencia’s chamber of commerce and the owner of a local logistics company. Ticking off crises going back to the Spanish Civil War in his youth, he said, “this is different. It’s like an illness.” After price cuts by competitors, Mr. Virosque’s company reduced charges for storage and transportation, and slashed its work force to about 170, from 250. “The worst thing is that we have to cut the young people,” he said, because higher severance makes it too expensive to fire older workers. While unemployment traditionally is higher in Spain than in much of Europe, the sharp increase has many here nervous. The jobless rate for those under 25 is at a Depression- like level of 31.8 percent, the highest among the 27 nations of the European Union. Before cutting prices in early 2009, Mr. Maestre ordered several rounds of job cuts at his company, Fermax, as sales of the intercoms collapsed with Spain’s housing bubble. “It’s a question of survival for everybody,” he said. Still, the lower prices have not translated into higher sales. Fermax’s orders fell 25 percent in the first quarter. Prices for some intercom parts that he buys, like video screens, have also come down, but it is not enough to make up for the sales drought. “Prices have to come down more and we will have to spend less,” he said. The effects of this downward spiral are evident at Valencia’s principal soup kitchen, in an imposing stone building constructed a century ago as an alms house. Each day, a line forms around the block by noon. The Casa de la Caridad, or House of Charity, is helping three times as many people as it did a year ago. More than 11,000 meals were served in March, and it expects to top 12,000 this month. As the economic decline has broadened, so has the range of people seeking help. In the past, most were out-of-work immigrants or the homeless, said the center’s director, Guadalupe Ferrer. Today, “it’s more and more people like us who had a house, a respectable job, but are now unemployed.” The employed worry that falling prices will endanger their jobs as well. Yolanda Garcia has worked as a butcher under the arches of Valencia’s soaring Art Nouveau central market for a decade, but she’s troubled that a drop in the price of chicken, to 5.99 euros a kilo, from 6.99, has not attracted more customers to her stall. “Of course, we’re worried the boss will have to reduce staff,” said Ms. Garcia, 38, whose husband, a construction worker, was laid off two months ago. All this has made deflation, once a subject largely reserved for economists who studied the Great Depression, into front-page news here. The American economy is less vulnerable to deflation, in part because of the Federal Reserve’s decision to cut interest rates to near zero and increase lending by $2 trillion.

629 The European Central Bank has also cut rates, though more slowly, and it has resisted the lending measures adopted by the Fed and the Bank of England to prop up spending. When Spain had its own currency, the peseta, the central bank could have simply devalued it, or cut interest rates to zero. But that is not an option in the era of the euro, when monetary policy is controlled from the European Central Bank’s headquarters in Frankfurt, said Santiago Carbó, a professor of economics at the University of Granada. “If we enter into a deflationary period, we won’t have the monetary tools to sort it out,” Mr. Carbó said.

630 Economy

April 21, 2009 Bank Aid Programs Are Seen as Open to Fraud By EDMUND L. ANDREWS WASHINGTON — The Treasury Department’s most ambitious plans to rescue troubled banks — partnerships between the government and private investors, backed by the Federal Reserve — are inherently vulnerable to fraud and should not be started without stronger safeguards, a top government investigator warned in a report to be released Tuesday. The report also warned that the Treasury’s $700 billion Troubled Asset Relief Program has evolved into a $3 trillion effort of “unprecedented scope, scale and complexity” and comes with too little oversight and too little information about what companies are doing with the taxpayer money they are getting. “The American people have a right to know how their tax dollars are being used,” wrote Neil M. Barofsky, the special inspector general assigned to monitor the bailout program, in his second report to Congress. Mr. Barofsky was particularly critical of the Treasury Department’s refusal to demand detailed information from banks and other financial institutions about what they are doing with the money they receive. Noting the widespread public outrage unleashed over the Treasury’s huge payments to the American International Group, the failing insurance conglomerate, Mr. Barofsky warned that Treasury officials were jeopardizing the credibility of their efforts by not requiring companies to disclose far more about their use of taxpayer money. “Failure to impose this requirement with respect to the injection of yet another $30 billion into A.I.G. would not only be a failure of oversight, but could call into question the credibility of the government’s efforts,” he said. He was referring to bailout money that had been pledged, but not yet delivered, to the insurance giant. The inspector general was particularly pointed in his criticism of the Obama administration’s plan to buy up questionable assets from banks. That plan calls for the Treasury to spend $100 billion to buy up troubled mortgages and mortgage-backed securities. The plan also calls for multiplying the total volume of those asset purchases to almost $1 trillion by allowing private investors to borrow money at low interest rates from the Federal Reserve. Mr. Barofsky said the plan posed “significant fraud risks,” especially when it came to buying up securities backed by exotic mortgages made during the peak of the housing bubble, when the excesses of poorly documented loans and no-money-down loans reached their zeniths.

631 The report said that the Federal Reserve intended its lending program, known as the Term Asset-Backed Securities Loan Facility, or TALF, to finance new lending rather than to buy up existing assets. It warned that the Fed was not currently planning to examine the securities that it would finance, and would be relying instead on the evaluation by credit rating agencies that originally failed to spot the dangers of subprime mortgages. “Credit ratings, cited as one of the primary credit protections in TALF as currently configured, have been proven to be of questionable value,” the report said. “The wholesale failure of the credit rating agencies to rate adequately such securities is at the heart of the securitization market collapse, if not the primary cause of the current credit crisis.” Mr. Barofsky also warned that the Treasury’s plan might allow investors to double up on government subsidies for buying up troubled assets. The Public-Private Investment Program would have the Treasury invest alongside private investors. But the partnerships would also be able to borrow money from the Fed through “nonrecourse” loans. If the investments flopped, the investors could walk away from the loans and leave taxpayers with most of the losses. The Treasury and the Federal Reserve have not yet begun the asset purchase programs. The two agencies started up a limited version of the TALF program last month, which is mainly focused on financing consumer and small-business loans. In February, Treasury Secretary Timothy F. Geithner announced the broader Public- Private Investment Program, which is aimed at buying up both mortgages and mortgage- backed securities. Part of the plan calls for marrying the public-private program with the Fed’s lending program, but the program still appears to be at least a month or two away from starting. Senator Charles E. Schumer, Democrat of New York and a member of the Senate Banking Committee, said some of the inspector general’s criticisms about buying up “legacy assets” — usually troubled mortgage-backed securities — made sense. “There are a few problems with using the TALF program to buy up legacy assets,” he said. “First, it’s rewarding the worst behavior — buying no-doc loans.” Second, he said, the public-private program “is a very rich subsidy program to begin with. You have to ask whether it needs the extra enrichment of TALF, particularly when it involves the most egregious of mortgages.” Treasury officials had no comment on Mr. Barofsky’s report. But Mr. Geithner is scheduled to discuss it on Tuesday at a hearing of a Congressional panel that oversees the financial bailout program. Both the Treasury and the Fed have increased the amount of information they are making public about their various rescue plans. Treasury officials have pushed the banks to provide information about their lending volumes, and they are demanding more information about what banks are doing with their money. But Treasury officials have argued that it is almost impossible to get meaningful information about how banks are using money under the troubled-asset program, in part because the money came with few conditions. Treasury officials have also noted that if the funds are allocated for one purpose, like mortgage lending, they free up other money that can be used for a very different purpose, like making acquisitions.

632 Financial Times ft.com/alphaville Back to 1960 Posted by Izabella Kaminska on Apr 21 10:25. We were all much relieved in Britain at the end of March when a widely anticipated deflationary figure for RPI in February came in just above zero at 0.1 per cent. Alas, such relief has proved short-lived. The latest inflation numbers from the UK’s Office of National Statistics present at -0.4 per cent the first negative annual reading for the retail price index since 1960. Here’s the relevant par from the release:In the year to March, the consumer prices index (CPI) rose by 2.9 per cent, down from 3.2 per cent in February. In the year to March, the all items retail prices index (RPI) fell by 0.4 per cent, compared with no change in February, that is, an annual rate of 0.0 per cent. Over the same period, the all items RPI excluding mortgage interest payments index (RPIX) rose by 2.2 per cent, down from 2.5 per cent in February. The leading downward contribution to the change in the RPI according to the ONS came from housing, principally from house depreciation and mortgage interest payments. These of course are not accounted for in the CPI measure, which at 2.9 per cent remains firmly above the government target of 2 per cent. As UK economist Howard Archer at IHS Global Insight states, this demonstrates to what extent UK CPI is markedly stickier than in the Eurozone, most likely due to the upward impact on prices from sterling’s sharp depreciation. Other downward contributions to RPI meanwhile also came from: • fuel and light where, as in the CPI, gas prices fell this year but were unchanged a year ago, and the price of heating oil fell this year but rose a year ago • food where prices overall fell this year but rose a year ago. The effect came from across a range of both seasonal and non-seasonal foods with the largest contributions from fresh vegetables and fresh fruit • fares and other travel costs where, in the other travel costs section, passenger air fares fell this year but rose a year ago with the main effect coming from European routes partially offset by domestic fares. To help you cope with the new price environment here’s what Britain looked like 49 years ago. This entry was posted by Izabella Kaminska on Tuesday, April 21st, 2009 at 10:25 and is filed under Capital markets. Tagged with 1960, cpi, Deflation, Rpi.

