Tuesday, November 30, 2010

European Debt Crisis – Moral Hazard and the Sovereignty Issue

The bail-out plans for Greece, Ireland and, via the new enlarged EU bailout fund, for the next countries to go to the brink, are all deeply flawed because they encourage behavior that will tend toward ensuring that future crises and bail-outs occur.

First and foremost, it makes explicit what some in the financial markets were betting would happen, but didn’t know for sure would happen, namely a bailout. Up until now, those who bought the debt of financially weak European countries, or sold default insurance on such debt (pre-bailout), were at least taking a risk that they were guessing wrong as to what the EU would do when the music stopped. (Not much of a risk, I admit, after the Greek bail-out.) Now there is virtually no risk, at least in the near and medium term. Germany sought to require that, for future bail-outs, private holders of bailed-out government debt, or the private issuers of default insurance on such debt, should suffer some automatic loss of value (compared to face value) as a pre-requisite to a bailout. In other words, these countries would have to go through some form of debt default and work-out which would impose at least some pain on those who had lent to a risky credit, or who wrote default insurance on such debt. However, in order to get a deal done, Germany eventually dropped that demand. So now buyers of the debt of Portugal, Spain and Italy, and sellers of default insurance on such debt, know that any debt of these counties with a maturity of, say, five years or less, will be paid off in full, either because the country will, at maturity, be able to borrow the money it needs to pay the debt from the private market or from the EU bail-out fund. As a result, buyers of debt of potentially insolvent European countries, and sellers of default insurance on such debt, are only taking the much lower risk that the EU as a whole defaults or reneges or breaks-up prior to maturity. The consequence, of course, is that many more investors will be willing to buy and hold such debt at substantially lower yields than otherwise, which means that the private market will remain open to these countries, and at lower borrowing costs, without regard to whether they are taking the politically difficult steps to straighten out their national finances. This leads us to the second perverse result.

Straightening out the finances of a financially weak country, without a debt default and workout, or currency devaluation (not available to Euro-zone countries), requires enormous political will and, in democracies, involves taking enormous political risks, because the measures necessary to straighten out a country’s finances involve massive spending cuts and/or tax increases. Politicians in the governments of Spain and Portugal and Ireland (pre-bailout) were taking those political risks and were adopting those painful measures (to varying degrees) to avoid the risk of default. Now, the political calculus is different. They will continue to take those risks and adopt those measures only if they believe that the political risk of taking responsibility for austerity measures is less than the political risk of sailing into 1) the stigma of being a bail-out recipient and 2) losing most of the remainder of its national sovereignty (namely sovereign control of its spending and taxing policy) not already given up under the Maastricht and other EU treaties. (Point 2 was why Ireland was resisting for so long the proffered EU bail-out.) These risks may not be sufficient political motivation. It may be more politically attractive to defer taking responsibility for the tough measures (thereby ensuring a bail-out) and letting the measures be imposed on the country by a force not answerable to the people of that country at the polls. This leads us to the third perverse result.

Greece and Ireland, and in the future perhaps Spain, Portugal and maybe Italy, will become colonies of the creditor-countries of Europe: they will have taxation without effective representation like the American colonies prior to 1776. Yes, they will be represented in Strasbourg, but not were the decisions will be taken (the capitals of the European creditor-countries). This is an intolerable situation for a country with a tradition of democracy. If democracy means anything, it means that those who make the laws and determine taxes and spending policy should periodically run the risk of being thrown out of office. The Irish citizen (for example) has no option to throw out of office European creditor-country politicians who impose, as a condition of a bail-out, a particular cocktail of spending cuts and tax increases on Ireland which that citizen believes is wrong-headed or ruinous or simply unfair (imposing too much pain on one sector of Irish society and not enough on another sector of Irish society or imposing to much pain on Irish citizens and businesses as a whole and not enough pain on citizens and businesses of creditor countries of the EU, for example). He can, however, vote for Irish politicians who stand for revolution, namely, Ireland dropping out of the Euro-Zone and the EU. Unfortunately, the Irish citizen has no democratic option between suffering in silence (maybe for a generation) and voting for revolution. This is a very dangerous situation.

This erosion of democracy could, of course, be solved by completing the unification of Europe: by giving the EU parliament (in which the Irish citizen has a voice) the power to require any member country (say Germany) to contribute to a bail-out of another member country which is approved by majority (or some super-majority) vote of that parliament (and despite the objections of the German Government). Of course, that means equalizing the losses of sovereignty of member countries. Under this change, not just the debtor-country governments lose sovereignty, the creditor-country governments do also. Of course, this would effectively entail giving the EU Government the power to directly tax the citizens of each member country, in the same way that the US Federal government has direct power to tax the citizens of the various states of the union (without regard to the protestations of the state government).

Will the citizens of the creditor-countries of Europe agree to this? The last round of transfer of sovereignty from EU member countries to the center was a near run thing, with various national “no” votes, and that was when it was still possible for elites who were pushing the plan to say, with a straight face (although fraudulently), that concerns about loss of sovereignty were over-blown and inspired by ignorant, xenophobic politicians. There will be no disguising this loss of sovereignty.

Absent the completion of EU unification, the pressure for revolt will continue to build. It may be relieved to some extent by creditor-country governments sweetening the pot: either by easing the terms of the EU bail-out debt or by easing the required austerity measures. But such steps entail increased political risk in the creditor-countries. Too much of that and one or more creditor-country governments fall, in favor or a political group that gets elected on a "get tough" policy platform.

