Credibility in Markets

One.

Italy's situation has not notably been improved by the supposed resolution of the Eurozone problem; as interest rates on Italian state debt have continued to rise. The Prime Minister who is regarded outside Italy as a buffoon remains a formidable operator within  the country: he has said that he is willing to stand down later in the year, but most observers are sceptical. Parliamentarians descended to fisticuffs while Berlusconi was in Brussels delivering a long and explicit letter to his Eurozone peers in which none of them placed complete credence.

If the politicians cannot even pretend that the Italian state is credible, how can anyone expect the herd of analysts and traders in international debt to have any faith in it? 'The markets' are just a network of websites: the avatars who inhabit them that reflect the decisions of company representatives who do not have the sort of freedom to take risks that they did in the years 2002 to 2008. Now the boards of their employing companies consciously set the parameters within which the traders can operate, and the terms in which analysts can summarise the data that they select as a basis for comment. As long as Italy is perceived as a public scandal and a rather obsecene private joke, the herd will take its cue from that assessment. Any investor who is contemplating putting money into the 're-engineered' Euro bail-out funds is advised to assess what 'the markets' indicate: and the declining valuation of Greek and Italian debt is a huge inhibiltion on the credibility of the financial engineering that was bodged in Brussels last week, The stock markets had a minor boost from the apparent solution of the problem: because companies based in Germany, France and Finland are trusted and their shares are more widely held than are industrial and bank shares in Italy and Greece, or Spain and Portugal. So over the coming weeks there will almost certainly be a bifurcation between 'northern' shares and 'southern' state stocks. The de facto division of the EU will be consolidated.

Two

Italy will probably eclipse Greece in the analysts' comments and in reports of the markets' behaviour for a few weeks: until the desperate state of Greek politics again demands the prime attention. The Greek people have been so misled by the the state's corruption in ignoring tax obligations, and by its reckless borrowing to pay them pensions and benefits that no economy on earth has ever been able to support from its earnings, that millions of them cannot believe that the austerity package that has been imposed by the Eurozone is either necessary or desirable. They have been told by the media that foreign banks have been induced to write-off half the value of the Greek state securities that they own: so why should not all the state's creditors do the same? And why not 99%, rather than just 50%? What can foreigners do to them, if they simply tell the Eurozone to forget the past and leave their future to them? The failure of CDSs on Greek debt [see Three below] will reinforce the opinion that 'the markets' don't really matter at all.

Three 

There has been a lot of comment on the recent collapse of 'value' in CDSs on Greek debt. The media have glibly described them as 'insurance policies' - which is precisely what they are not: that misrepresentation is wildly misleading. Credit Default Swaps [CDSs] are gambling contracts, of a special type that was invented in US wholesale banks in the nineteen nineties.

The concept was massively oversold by an ill-supervised wholesale-market branch of the greatest US insurance company, AIG, based in London [well away from scrutiny by the Head Office]. This small clique of people earned huge bonuses - and big notional profits for the firm - by selling these bets to banks, who wanted to be able to dress-up their balance sheets with an 'asset' that offset the perceived risk in owning bonds issued by institutions - mostly banks and governments - whose long-term credit worthiness could become questionable. In the credit crunch of 2007-8 holders of CDSs that offset assets that lost their 'value' came for their money, in such numbers that the small funds held by AIG's London office were instantly exhausted. There was a good chance that all the real insurance policies that had been underwritten by AIG would be voided if the company failed, due to the fact that its obligations under CDSs would massively exceed its reserves. One important consideration was that AIG - American International Group - was a huge player in the emergent markets in Asia, If the company failed the reputation of the USA would massively be diminished, especially in China, which had been the main target of the company's long-term Chief Executive 'Hank' Greenberg who had received massive political backing from the US government. Welching on China was considered unthinkable; so the US Administration and Congress agreed to support AIG with as many billion dollars as was needed to settle non-insurance obligations. The AIG case, however, gave credibility to the idiotic misdescription of CDSs as 'insurance policies'.

The really bad story about CDSs began after the bail-out of AIG. Despite that disaster, the players in the wholesale financial markets saw CDSs, alongside 'derivatives', as 'products' that they could sell in massive volume as ephemeral electronic contracts out there in cyberspace. Insurers as such had never been involved in the market: it was ab initio a bankers' creation and so it remained.  Banks bought CDSs - from each other - and reported them as 'assets' that could offset the risk that might exist in holding Greek or Italian government bonds as part of their reported capital reserves. Then they started selling each other CDSs as pure gambling slips, only notionally related to 'real' obligations: and in some cases multiple CDSs were raised in a series of separate contracts which notionally covered the same perceived risks. An increasing proportion of the purported risk-cover held by banks was in this form.

Then came the Irish crisis: where the government saved the situation by accepting all the banks' debts itself, and so the CDSs held against that possible default were not activated. As the Greek crisis approached its first peak even bankers saw it coming, so they mostly sold off the CDSs that they held against Greek debt [at heavily discounted prices] on the crude assumption that it was better to have a tiny asset rather than an undeliverable promise. This made it possible for the club of banks known as the international derivatives association, which was accepted by all the member banks as having authority to say when CDSs should be activated by declaring a 'default' by the issuer of the underlying assets - in this case, Greek government debt - to declare that the 50% write-down of Greek debt was not a default, so the remaining CDSs against Greek debt could not be activated and the balance sheets of the issuers of the CDSs were unimpaired. In the immediate event, the issuing banks were protected: but the longer-term credibility of CDSs as a cover for potential losses was challenged, possibly beyond repair.