633 U.S. April 21, 2009 With Son in Remission, Family Looks for Coverage By KEVIN SACK HUMBLE, Tex. — When Danna Walker left the second-floor conference room and returned tearily to her desk — where someone had already deposited a packing box for her belongings — her first thought was not of the 14 years she had worked for DHL or the loss of her $37,000-a-year salary. It was of Jake. In three months, once her benefits ran out, how in the world would she provide health insurance for Jake, her mountainous, red-headed 21-year-old son, who had learned three years earlier that he had metastatic testicular cancer? Since the day she was laid off in October, Ms. Walker and her husband, Russ, co-owner of a struggling feed store here on the outskirts of Houston, have mounted a largely fruitless quest to find affordable coverage for Jake’s pre-existing condition. Their odyssey has become all too familiar to millions of newly uninsured Americans who suddenly find themselves one diagnosis away from medical and financial devastation. The Walkers, both 46, are among nine million people who have lost employer- sponsored insurance since December 2007, according to projections by the Kaiser Family Foundation. Some have qualified for government insurance, and others have bought individual policies. But an estimated four million have joined the ranks of the uninsured, heightening the urgency in Washington to close the coverage gaps in American health care. Like many others, the Walkers live on a knife’s edge of risk. Without insurance to cover her high blood pressure or his diabetes, they defer doctors’ visits when possible and obtain their prescriptions — nine between the two of them — for $4 apiece at Wal-Mart. But their primary concern has been finding insurance for Jake, who, after four operations, two stem cell transplants and round after grueling round of chemotherapy, has been cancer-free for a year. He continues to face a significant threat of recurrence and requires regular monitoring for at least two years. His twice-a-year CT scans cost $3,000 each, and quarterly blood tests and X-rays run more than $1,000. Late last month, in a race against the clock, the Walkers obtained a short-term policy for Jake through Oklahoma State University, where he is a junior studying animal science on a scholarship. Doing so could be crucial to his future insurability because federal law allows insurers to deny coverage for pre-existing conditions when there has been a gap in coverage of at least 63 days. With a week to spare, they scraped together $335 to pay the quarterly premium by delaying a house payment and pleading with the power company for a 10-day extension. But the policy will expire on May 16, and its coverage limits will afford minimal protection against bankruptcy if the cancer returns before then.

634 Now the Walkers face the possibility that Jake will no longer be seen at Houston’s renowned M.D. Anderson Cancer Center, which they credit for his remission. “You realize how vulnerable you really are,” said Ms. Walker, who exhibits the maternal ferocity of a black bear. “You just — not give up — but you just feel that you’re at a loss, that you’re at your wits’ end. I ask myself, ‘Do I really have to lose my home to save my son’s life?’ ” Neither of the Walkers has been able to land a job with the kind of large group coverage that would disregard Jake’s health status. His cancer history effectively makes him uninsurable on the individual market. He is too old to qualify for Medicaid as a child, and it is virtually impossible in Texas to qualify as an able-bodied adult. Because the Walkers own their modest house, they have been told they do not merit other government assistance. With little predictable income beyond Ms. Walker’s $688 unemployment check every two weeks, the family cannot afford the state’s high-risk insurance pool or continuation coverage through the federal Cobra law. To date, Jake’s treatment has cost nearly $2 million. Almost all of it has been paid by Cigna under a preferred-provider family policy that Ms. Walker paid $426.28 a month for through DHL, the troubled shipping company where she worked as a billing agent. Until last fall, Mr. Walker was the co-owner of a business that supplied DHL with trucks and drivers, but it too fell victim to downsizing. The feed store, the last in an area where suburbs are swallowing ranchland, has been losing money. What has made the Walkers feel most helpless, though, is that their son has been left so exposed, after all he has endured. “Your job as a parent is to protect your children at any cost,” Ms. Walker said. “I really felt like I had let him down.” At 6-foot-2 and 285 pounds, Jacob Walker often dwarfs the prize livestock he parades in the show ring. He first noticed that his left testicle had become larger than the other as a senior in high school. He waited a few weeks to tell his parents so he would not miss the county fair, where his favorite heifer and goat both won grand-champion ribbons. By then, the cancer had spread to his abdomen, and he received a Stage 3 diagnosis. Over the next two years, surgeons would remove the testicle and slice off diseased sections of his abdomen and liver. The chemotherapy preceding the stem cell transplants was so toxic that it peeled his skin. Through it all, Jake maintained an optimistic determination. “Life’s tough,” he would say. “Sometimes you have to get a helmet and run with it.” His mother left the hospital once in 26 days during the stem cell transplants. When he started college online from his hospital bed, she read to him from his world-literature text. His father, not often given to emotion, started telling his son every day that he loved him, before going home to cry. During Jake’s chemotherapy, his buddies in Future Farmers of America shaved their heads in solidarity. Late in 2007, Jake’s doctors at Texas Children’s Hospital told him that they had done all they could and gave him a 20 percent chance of surviving the next year. The Walkers were not ready to quit, and sought out Dr. Lance C. Pagliaro, a specialist at M. D. Anderson.

635 Dr. Pagliaro recommended an experimental chemotherapy regimen, and Jake has shown no sign of cancer since the treatments ended in March 2008. “Needless to say, we’re very pleased with how he’s doing,” Dr. Pagliaro said. But during Jake’s check-up in December, Ms. Walker told the hospital that her son would be uninsured at the end of January. She said a hospital official then told her that if she was not able to pay up front, she should take her son elsewhere. Dr. Pagliaro pledged that he would do what he could to make sure that Jake would be seen. “To deny him the relatively inexpensive follow-up that is so crucial,” he said in an interview, “just makes absolutely no sense.” But the doctor has yet to intercede with the business office about waiving fees, saying it would be premature. Last month, when the Walkers showed up for an appointment with Jake’s oncologist, only a last-minute dispensation enabled him to be seen without payment in advance. The Walkers left with the impression they would be billed $700; the hospital says it will be $1,507. In either event, they have no way to pay it. The hospital has suggested that Jake have his next tests elsewhere and send the results to Dr. Pagliaro to review, with payment to be negotiated in advance. The Walkers are now completing the voluminous paperwork to apply for M. D. Anderson’s charity care program for Texas residents. The hospital, which had $2.2 billion in net patient revenue last year, spent $209 million on such uncompensated care. But Dr. Ron Walters, the hospital’s vice president for medical operations, said economic pressures had made it more difficult to assist patients who were not under active treatment. Dr. Walters said it had been “good financial counseling” to advise the Walkers to explore other options, and questioned whether they would qualify for charity care because they had assets. Among the criteria, he said, is whether a patient can receive comparable treatment elsewhere. Dr. Walters said requests for deferred payment by uninsured patients had risen tenfold in four years. But Ms. Walker said she could not help taking the hospital’s stance personally. “You feel like you’ve been kicked to the curb,” she said. “It’s like, ‘As long as you have insurance, we’re willing to go over the moon to see you and make sure that everything is taken care of.’ And the minute you don’t, they don’t want you.” The Walkers had not heard about the Texas Health Insurance Risk Pool, which provides coverage to 26,550 otherwise uninsurable people. Once they learned about it, they concluded they could not afford the most useful policy for Jake, a plan with a $1,000 deductible that would cost $414 a month. Now they are revisiting whether they might extend their P.P.O. coverage under Cobra, which allows laid-off workers to continue their insurance at full price for up to 18 months. When Ms. Walker first investigated, she learned it would cost $1,359 a month to replicate her coverage. The recently enacted federal stimulus package includes a 65 percent subsidy for nine months of Cobra coverage for the newly unemployed. That would reduce the Walkers’ price to $476 a month, which they said they still could not afford. They are now inquiring about whether they can cover only Jake. If they can find a policy for him for less than $200 a month, Ms. Walker said, she would find a way. “It will happen,” she said, “if I have to walk up and down the street and collect tin cans.” Brent McDonald contributed reporting.