Bear in mind that each European creditor-country also has huge domestic fiscal time-bombs ticking. Even though they have been less profligate then the PIGS (Portugal, Ireland or Italy, Greece, Spain), the difference is only one of degree. Each are locked into expensive welfare state policies with declining and aging populations and high taxes and national debt levels. These situations will eventually force tough political decisions concerning tax increases and spending cuts, even without the added cost burden of bail-outs of the European debtor countries.

So, in the near or medium future, Europe will be forced to address the sovereignty issues swept under the carpet at Masstricht, one way or the other.

Wednesday, April 28, 2010

Damned if You Do and Damned if You Don't

In the recent past, we were shown the spectacle of CEO's of failed and almost failed financial institutions (i.e. Fuld (Lehman) and Prince (Citibank)) raked over the coals in the Senate. Their crime was to buy, and promote to their customers, what the Government (Fannie and Freddie) was selling and not being smart enough or insightful enough to foresee the coming housing collapse and therefore not able to position their institution to weather the financial storm. They were forced to act contrite (even as they assert that "everyone was doing it" and "nobody was smart enough to foresee the collapse"). It was not pretty, but understandable; big losers often get pilloried.

Now, however, we have the spectacle of a CEO of a successful financial institution (Goldman) that did foresee the collapse (or at least recognized the significant risk and took steps to manage that risk) being raked over the same coals in the Senate. Their crime was in participating in the marketplace, buying and selling instruments that regulators permitted to circulate there, and to do so in such a way as to avoid losing (and even worse, perhaps making) money during the financial meltdown.

So, there we have it. The crime is not being stupid (failing the trust put in them by others), the crime is just being a financial institution in bad times.

The Government (including the Fed) serves up a dangerous cocktail of easy credit and legislatively mandated reduction of credit standards, and a major increase in the availability of Government guarantees for dubious credits. Private institution take these components and play a furious game of musical chairs for profit. The music stops. Some are winners and some are losers. And the guys who created the environment sit in judgment of the players and declare that winners and losers are both at fault.

Judge not lest ye be judged. Election time is coming. The public is not as gullible as populist demagogues think.

Friday, April 23, 2010

Abacus 2007 AC-1

A sophisticated gambler ("A") walks into a casino and joins a private game of poker. He knows some but not all of the other gamblers at the table, but they all appear to be pros like him. The house has set the rules (maximum bet, maximum number of raises, permissible poker games which may be called by the dealer, and so forth). Unbeknownst to A, one of the anonymous faces at the table is a gambler ("B") who is as experienced as he is, and was consulted by the casino concerning the setting of the house rules. The casino itself is represented at the table by one of the players. A loses heavily, as does every other player (including the house), except B, who wins everything. Later, the Government sues the casino for fraud: it failed to tell A the identity of B and that B was on the other side of each bet A made. Further, the complaint alleges that the casino committed fraud by failing to tell A that B had been consulted on the setting of the house rules. The case was launched by the Government just as it ramped up its efforts to pass legislation to further regulate casinos.

I submit that this is an accurate analogy to the fraud case launched by the Government against Goldman Sachs (with the exception that there is no law requiring material disclosure in the casino world). I also suggest that, just as in the analogy, there is no fraud in the case. Any sophisticated gambler knows that in order to have a chance to win money, some other gambler must be willing to take the opposite side of each bet he makes. Who was involved in setting the house rules is not material, the house rules themselves were fully disclosed at the start of the game, and each player could analyze the impact of those rules on his style of play and his chances of winning.

The bigger issue posed by the facts of the Abacus 2007 AC-1 deal is whether such deals should be permitted at all (other than in a casino).

Healthy capital markets are necessary for the smooth and efficient movement of capital from those who have it and want to invest, to those who do not, and need investment capital. The entire structure of our (small "l") liberal western economy since the Renaissance is built on such a financial foundation. However, that does not mean that any transaction that can be imagined, that has the potential to create winners and losers, should be allowed to occur within the precincts of the capital market. We do not allow investment banks to create synthetic securities, the purchase and sale of which is the functional equivalent of betting on the outcomes of the following week's sports events. Such a side bet does not facilitate the larger purpose of a capital market.

I suggest that before any product is allowed in the capital marketplace its proponents must give satisfactory answers to two questions (1) “What legitimate purpose does it serve?” and (2) who has a legitimate need to buy or sell the product?” Credit default swaps pass the first question—they allow those with credit default risk to insure against it. However, that does not mean that those who do not have a credit default risk should be allowed to buy a swap. If the proper analogy for a credit default swaps is insurance, than the prohibition against a person without an insurable risk buying an insurance policy should apply.

Allegedly, Abacus 2007 AC-1 was fashioned for the sole purpose of permitting one party to place a massive bet that a certain group of securities collateralized by a pool of mortgages would be downgraded and ultimately default (and, of course, to generate fees for Goldman). There is nothing wrong with wanting to profit from a market insight you have that others don’t share. But that does not justify building a security for that specific purpose. There were ample other means of placing negative bets on the mortgage market (although those means would, undoubtedly, be more expense and more transparent). In addition, it masks price information. If all those who think x will go up or down must place their bets by buying or shorting x, this activity affects the price of x. A side bet does not. Furthermore, creating such a security also has a money supply inflationary effect, it creates an “asset” out of thin air, out of the fact that there is a person who thinks x will go up and another who thinks x will go down.