636 U.S.

April 21, 2009 Civil Lawsuit Over Katrina Begins By JOHN SCHWARTZ NEW ORLEANS — A groundbreaking civil suit began in federal court here Monday to consider claims by property owners that the Army Corps of Engineers amplified the destructive effects of Hurricane Katrina by building a poorly designed navigation channel adjacent to the city. The Mississippi River Gulf Outlet, a 76-mile-long channel known locally as MR-GO and pronounced “Mister Go,” was completed in 1968 and created a straight shot to the Gulf of Mexico from New Orleans. The suit claims that the channel was flawed in its design, construction and operation, and that those flaws intensified the flood damage to the eastern parts of New Orleans and St. Bernard Parish. One geological expert testified on behalf of the plaintiffs that the channel was “one of the greatest catastrophes in the history of the United States.” The federal government argued that Hurricane Katrina would have devastated the region whether or not the channel had ever been dug. The government’s filings in the case say the plaintiffs’ assertions that the taxpayers are liable for the damage are based on “misguided and internally inconsistent arguments.” If they win, the plaintiffs — a local newscaster, Norman Robinson, and five others whose homes or businesses were destroyed by the 2005 storm — could receive hundreds of thousands of dollars each as compensation for their losses. More broadly, a victory could pave the way for more than 400,000 other plaintiffs who have also filed claims against the government over the hurricane’s destruction. The government has historically enjoyed strong legal protection against lawsuits related to collapsing levees. The Flood Control Act of 1928 bans suits against the United States for damages resulting from floods or floodwaters. In January 2008, a federal judge, Stanwood R. Duval Jr., ruled that the corps was immune in a different lawsuit related directly to the levee and floodwall failures during Hurricane Katrina in the city’s major drainage canals. This case, however, is different because MR-GO is a navigation canal, not a flood- control project. In March, Judge Duval allowed the suit to go forward — over repeated efforts by the Justice Department to get him to dismiss it — based largely on a 1971 case, Graci v. United States, that found there was no immunity for flooding caused by a federal project unrelated to flood control. The Graci decision did warn that the lack of immunity still left a “heavy burden” on plaintiffs to prove that the government was negligent in building its projects, and that this negligence, not a hurricane, was the cause of the damage. The trial is expected to take four weeks. In his opening comments, Judge Duval, who is hearing the case without a jury, called it “significant” and “the first real trial” about Hurricane Katrina, the levees and the role of the federal government. The canal has been controversial from the start; critics had long called it a “hurricane highway” and warned that it would help carry storm surges into New Orleans. The suit alleges that the channel killed the protective wetlands and cypress swamps to the east of

637 the city by allowing the intrusion of salt water from the gulf and caused the adjacent levees to subside. That, the plaintiffs say, exacerbated the effects of waves coming across the channel. The corps has consistently argued that the canal’s effect during Hurricane Katrina was insignificant. At the direction of Congress, however, the corps has begun to close the MR-GO canal using 434,000 tons of rock. During the trial’s opening session, the plaintiffs’ expert on geology and the coastal environment, Sherwood M. Gagliano, cited reports from as early as 1957 that claimed the canal would pose a danger to the people of St. Bernard Parish and reports of his own dating from 1972 that warned of the increased flooding risk from wetlands destruction. Mr. Gagliano testified that the corps was aware of such research and even prepared a report in 1988 that mentioned “the possibility of catastrophic damage to urban areas” from the channel but did little to reduce the risk. Under questioning by Kara K. Miller, a lawyer for the government, Mr. Gagliano acknowledged that the corps had agreed to some of his recommendations to improve the canal, like planting grass atop some of the levees to stabilize them. The plaintiffs say they hope a victory in the case can open the door for a broader class action in which more than 400,000 claims have been filed against the government. A financial projection by the Army has concluded there is a reasonable possibility that potential government losses could ultimately range from $10 billion to $100 billion. Beyond the monetary damages, many in New Orleans hope the lawsuit could put an end to the search for someone to blame for the flood damage during Hurricane Katrina, a quest that has haunted many who remain angry at the loss of their homes and businesses. Like so many in the New Orleans area, Lucille Franz, one of the plaintiffs in the case, lost everything in the storm. Mrs. Franz and her husband, Anthony, came back from their evacuation to Texas during Hurricanes Katrina and Rita to find that their home on St. Claude Avenue in the Lower Ninth Ward had steeped for three weeks in 18 to 22 feet of water. The water came three feet up the walls of the second floor. “I’ve been through a lot,” she said in an interview. The home, which the family owned, was deemed a total loss. The Franzes do not have the money to tear it down, much less to rebuild it. Family photographs, furniture and the accumulations of a lifetime were ruined; a community of neighbors was scattered. Mrs. Franz is 75, her husband, 80. They were uninsured; she said that they did not have flood insurance, and that the $80,000 they received from the Road Home program was not enough to start again. “You might purchase a trailer, but you can’t get a house,” she said. The money pays their rent for an apartment in Harahan, west of the city. “We need a home,” she said. Jonathan Beauregard Andry, one of the lawyers representing the Franzes and other plaintiffs in the case, said the Franzes were typical of those who suffered damage and showed why the suit was important. “Their whole life is changed,” Mr. Andry said, “and they should be compensated for that.” Mr. Andry, whose father argued the Graci case in 1971, is a native of St. Bernard Parish and among more than 50 lawyers from 20 law firms around the nation working on the case. The people of the Lower Ninth Ward and St. Bernard Parish, he said, “don’t want sympathy, and they don’t want something for nothing.”

638

The central bank panic of 2008

Posted on Monday, April 20th, 2009 By bsetser Central bank purchases of Agencies in 2007 (Setser and Pandey estimate, based on the survey data – the BoP data should be similar once it is revised to reflect the 2008 survey): $300 billion. Central bank sales of Agencies in 2008: close to $100 billion. That is a one-year swing was close to $400 billion. It just occurred to me that this was a larger swing – in dollar terms – than the swing in non-FDI private capital flows in Asia in 1997 and 1998. According to the IMF’s WEO database, developing Asia attracted $70 billion in portfolio and bank inflows in 1996. In 1998, $110 billion flowed out, for a total swing of around $200 billion.*

So much for the notion that sovereign investors are always a stabilizing force in the market. Maybe sovereign funds are different (as the FT argues), but central banks ultimately proved to be rather loss adverse. They moved in mass into the Agency market for a few extra basis points, and then moved out faster than they moved in. Kind of like fickle private investors … Of course, the comparison between central banks now and private investors in Asia is a bit unfair. Developing Asia back in the 1990s had a GDP of about $2 trillion. The US

639 today has a GDP of around $14 trillion. So the swing in demand for Agencies is far smaller, relative to US GDP, than the swing in private capital flows was relative to Asia’s GDP. The swing in capital flows to Asia was in the realm of 8% of its GDP. Even if the fall in Agencies in 2009 is around $150 billion (it was $125b in the 12ms through February, but the basis for the y/y comparison will start to shift as the year goes on … ), the swing for the US will be more like 3% of US GDP.

The comparison though should give pause to those arguing that sovereign investors are always a stabilizing force in the market because of their long investment horizons. If a few very large actors loses confidence in a certain type of debt, they can have a big impact. There is a second reason why central banks’ sales of Agencies wasn’t quite as disruptive as it might have been: The US central bank – moved to offset the outflow of foreign central banks from the Agency market. Foreign central banks sold Agencies to buy Treasuries, and the US government sold Treasuries to buy Agencies. And American money market funds never lost confidence in the Agencies. When they stopped holding the financial sector’s paper, they bought both short-term Agencies and short-term Treasuries. The willingness of the official inflows (from places like the IMF) to offset the swings in cross-border private capital flows has, historically, been smaller. With the benefit of hindsight, a strong case can be made that the IMF’s financial response to the Asian crisis was too timid, with the IMF asking for too much adjustment and providing too little financing. Loans from the IMF and World Bank were clearly far too small to offset the swing in private capital flows. This isn’t just a historic debate either. Eastern Europe has attracted large net capital inflows over the past few years. Bigger inflows, relative to its GDP, than Developing Asia in the 1990s

640

And by all indications Eastern Europe is now experiencing a comparable stop in private inflows. In all likelihood, the large private inflows of the past few years will turn into large private outflows. But there also now seems to be a greater willingness to use the IMF to provide more financial support than in the past … * The swing would be larger if I added data for the Asian NIEs (including Korea, a crisis country) to the total. Alas, the IMF WEO data set doesn’t have BoP data for the NIEs. Help, please! I am a heavy user of the IMF data, and this is something that they should be able to add … http://blogs.cfr.org/setser/2009/04/20/the-central-bank-panic- of-2008/#more-5226

641 Welcome to The Wall Street Journal Opinion Journal forum Tuesday, April 21, 2009 As of 3:56 AM (GMT +2 hours) Opinion Journal A Crisis of Ethic Proportions We must establish a 'fiduciary society.' By JOHN C. BOGLE APRIL 20, 2009, 9:56 P.M. ET I recently received a letter from a Vanguard shareholder who described the global financial crisis as "a crisis of ethic proportions." Substituting "ethic" for "epic" is a fine turn of phrase, and it accurately places a heavy responsibility for the meltdown on a broad deterioration in traditional ethical standards. Commerce, business and finance have hardly been exempt from this trend. Relying on Adam Smith's "invisible hand," through which our self-interest advances the interests of society, we have depended on the marketplace and competition to create prosperity and well-being. But self-interest got out of hand. It created a bottom-line society in which success is measured in monetary terms. Dollars became the coin of the new realm. Unchecked market forces overwhelmed traditional standards of professional conduct, developed over centuries. The result is a shift from moral absolutism to moral relativism. We've moved from a society in which "there are some things that one simply does not do" to one in which "if everyone else is doing it, I can too." Business ethics and professional standards were lost in the shuffle. The driving force of any profession includes not only the special knowledge, skills and standards that it demands, but the duty to serve responsibly, selflessly and wisely, and to establish an inherently ethical relationship between professionals and society. The old notion of trusting and being trusted -- which once was not only the accepted standard of business conduct but the key to success -- came to be seen as a quaint relic of an era long gone. The proximate causes of the crisis are usually said to be easy credit, bankers' cavalier attitudes toward risk, "securitization" (which severed the traditional link between borrower and lender), the extraordinary leverage built into the financial system by complex derivatives, and the failure of our regulators to do their job. But the larger cause was our failure to recognize the sea change in the nature of capitalism that was occurring right before our eyes. That change was the growth of giant business corporations and giant financial institutions controlled not by their owners in the "ownership society" of yore, but by agents of the owners, which created an "agency society." The managers of our public corporations came to place their interests ahead of the interests of their company's owners. Our money manager agents -- who in the U.S. now hold 75% of all shares of public companies -- blithely accepted the change. They fostered the crisis with superficial security analysis and research and by ignoring

642 corporate governance issues. They also traded stocks at an unprecedented rate, engaging in a dangerous spree of speculation. Adam Smith presciently described the characteristics of today's corporate and institutional managers (many of whom are themselves controlled by giant financial conglomerates) with these words: "[M]anagers of other people's money [rarely] watch over it with the same anxious vigilance with which . . . [they] watch over their own . . . they . . . very easily give themselves a dispensation. Negligence and profusion must always prevail." The malfeasance and misjudgments by our corporate, financial and government leaders, declining ethical standards, and the failure of our new agency society reflect a failure of capitalism. Free-market champion and former Federal Reserve chairman Alan Greenspan shares my view. That failure, he said in testimony to Congress last October, "was a flaw in the model that I perceived as the critical functioning structure that defines how the world works." As one journalist observed, "that's a hell of a big thing to find a flaw in." What's to be done? We must work to establish a "fiduciary society," where manager/agents entrusted with managing other people's money are required -- by federal statute -- to place front and center the interests of the owners they are duty-bound to serve. The focus needs to be on long-term investment (rather than short-term speculation), appropriate due diligence in security selection, and ensuring that corporations are run in the interest of their owners. Manager/agents need to act in a way that reflects their ethical responsibilities to society. Making that happen will be no easy task. Mr. Bogle, founder and former chief executive of the Vanguard Group of Mutual Funds, is author of "Enough. True Measures of Money, Business, and Life" (Wiley, 2008). Turnaround Lesson

By Barry Ritholtz - April 20th, 2009, 5:16PM

643 > Tom Toles

644 End of Economic Gloom? Not as Early as You Wish. Roubini’s latest Article for Project Syndicate

Nouriel Roubini | Apr 20, 2009 Project Syndicate is distributing in newspapers around the globe my latest op-ed written about two weeks ago where I discuss the economy and the recent bear market rally: End of economic gloom? Nouriel Roubini Mild signs that the rate of economic contraction is slowing in the United States, China and other parts of the world have led many economists to forecast that positive growth will return to the US in the second half of the year, and that a similar recovery will occur in other advanced economies. The emerging consensus among economists is that growth next year will be close to the trend rate of 2.5 per cent. Investors are talking of 'green shoots' of recovery and of positive 'second derivatives of economic activity' (continuing economic contraction is the first, negative, derivative, but the slower rate suggests that the bottom is near). As a result, stock markets have started to rally in the US and around the world. Markets seem to believe that there is light at the end of the tunnel for the economy and for the battered profits of corporations and financial firms. This consensus optimism is, I believe, not supported by the facts. Indeed, I expect that while the rate of US contraction will slow from -6 per cent in the last two quarters, US growth will still be negative (around -1.5 to -2 per cent) in the second half of the year (compared to the bullish consensus of +2 per cent). Moreover, growth next year will be so weak (0.5 to 1 per cent, as opposed to the consensus of 2 per cent or more) and unemployment so high (above 10 per cent) that it will still feel like a recession. In the euro zone and Japan, the outlook for 2009 and 2010 is even worse, with growth close to zero even next year. China will have a more rapid recovery later this year, but growth will reach only 5 per cent this year and 7 per cent in 2010, well below the average of 10 per cent over the last decade. Given this weak outlook for the major economies, losses by banks and other financial institutions will continue to grow. My latest estimates are $3.6 trillion in losses for loans and securities issued by US institutions, and $1 trillion for the rest of the world. It is said that the International Monetary Fund, which earlier this year revised upward its estimate of bank losses, from $1 trillion to $2.2 trillion, will announce a new estimate of

645 $3.1 trillion for US assets and $0.9 trillion for foreign assets, figures very close to my own. By this standard, many US and foreign banks are effectively insolvent and will have to be taken over by governments. The credit crunch will last much longer if we keep zombie banks alive despite their massive and continuing losses. Given this outlook for the real economy and financial institutions, the latest rally in US and global stock markets has to be interpreted as a bear-market rally. Economists usually joke that the stock market has predicted 12 out of the last nine recessions, as markets often fall sharply without an ensuing recession. But, in the last two years, the stock market has predicted six out of the last zero economic recoveries -- that is, six bear market rallies that eventually fizzled and led to new lows. The stock market's latest 'dead cat bounce' may last a while longer, but three factors will, in due course, lead it to turn south again. First, macroeconomic indicators will be worse than expected, with growth failing to recover as fast as the consensus expects. Second, the profits and earnings of corporations and financial institutions will not rebound as fast as the consensus predicts, as weak economic growth, deflationary pressures and surging defaults on corporate bonds will limit firms' pricing power and keep profit margins low. Third, financial shocks will be worse than expected. At some point, investors will realise that bank losses are massive, and that some banks are insolvent. Deleveraging by highly leveraged firms -- such as hedge funds -- will lead them to sell illiquid assets in illiquid markets. And some emerging market economies -- despite massive IMF support -- will experience a severe financial crisis with contagious effects on other economies. So, while this latest bear-market rally may continue for a bit longer, renewed downward pressure on stocks and other risky assets is inevitable. To be sure, much more aggressive policy action (massive and unconventional monetary easing, larger fiscal-stimulus packages, bailouts of financial firms, individual mortgage- debt relief, and increased financial support for troubled emerging markets) in many countries in the last few months has reduced the risk of a near depression. That outcome seemed highly likely six months ago, when global financial markets nearly collapsed. Still, this global recession will continue for a longer period than the consensus suggests. There may be light at the end of the tunnel -- no depression and financial meltdown. But economic recovery everywhere will be weaker and will take longer than expected. The same is true for a sustained recovery of financial markets. Nouriel Roubini is professor of economics at the Stern School of Business, New York University, and chairman of RGE Monitor. Copyright: Project Syndicate, 2009. http://www.rgemonitor.com/roubini- monitor/256485/end_of_economic_gloom_not_as_early_as_you_wish__roubinis_latest _article_for_project_syndicate

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April 20, 2009, 2:39 pm Preferred shares to common equity: an analogy A followup to my previous post. Here’s how I think about it: you started a business with a bunch of borrowed money, but of course had to put some of your own money in. Now, actually some of the money you put in was borrowed from your mother, but the original lenders don’t care about that, since they have prior claim. Eventually you run into some business difficulties, and your creditworthiness is in doubt — which in turn is making it hard for you to do business. What you need is evidence of ability to repay the money you already owe. So does it help if your mother converts her loan into a share of the business? Not really, because she won’t get repaid anyway unless all your other creditors get paid first. So the terms of her agreement with you don’t affect their prospects of payment. And in this case, the TARP is your mother. April 20, 2009, 7:52 am Bank bafflement OK, I don’t get the latest bank-rescue idea: converting TARP preferred shares to common equity. It really does seem to fall into the shuffling-the-deck-chairs category. James Kwak basically does the same analysis I did. Here’s my way of thinking about it: it’s all about seniority. What, after all, is the purpose of bank capital? It’s to protect the bank’s creditors: equity holders are first in line for any losses, so that creditors only take a hit if losses exceed capital. And that’s why banks have to have adequate capital in order to function. Now, preferred shares are sort of like a junior loan: the preferred shareholders are second in line for losses, but ahead of the rest of the bank’s creditors. So from the point of view of the creditors, capital includes preferred shares as well as common equity. Or to put it a bit more generally, from a creditor’s point of view capital is everything that has a more junior claim than you do. And that’s why Tier I capital includes preferred as well as common. But in that case, converting preferred into common does nothing: it’s just a swap among the junior stuff, with no impact further up the line. It’s certainly not a fresh infusion of capital in any meaningful sense. So who is supposed to be fooled by this? The markets? The pundits? There is, I guess, one possible advantage of the move: by increasing the government stake, it means that taxpayers get more of the upside if the government throws money in the banks’ general direction, say by overpaying for toxic assets. But aside from that, nada.

647 Marcus Baram [email protected]

April 21, 2009

Judge Richard Posner Questions His Free-Market Faith In "A Failure Of Capitalism" 04/20/09 06:33 PM

"If you're worried that lions are eating too many zebras, you don't say to the lions, 'You're eating too many zebras.' You have to build a fence around the lions. They're not going to build it." - Judge Richard A. Posner One of the most prominent proponents of free-market capitalism is having second thoughts. Judge Richard A. Posner, a federal appeals court judge who has been called the most cited legal scholar of all time, discussed his doubts and his analysis of the current financial crisis in a wide-ranging interview with the Huffington Post. A longtime proponent of deregulation, the idea that business works best in a free market without burdensome government regulations, Posner began to change his mind when he realized the enormity of the crisis. This change of heart inspired him to write his upcoming book, "A Failure Of Capitalism." Though still a believer in the virtues of capitalism, Posner now emphasizes the importance of government regulations; the need to strengthen the regulatory structure by directly funding authorities rather than the current fee-based model; the dangers of excessive executive compensation, and even expressed support for the idea of changing bankruptcy law to make it easier for homeowners who face foreclosure. "I wouldn't have thought the economy was as vulnerable," he explains. "I wouldn't have thought that banking deregulation was dangerous." Posner says he grew "complacent" about the risks of deregulation since economists "said they had solved the problem of depression and knew how to control inflation without

648 causing recession." His relaxed attitude was also due to the fact that the economy had been running fairly smoothly since the early 1980s. Now, he realizes that more regulation of our financial markets is needed, employing a typically entertaining analogy to illustrate his point: "If you're worried that lions are eating too many zebras, you don't say to the lions, 'You're eating too many zebras.' You have to build a fence around the lions. They're not going to build it." Posner emphasizes that he doesn't blame the bankers for not sensing earlier the damage that their risky behavior had on the larger economy. "If you say to a banker, 'If all the banks go broke, the economy will take a hit.' They'll say, 'What can I do. If I decide to play it safe, my competitors will take all my business.' Since our free-market system encourages businessmen to be self-interested profit maximizers, Posner says it doesn't make sense to also ask them to be conscious of their impact on the wider economy. "You can't expect [an] individual firm to be worrying about what his collapse will do to the rest of economy. That's why you need government regulation of banking... Coal- burning utilities in the Midwest don't worry about acid rain because that's going to be in the east. That's why you need regulation." Posner is critical of the government bailout because it doesn't seem to have served its purpose: banks are not lending, but rather hoarding the billions they have received of TARP funds. "What government has been trying to do is give them enough money to feel safer. But it doesn't work too well because if making loans is risky... and there's not much demand for loans... they'll find other things to do with the money. You can lead a bank to money but you can't make it lend." Posner is careful to emphasize that while the bailout may be wrong, it may have prevented an even greater crisis: "You don't know how much worse things would be if government hadn't done this. Without all those hundreds of billions, maybe the banks would have collapsed." Overall, he doesn't have much confidence in the government's approach. "What I criticize them for is the failure to have had any contingency plan. So it's now 6 months since the September crash of the banking industry... my sense is that the government is still feeling its way. It improvises, doesn't have any real long-term plan." And he warns that the crisis's aftershock may be worse. "The danger here is that the Fed is pumping several trillion dollars into the economy, on top of the Bush deficits... the danger is that in a couple of years, we have very severe inflation." Posner even seems amenable to an idea suggested recently by Yale professors John Geanakoplos and Richard Levin to reduce the mortgage principal and not just the interest rate of homeowners facing foreclosure. That would probably involve a change in bankruptcy law: "It's not a bad idea... If you reduce the principal, you're going to reduce foreclosures... It might be possible to have a law that does that - that would be really radical... if it could be done legally." Posner was also critical of the current regulatory structure, in which the numerous federal agencies are funded by fees from the banks and institutions they regulate. That

649 creates a "cozy" relationship which can lead to lax regulation. "There's a kind of shopping involved. Countrywide was originally under the Federal Reserve because it had a bank connected to it... and decided that the Fed was too rough on it, got rid of its bank and as a result was regulated by the Office of Thrift Supervision." Instead, he suggests, regulatory agencies should be "supported by general tax revenues." Posner's other non-traditional free market suggestions: Putting a ceiling on credit card interest rates and payday loans and possibly capping the salaries of bank executives (though he prefers disclosing the full compensation of all senior executives and requiring that a substantial share of compensation be tied to a company's future performance) and even increasing the marginal income tax rate of high-income individuals. In his book, Posner takes aim at the Republican Party, explaining that thoughtful conservatives were "appalled at the intellectual vacuity" of the McCain campaign. Echoing Stephen Colbert's mock-conservative take, he derides how the party flaunted the 'anti-intellectualism of its supporters', concluding that "The economic crisis in which the nation finds itself cannot be solved in the gut." And he makes sure to include the failures of liberalism in his rant, condemning how they are "trapped in fantasies of equality." Filed by Marcus Baram http://www.huffingtonpost.com/2009/04/20/judge-richard-posner- disc_n_188950.html?view=print

650 Apr 20, 2009 Steve Forbes interviews Nouriel Roubini "The Roubini Recovery"

Nouriel Roubini |

Steve Forbes interviews Nouriel Roubini, chairman of Roubini Global Economics and professor at the Stern School of Business at New York University. Steve: A Destructive Court Welcome, I'm Steve Forbes. It's a privilege and pleasure to introduce you to our featured guest, New York University professor and economist Nouriel Roubini. Nouriel had amazing prescience calling the markets' downtown, earning his infamous moniker, "Dr. Doom." Now he'll tell us why he thinks there's a glimmer of hope for the economy. Our conversation follows in a minute. But first ... Innovation flourishes in a benign environment of low taxes, common-sense regulation and a sensible, restrained judiciary. The U.S. Supreme Court certainly fell short of those principles when it ruled against medical innovation in Wyeth v. Levine . The court gave a green light to the plaintiff's lawyers, who would steamroll pharmaceutical companies at the cost of lifesaving drugs and treatments for the rest of us. The plaintiff in this case lost an arm to gangrene after she was injected with the Wyeth drug Phenergan. The drug was clearly labeled with a warning that gangrene could result if the drug were directly injected into a patient's vein, and the tragedy was the result of a mistake of a doctor's assistant. She sued the hospital and won. But she also sued Wyeth, arguing that a stronger warning should have been provided. Wyeth's warning label has been specifically approved by the FDA. The plaintiffs don't deny that. The hospital employee that made the mistake acted outside of Wyeth's control. Again, the plaintiffs don't deny that. She also prevailed in her suit against the hospital. A court can't make everything right or take away the pain of such a loss, but the victim had, and pursued her case against a legitimate defendant. In the wake of this precedent, companies can now be held liable and suffer substantial losses when a third party misuses their products, even though they'd been amply warned in language approved by the federal government. This is destructive to innovation, imagination and, ultimately, to the health of the nation. In a moment, my conversation with Nouriel Roubini.

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Glimmer of Hope Steve Forbes: Well, thank you for joining us. You have acquired quite a reputation for calling the extent of the credit crisis two or three years ago--that something was rotten in the state of Denmark or Wall Street or whatever. But you see some glimmers that things might be improving a smidgen, later this year and early next year? Nouriel Roubini: They are improving in the following sense: that the degree of economic contraction is not going to be as severe as the last quarter of last year and first quarter of this year. So, from -6 [percent] growth, we are going to go toward -2 [percent] toward the end of the year. But compared to the optimists that see already a recovery of positive growth by the second half of this year are more bearish and for next year, the consensus thinks a growth rate close to 2%, maybe it is going to be below one 1% and unemployment rate above 10%. So while we are going to be technically out of a recession, you know, it is going to feel like a recession. So more optimist in the sense that the thing that the policy action are going to avoid L-shaped near-depression, like the one that Japan experienced. We are in the middle of a severe U-downturn. And we are going to eventually get out of it by sometime next year. So the tail risk of a depression has been reduced. That is good news. And the rate of contraction is going to be less than otherwise. Secondary, rates are becoming positive. But I do not see yet the light at the end of the tunnel the same way the consensus sees it. Steve Forbes: And so that, in turn, means that next year, 2010, if you only have a 1% or even a less than 1% growth rate, unemployment will go up. Will it stop at 10%? It is already at 8.5% now. Nouriel Roubini: It is. And in my view, probably is going to peak above 10%, might be more close to 11%. And even today, if you take a broader measure of an unemployment rate that includes those who are partially employed and those who are discouraged, that have left the labor force, the number is already 15%. So by some standards, this is really rough worse than losing 600,000 to 700,000 jobs per month. It's very painful. Stay on the Sidelines Steve Forbes: And what does this mean for investors? You have recommended in the past, hold cash. Don't be plunging into these bear-market rallies. Do you see the current rally as another bear market rally and it is just prudence should be the dictate? Nouriel Roubini: Yeah, I would be prudent for the following reason. You know, people usually joke and say the stock market has predicted 12 out of the last nine recessions, because sometimes it falls and there is no recession. Steve Forbes: You have an even better description. Nouriel Roubini: Yeah, this time around, the stock market predicted six out of the last zero economic recoveries, because six times around, the last two years, markets fell because of the bad news on banks. The economy, then there is radical policy action. They recover, and then the bad news, macrofinancial earnings and then you reach a new low.

652 Now of course, the lower you go, at some point, you might be closer to a true bottom and more time passes, with the policy action, the closer we might be to the bottom of earnings of the economy. Now is this rally a robust one? Is this going to be the beginning of a real boom-market rally? I am still skeptical for three reasons. One is that if I am right on the macro view, -2% rather than +2% [in Q4] and weak recovery [in 2010], then there will be surprises on the downside in terms of the macroeconomic, U.S. and abroad. The second reason is that I think that earnings are going to surprise--not just this quarter, but also the next few quarters--on the downside, because we have a weak economy. And with deflationary pressures, then the pricing power, the corporate side, is going to be limited. Therefore, margins are going to be compressed. To have a very big rally of earnings like people predict for next, you need a boom of the economy, going to potential above and then going away from deflation. And I see deflationary forces for the next two or three years. So I see compression of earnings are going to last and surprise people on the downside. And three, I see financial shocks. Some banks will be found insolvent. We will have to probably take them over, do something with them. That is going to be bad news. We will have many financial institutions are going to go out of business, like many hedge funds. And deleveraging by them and selling liquid assets in liquid markets going to be negative. And third, some emerging markets, in spite of IMF help, may have a fully fledged financial crisis. And then may have contagious effect. So, all in all, I think that over the next few months, surprise on the macro side, on the earnings side, in terms of the financial shocks, may imply that the previous lows might be tested again. Steve Forbes: So, in terms of an investor, just stay on the sidelines for now. Nouriel Roubini: I would stay on the sidelines. You know, people worry about not getting the rally that is going to start. But if it is going to be a robust rally, it is not going to be [only] 20, 25 [percent]. You know, we know eventually we'll have a recovered economy. We will get it cleaned up, and actually, I'm not a permabear. I believe that actually, if we do the right things, the U.S., Europe, Japan, but especially emerging markets, can have a bright future of high economic growth. So for the middle term, I am actually quite bullish about the global economy and that high global economic growth, once we fix the problems. Equities should be outperforming other asset classes. But I would not worry about losing the first 20%, because you might have another bear-market rally. [I] would wait until the data show more robust and consistent, persistent improvement of the real economy, of earnings. And then the market, they are going to rally on a more robust basis. Fed's Easy Money Steve Forbes: Could this bubble, this disastrous bubble, have reached the proportions it did if the Fed hadn't been so easy with money in the early part of this decade? Nouriel Roubini: There were many mistakes. Certainly one of them was that the Fed cut rates and kept them too low, from six and a half down to one [percent], for too long. In addition to that mistake, the normalization from 1% back to 5.25%, was these moderate pace, step-by-step, 25 basis points every six weeks. And that is one of the last things. It is not just how long you keep it low but then, when you get out of this recession, we have to normalize it fast enough.

653 That is going to be one little lesson. But there are also broader issues about poor supervision and regulation of financial institutions. I think that, while deregulation is positive of the economic financial institution, we took it to an extreme, you know. Even financial markets need laws, institution, rules; otherwise it is the law of the jungle. Greed is good. There is nothing bad with greed. You know, that's what drives capitalism. But greed has to be contained by fear of losses and also [the] realization [that] you are not going to be bailed out in bad times. And I think there were a number of distortions that Greenspan put, easy money, easy credit, lack of supervision and regulation of the proper form. Steve Forbes: In terms of where we go from here, in terms of what new regulations, rules, transparency, one suggestion has been made: We do need real exchanges, clearing houses for some of these exotic instruments, so they become standardized. People can actually see what is out there, what the volumes are, what the trades are. And therefore, we can get some proper collateral behind them. What other things do you think need to be done to prevent a repetition of this in the future? Nouriel Roubini: Well, many things. I think we have learned that, all in all, financial institutions need more capital compared to what they had and what the requirements were. That they probably have to be required to have less leverage, both banks and on banks, shadow banks, that the liquidity risk is big and therefore liquidity buffers are important. There is a whole issue with compensation. I think that the issue is not with bonuses. Yes, last year and so on. But if you have a system in which you are having incentive maximize the risk in the short run and essentially do things like insurance over cataclysmic effect, events. And therefore, for a few years, you are making lots of profits and revenues. You are paid that way. And when things go bust because you took a big risk, the financial institutions go bad. Compensation is not [set [properly on a risk adjusted basis] ... Better Bonuses Steve Forbes: Do you think that is an area, where if you are a regulated financial institution, where the government should say, "A bonus has to be paid out over five years," or is this something boards of directors will learn if they know they can actually fail? Nouriel Roubini: Ideally, you want a world in which a board of directors would do that if you have appropriate corporate governance. You don't want the government to impose it. But we saw also failure of corporate governance. You know, there are the typical agency problems within principal and agents shareholders and managers. And in financial institutions, those agency problems are bigger because the symmetric information is bigger. There's no way a CEO or a board can essentially know what the action of thousands of P&Ls were taking risks and trades and so on doing. Steve Forbes: Right Nouriel Roubini: Therefore, you need a system of compensation as bonusing models. They are changing. Some institutions are now having these bonus models, but there is an element of worries about stigma, of losing the best kind of talent. Therefore, at least the government, not forcing, but the frame-up right now [that] was agreed [on] by the G-20, one in which there has to be reform of compensation. I would

654 let institutions do it their own. If they do not do it, then, in the context of that regulation supervision, the form of compensation should be one of the measures of whether you have an appropriate risk management system, because [an]appropriate risk management system means make sure that risk management is done properly. And one element of it is compensation. Steve Forbes: Do you feel the credit system is now going to start to function again? Right now, we still have very wide spreads between Treasuries and, say, single-A, triple-B corporate [bonds]. Do you see any sign that that is going to narrow, where credit is going to naturally start to flow again? Nouriel Roubini: It is going to be a very slow process in my view. Of course, compared to the disaster after Lehman, when everything was frozen--commercial paper, high grade, high yield--at least right now, the money-market spreads are lower. Corporates that are high-grade can borrow again. In the high-yield spreads, the spreads are still too wide. The market is shut down. We will see whether TARP is going to work. Other actions reduce market spreads, mortgage rates by buying MBSs and mortgage-backed securities. I think it will be a very, very difficult process because a lot of the shadow banking system has collapsed. And a lot of the intermediation was not through banks, but through securitization or through capital markets. We have essentially destroyed a good chunk of our capital market. We want to rebuild it. It is going to take time. Bank Nationalization Steve Forbes: You proposed, a few weeks ago, nationalizing some of the banks. Do you feel that is still going to happen before this over? Nouriel Roubini: Oh, I think some of them will have to be taken over. I mean, I proposed these from a market-friendly point of view. Nobody is in favor of medium- or long-term ownership of financial institutions by the government. But in my view, paradoxically, the temporary nationalization is a more market-friendly solution, because you know, if you don't do it, then you end up with zombie banks, and the fiscal costs are going to be large. That's why, you know, fiscal conservatives have been in favor of it. That is why people like Lindsay Graham, conservative Republican from Carolina, is in favor. That's why Alan Greenspan, high priest of laissez-faire capitalism, has said we may have to nationalize some banks. We will have to do it carefully, choose only the ones that are really beyond pale, that even if you give time, time is not going to heal their wounds. We'll see. But I think, in some cases, that might be the appropriate thing. And if it is not market-friendly--take IndyMac, [which] was taken over middle of last year, cleaned up, separated. And now, the bunch of investors, George Soros and John Paulson [and] others, we bought it back and privatized it. It took six months. [It] does not have to take three years if you do it right. Geithner's Gamble Steve Forbes: What is your feeling about the latest Geithner plan? Nouriel Roubini: My view of it is, actually, that it can work for dealing with the toxic assets of banks that are solvent, because even after you do this stress test and you do a triage within solvent, insolvent. With the insolvent ones, you cannot apply the

655 Geithner plan because the losses are so big that if you apply [that] to them, they are underwater. You have to take them over. But even with a solvent one, you have to still separate good and bad assets. Now there are five different ways of doing them. We do not have time to go into each detail. Each one of them has merits and some flaws. These ones are among the five different ways in which you can separate good and bad assets of solvent banks--is not the worst. There [are] some design issues, some flaws in which the way the design can be fixed. In my view, all in all, it is actually a reasonable plan. Steve Forbes: And are you upset at all about some of the details coming out about it, that he wants to restrict it to only a handful of large institutions? Should it be more open if an institution wants to or if a group wants to be part of it? It should not be excluded? Nouriel Roubini: That was actually, absolutely one of the important flaws. I think they have just announced that actually, they are going to open up the bidding process also to smaller financial institutions. You do not have to have $10 billion- plus of assets and so on, in order to do that. So, I think, you know, they have been responsive to some of the criticism. I think that by the time they implement it, there will be a number of other things you have to fix it. And there may be even incentives for insiders to buy at face value, you know, the stuff and then get a cost-only loan and default on it. So you should make sure that banks cannot buy their own things. This idea of rivals buying each other's assets also is subject to gaming. And plus, the whole point is about making sure banks do not have toxic assets, not to buy more of them. So I think there are many things in the design you can fix. Steve Forbes: Now, the Federal Reserve surprised some of us that between December and March, they actually shrunk their balance sheet, after expanding it in the fall, shrunk it by $400 billion. Now they are gingerly bringing it up. Is the Fed being aggressive enough in this, right now? Should it be more buying [of] mortgage-backed assets and the like to try to get the system more, better functioning? Nouriel Roubini: I would say they have been very aggressive, you know, with ups and downs. You know, yeah, the balance sheet went from, you know, 800, 2.2, now down to a 1.8. But now, with the new initiative, is going to be about $3 trillion. It is zero interest rates. It is quantitative easing. And it is a variety of unconventional things, like buying Treasuries, buying an agency- backed, a mortgage-backed security, reduced mortgage rates. You know, intervening in the securitization market with the tariffs and other things that, over time, are going to restore credit and securitization. They are very aggressive. And so are their central banks, like the Bank of England, the Swiss national banks, the Japanese. Even Europe eventually is going to get to zero rates and quantitative easing and some of the unconventional stuff. Unfortunately, you know, traditionally, since the banks are the lender of last resort in this crisis, since banks do not lend to each other, they do not lend to non-banks. They [did] not lend even to the corporate sector for a while. The central banks have become the lender of first and only resort. I mean, that is the paradox of the market failure we have been observing. It is not a normal situation. We do not want it to be permanent, but that is the current situation. And I think the margin, those policy actions, are actually the correct ones. Risky Leverage

656 Steve Forbes: You had mentioned earlier that banks are going to have to, in the future, deal with less leverage. What have we learned about risk in this crisis? Nouriel Roubini: We have learned that, you know, leverage can be dangerous and is excessive. That you have to have a system of incentives and compensation that avoids excessive risk-taking, regardless of leverage. That liquidity risk is important. That shadow banks, in many ways, look like banks, because they were borrowing short, highly leveraged, lend-only liquid. But unlike banks, they did not have access to the lender of last resort support or deposit insurance. Therefore, the entire collapse of the shadow banking system is an example of what happens when you have a run on bank-like institutions. And therefore, to have a safer system for these known banks. You know, was non-bank mortgage lender went by ... hedge funds, you know, broker-dealers, now ... [a] financing crisis for private equities. Just a variant of the same idea. If you borrow short overnight, you leverage 30 times. You lend only liquid. Eventually, you are going to get in trouble. That is not a stable system. That is why I predicted--over a year ago, before Bear Stearns--the collapse of major broker-dealers. I said, "Two of them are going to go bust. In a matter of two years, none of them is going to remain independent." I was too optimistic: it did not take two years, it took seven months [for Bear Stearns and Lehman to go bust, for Merrill to be forced to merge with Bank of America and for Morgan Stanley and Goldman Sachs to be forced to convert into bank holding companies]. Steve Forbes: By the way, do you think, in the future, partnerships are going to come back, where, if you do have an investment house, you know it is your money on the line and not somebody else's? Nouriel Roubini: Certainly either partnership or a situation which then shareholders or bankers have some of their own skin in the game, because again, you want to avoid excessive retaking. Paradoxically, crisis not of hedge funds but more crises of traditional banks. Why? Because hedge funds, the owners have some of the skin in the game. Therefore, the risk management is different. So whether it is going back to partnership or other things, whatever implies more capitals, more of the skin in the game, so that you avoid excessive risk-taking, should be part of, makes valuable financial institutions. Steve Forbes: What is the big one misplaced assumption, still, out in the markets today that you see? Nouriel Roubini: I would say that, you know, there is excessive optimism about the system being able to heal itself without taking the proper action. Monetary, fiscal, credit policy, clean up the banks, proper forms of forbearance, helping emerging markets. I think we still need aggressive policy action. I think that the system, unfortunately, as well as a significant market failure, is not going to heal itself. And that means that also the appropriate balance between the markets, because we all believe in markets and having the appropriate forms of government regulations is going to be a challenge. Bail Out Balkan Banks Steve Forbes: Looking here and briefly around the world, what has not been done that needs to be done?

657 Nouriel Roubini: Oh, some countries are behind the curve. The ECB are behind the curve. Fiscal and stimulus in Europe could be a little bit larger than otherwise. I think that, for the banks that are insolvent in U.S. and other countries, [they should] be taken over, not to end up with zombie banks like Japan. I think that more aggressive policies to reduce the risk of mortgage foreclosures should be done. Steve Forbes: Do you think the Fed, maybe some other central banks, are ready to help out, say, banks in Ukraine or Central and Eastern Europe that, if allowed to fail, could have systemic risk? Nouriel Roubini: They may be doing it directly, like you see, we give money directly to Hungary. The Europeans are going to be helping some of emerging Europe. But the way it has been done internationally now is that the G-20 and agreement to triple the resources of [the] IMF, so that the IMF can give money to some of these countries. Now emerging market have two groups, those that are victims of collateral damage, with good fundamentals--the and Brazils of the world--and then there are the other countries, some of them in emerging Europe, that have massive financial, fiscal vulnerabilities and policy mistakes. For those countries, it is not enough to give them money. They need policy correction. If you give them money and there is no policy correction, you end up like Argentina or like Russia or like Ecuador. So you need the combination of money and appropriate policy actions. Steve Forbes: What is the best financial lesson you have ever learned? Nouriel Roubini: It is that, you know, it is better to be safe and be cautious and not to leverage too much. You know, leverage can be deadly. I mean, I think it is crucial that all of capital and equity, in corporations, in financial institution and also in the household sector. You know, when your households that were buying homes with zero down payment, the leverage was infinite, was even worse than financial institutions. So I think leverage is deadly. I think that is the lesson. We need more capital or equity. A little bit less debt, relatively speaking. The Great Crash Steve Forbes: And finally, other than your own books, what is the best book you have ever read, [the best] financial book? Nouriel Roubini: Some of the classic selections, you know, The Great Crash by Galbraith. You know, you go and reread those books and you change the dates, and it is amazing how much things look like exactly the same. It means that history repeats their selves, you know? In many ways, financial crisis are very similar to each other. And as we know, if we do not learn from the past, we are going to be bound to repeat the same mistakes. Hopefully, next time around, we will learn the lesson and we will have a more robust system. Steve Forbes: [There's] one final thing I just want to ask you, given your historic perspective, and that is, we've had bubbles in the last 30 years. We had the great inflation of the '70s. We had the problems in Asia, Russia. [A] high-tech bubble much bigger than the normal, new industry bubble, what happened in housing. Do we need a new international monetary system, like we had before 1971 or what we had before World War I? Nouriel Roubini: We will have to think about the redesign. I am not convinced about things like going back to gold or a system of fixed exchange rates. I think that that is not

658 going to be likely and desirable, overall. But having a system [in] which these imbalances, these excesses, do not occur. We will have to rethink, also ... all of reserve currencies and so on. So first, we have to fix this crisis. Then we have to fix the banks. Then we have to think about how we design a new international monetary system. Things are going to take a while. For the time, we have already our hands full of problems. And having to fix them. Steve Forbes: Well, thank you very much. Appreciate it. Nouriel Roubini: It was a great pleasure being with you today. Thanks. “Steve Forbes interviews Nouriel Roubini "The Roubini Recovery"”, en: http://www.rgemonitor.com/roubini- monitor/256476/steve_forbes_interviews_nouriel_roubini_the_roubini_recovery

659 Apr 13, 2009 Sifting Through Past FDIC Troubled Asset Auctions: Average 56 Cents on Dollar Value Implies Additional $1 Trillion Writedowns

Overview: April 3 Mark Pittman (Bloomberg): U.S. regulators may force Bank of America, Citigroup and at least a dozen of the nation’s biggest financial institutions to write down as much as $1 trillion in loans, twice what they’ve already recorded, based on past Federal Deposit Insurance Corp. auction data compiled by Bloomberg. Indeed, assets sold under the Legacy Loans Program may be worth an average of 56.3 cents on the dollar, based on the results of FDIC auctions at failed banks over the past 15 months. In view of the potential losses, reports emerge of banks trying to game the system by bidding each other's asset prices up (see also Bebchuk for necessary safeguards for taxpayers.)

o April 10 Sender (FT): GoldmanSachs and Mike Mayo report in their analysis that most banks carry unsecuritized loans at 92-98 cents on the dollar on their books. Moreover, most of the assets in the PPIP are loans.

o Pittman: Details of past FDIC distressed assets auctions: The FDIC’s average auction value of 56.3 cents on the dollar for residential and commercial loans is based on 312 sales worth $1.1 billion since Jan. 1, 2008, according to the FDIC. The average for 348 commercial loans for which borrowers stopped paying was 32 cents on the dollar. Auction prices ranged from 0.02 cent to 101.2 cents on the dollar, according to the FDIC.

o cont.: Writedowns would total $1 trillion if the program buys $500 billion in loans at 32 cents on the dollar, the average for non- performing commercial loans in the FDIC sales.

o cont.: Banks failing Federal Reserve evaluations of loans this month may be ordered to make sales worth as little as 32 cents on the dollar, according to FDIC data. That would be less than half of the 84 cents on the dollar the Treasury Department suggested was a possible purchase price. Some of the bank- insurance agency’s auctions brought 0.02 cent on the dollar.

o Stiglitz, Roubini: Banks will only sell when forced in the face of large writedowns. o Pittman, cont.: The FDIC would auction assets after the Office of the Comptroller of the Currency, Office of Thrift Supervision or the Fed signals that a bank is in danger of failing.

660 o cont.: Treasury spokesman Isaac Baker said in an e-mail that the program is voluntary. "Past auctions cannot reliably predict asset prices in the Public Private Investment Program, as we are creating a new market that has not previously existed to help value these assets, and offering financing to help investors purchase them." o cont.: Jim Wigan (FDIC): The FDIC is considering allowing banks to share in future profits on loans sold to public-private partnerships to encourage healthier lenders to participate. The regulator is seeking comments through April 10 on the program. o Daniel Alpert (Westwood Capital LLC via Pittman): Banks have almost $4.7 trillion of mortgages and $3 trillion of other loans that aren’t packaged into bonds, according to the Fed. "The vast majority are carried at full value because they don’t need to be written down until they default." o Pittman: While regulators don’t intend to publish the details of their stress tests, the results will effectively become known once banks announce how much capital they need to raise. Regulators will then give lenders six months to obtain funds from investors or taxpayers as a last resort. o March 25 FT Guha/Guerrera: The government’s toxic assets plan will force banks such as Citigroup, Bank of America and Wells Fargo to take large writedowns on their loans, requiring them to raise more capital from taxpayers or investors, executives and analysts have warned--> see Geithner presents new insolvency regime for holding companies and non-banks o cont.: Including TARP, the U.S. government and the Fed have spent, lent or guaranteed $12.8 trillion to combat the financial collapse and a recession that began in December 2007. The amount approaches the $14.2 trillion U.S. gross domestic product last year. http://www.rgemonitor.com/707

661 The Wall Street Journal OPINION: THE WEEKEND INTERVIEW OCTOBER 18, 2008 ANNA SCHWARTZ Bernanke Is Fighting the Last War 'Everything works much better when wrong decisions are punished and good decisions make you rich.' By BRIAN M. CARNEY, New York On Aug. 9, 2007, central banks around the world first intervened to stanch what has become a massive credit crunch. Since then, the Federal Reserve and the Treasury have taken a series of increasingly drastic emergency actions to get lending flowing again. The central bank has lent out hundreds of billions of dollars, accepted collateral that in the past it would never have touched, and opened direct lending to institutions that have never had that privilege. The Treasury has deployed billions more. And yet, "Nothing," Anna Schwartz says, "seems to have quieted the fears of either the investors in the securities markets or the lenders and would-be borrowers in the credit market." The credit markets remain frozen, the stock market continues to get hammered, and deep recession now seems a certainty -- if not a reality already. Most people now living have never seen a credit crunch like the one we are currently enduring. Ms. Schwartz, 92 years old, is one of the exceptions. She's not only old enough to remember the period from 1929 to 1933, she may know more about monetary history and banking than anyone alive. She co-authored, with Milton Friedman, "A Monetary History of the United States" (1963). It's the definitive account of how misguided monetary policy turned the stock-market crash of 1929 into the Great Depression. Since 1941, Ms. Schwartz has reported for work at the National Bureau of Economic Research in New York, where we met Thursday morning for an interview. She is currently using a wheelchair after a recent fall and laments her "many infirmities," but those are all physical; her mind is as sharp as ever. She speaks with passion and just a hint of resignation about the current financial situation. And looking at how the authorities have handled it so far, she doesn't like what she sees. Federal Reserve Chairman Ben Bernanke has called the 888-page "Monetary History" "the leading and most persuasive explanation of the worst economic disaster in American history." Ms. Schwartz thinks that our central bankers and our Treasury Department are getting it wrong again. To understand why, one first has to understand the nature of the current "credit market disturbance," as Ms. Schwartz delicately calls it. We now hear almost every day that banks will not lend to each other, or will do so only at punitive interest rates. Credit spreads -- the difference between what it costs the government to borrow and what private-sector borrowers must pay -- are at historic highs.

662 This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. "The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible." So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue." In the 1930s, as Ms. Schwartz and Mr. Friedman argued in "A Monetary History," the country and the Federal Reserve were faced with a liquidity crisis in the banking sector. As banks failed, depositors became alarmed that they'd lose their money if their bank, too, failed. So bank runs began, and these became self-reinforcing: "If the borrowers hadn't withdrawn cash, they [the banks] would have been in good shape. But the Fed just sat by and did nothing, so bank after bank failed. And that only motivated depositors to withdraw funds from banks that were not in distress," deepening the crisis and causing still more failures. But "that's not what's going on in the market now," Ms. Schwartz says. Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value." "Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of them, that would be an improvement." The only way to "get rid of them" is to sell them, which is why Ms. Schwartz thought that Treasury Secretary Hank Paulson's original proposal to buy these assets from the banks was "a step in the right direction." The problem with that idea was, and is, how to price "toxic" assets that nobody wants. And lurking beneath that problem is another, stickier problem: If they are priced at current market levels, selling them would be a recipe for instant insolvency at many institutions. The fears that are locking up the credit markets would be realized, and a number of banks would probably fail. Ms. Schwartz won't say so, but this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he's shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down." Rather, "firms that made wrong decisions should fail," she says bluntly. "You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich." The trouble is, "that's not the way the world has been going in recent years."

663 Instead, we've been hearing for most of the past year about "systemic risk" -- the notion that allowing one firm to fail will cause a cascade that will take down otherwise healthy companies in its wake. Ms. Schwartz doesn't buy it. "It's very easy when you're a market participant," she notes with a smile, "to claim that you shouldn't shut down a firm that's in really bad straits because everybody else who has lent to it will be injured. Well, if they lent to a firm that they knew was pretty rocky, that's their responsibility. And if they have to be denied repayment of their loans, well, they wished it on themselves. The [government] doesn't have to save them, just as it didn't save the stockholders and the employees of Bear Stearns. Why should they be worried about the creditors? Creditors are no more worthy of being rescued than ordinary people, who are really innocent of what's been going on." It takes real guts to let a large, powerful institution go down. But the alternative -- the current credit freeze -- is worse, Ms. Schwartz argues. "I think if you have some principles and know what you're doing, the market responds. They see that you have some structure to your actions, that it isn't just ad hoc -- you'll do this today but you'll do something different tomorrow. And the market respects people in supervisory positions who seem to be on top of what's going on. So I think if you're tough about firms that have invested unwisely, the market won't blame you. They'll say, 'Well, yeah, it's your fault. You did this. Nobody else told you to do it. Why should we be saving you at this point if you're stuck with assets you can't sell and liabilities you can't pay off?'" But when the authorities finally got around to letting Lehman Brothers fail, it had saved so many others already that the markets didn't know how to react. Instead of looking principled, the authorities looked erratic and inconstant. How did we get into this mess in the first place? As in the 1920s, the current "disturbance" started with a "mania." But manias always have a cause. "If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset. "The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it's so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses." The house-price boom began with the very low interest rates in the early years of this decade under former Fed Chairman Alan Greenspan. "Now, Alan Greenspan has issued an epilogue to his memoir, 'Time of Turbulence,' and it's about what's going on in the credit market," Ms. Schwartz says. "And he says, 'Well, it's true that monetary policy was expansive. But there was nothing that a central bank could do in those circumstances. The market would have been very much displeased, if the Fed had tightened and crushed the boom. They would have felt that it wasn't just the boom in the assets that was being terminated.'" In other words, Mr. Greenspan "absolves himself. There was no way you could really terminate the boom because you'd be doing collateral damage to areas of the economy that you don't really want to damage." Ms Schwartz adds, gently, "I don't think that that's an adequate kind of response to those who argue that absent accommodative monetary policy, you would not have had this asset-price boom." Policies based on such thinking only lead to a more damaging bust when the mania ends, as they all do. "In general, it's easier for a

664 central bank to be accommodative, to be loose, to be promoting conditions that make everybody feel that things are going well." Fed Chairman Ben Bernanke, of all people, should understand this, Ms. Schwartz says. In 2002, Mr. Bernanke, then a Federal Reserve Board governor, said in a speech in honor of Mr. Friedman's 90th birthday, "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again." "This was [his] claim to be worthy of running the Fed," she says. He was "familiar with history. He knew what had been done." But perhaps this is actually Mr. Bernanke's biggest problem. Today's crisis isn't a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job." Mr. Carney is a member of The Wall Street Journal's editorial board.

The Weekend interview.- Anna Schwartz: Bernanke Is Fighting the Last War, by B. M. Carney The Wall Street Journal, 18/October/2008, http://online.wsj.com/article/SB122428279231046053.html

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