There are still trillions of dollarsworth of CDSs in existence: they are still held as balance-sheet cover for the banks' perceived risks; and they may well be useless. Casino Banking has been storming ahead even while the bankers have supposedly been in the pillory and under close examination: so much for regulation, so much for the competency of government.

The more one knows, the less one can believe.

Even if one is irritated by the inarticulate clods who are wasting their time outside Saint Paul's Cathedral, it has to be conceeded that they have a point: if only they understood it.

Capitalism in Crisis?

The waifs, strays, agitators and rent-a-crowd who have settled outside Saint Paul's Cathedral are living under various banners, of which one of the most prominent declares CAPITALISM IN CRISIS.

It appears that the majority of the squatters broadly equate capitalism with 'bankers' who are inferred to be rich, exploitative, dishonest and void of social conscience. It is probable that a great majority of the British population would endorse that view of bankers, or at least of 'City bankers' or 'wholesale bankers' [as distinct from local retail branch bank counter staff]. But is the equation of 'capitalism' with 'banker' in any way valid?

The City of London and New York banking sectors have been hugely successful in the era since the regimes led by Margaret Thatcher and Ronald Reagan fostered liberalisation of the rules, enabling them to develop a completely reckless cats-cradle of interdependent innovations that made increasing use of developing computer software and passed way beyond the ken of inadequate regulators. Few people could explain how this system crashed and what was the nature of the collapse: but everyone has experience of the consequences, and can see the pathetic attempts of political systems to capture some sort of control over phenomena that they do not understand. The Economists do not fully understand them either: some Economists understand some features of the system and of the crisis very well, and have sensible policy suggestions: but nobody can definitively say to what extent this or that 'expert' has the right answer.The debate is close to stalemate; but it is increasingly obvious that the crisis occurred in 'banking' even though it subsequently threatened the existence of the economy as a support mechanism for human beings.

Few people in or out of politics, inside or outside the 'Economics profession', doubt that human survival in all the industrial and 'post-industrial' countries depends on developing the 'real economy'; and specifically on developing what is broadly [and therefore pretty meaninglessly] described as 'manufacturing'. No materially productive plant can be created without capital  in the forms of buildings, services to those buildings, machinery, supplies, ancillary services, trained labour [which is in itself expensive] and a cash float to pay the bills until sales revenue cover costs. Society cannot survive without capital. So what is 'capitalism', and does the addition of the suffix confer a morally or socially negative inferior - or even hostile - aspect to the necessary investment funds? It is highly improbable that any of the 'protesters' could answer that question in a credible manner.

The Importance of the Lottery

Unless a person has an outstanding artistic or sporting talent - which can bring about a meteoric rise to the Premier League, the Top Ten or the Turner/Booker Prize - the chances of anyone gaining significant net wealth [or even a high income] from conscientious work are negligible. Hence tens of millions of people participate in the National Lottery, which has enabled thousands to fulfil or to exceed their dreams and is seen by the unsuccessful millions as the only way out of the trivial round of work or the dire attempt to remain optimistically human in receipt of benefits. The apparently-conspicuous exception to this rule of modern life, which has been selected for vituperation from almost all other segments of the population, is so-called 'banking' where bonuses and incentive payments, rather than conventional salary-and-pension packages, have provided a minority of staff the 'telephone number' annual remuneration to which so much publicity has been given
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Most of the activities for which the huge incentive payments are made are various forms of gambling: using cyberspace betting-slips known as derivatives, options, futures and swaps. The players in these heady games do not bet with their own money. The bets are mostly entered 'on tick' in the names of the employing firms and they can be supported by the funds in the 'real-world' sections of the banks; and in the pension funds, sovereign investment funds and other sources from which the City derives its 'working capital'. Although the punters are awarded their bonuses according to the reported profitability of their punts, they are actually paid in deferred shares in their employer company [which dilutes the value of all pre-existing shareholders' assets] and in cash which is drawn from the profits that are taken in worldly money by the real-world banking business.
No betting tax is levied on these activities in which trillions of dollarsworth of bets are placed [and accepted]: while people of modest means must pay the appropriate duty on their lottery tickets and all their other bets in which they risk their own funds.
The complex of activities whose over-development enabled the financial crash of 2007-8 to take place has been described as 'casino banking', and regulators all over the world have belatedly acknowledged this simple fact. In the United Kingdom the Vickers Committee was established in 2010 to advise the government on what preventative measures would protect real-world, economically-necessary banking from the other, higher-risk activities that proved so ruinous.

 To nobody's surprise the committee has proposed the separation of essential banking from the other activities that financial services complex organisations undertake. This can be achieved by the separation of the two streams of business into separate companies, but most commentators expect a less dramatic solution whereby the different segments of a complex financial services organisation each perform in their own specific trading areas, with each trading unit sufficiently capitalised so that it will not become a drain on the reserves of the other sectors of the company.
This is a necessary first step towards ensuring that no bank would ever again be too complex to be transparent or too big to  be allowed to fail. But such separation is not enough to overcome the inherent risk of contagion from one unit to the others within a company, and thence on to other companies.
And even before the government has announced any programme for the implementation [or partial implementation] of the Vickers recommendations the focus of bankers' and regulators' attention is being diverted by the proposal from the European Union that there should be a tax on all banking transactions - in the widest sense of that term, so that derivatives and futures trade would be levied at the same rate as retail banking transactions, mortgage contracts and initial share sales. If such a tax were imposed throughout the European Union, including the City of London, it is believed that Europe would loose a massive amount of trade to jurisdictions where the tax was not imposed. The attention of the UK government immediately focussed on how to counteract this threat to the volume and profitability of the sector, with a consequential weakening of the focus on separation of 'real' and 'casino' activities.

A transaction tax on financial transactions was first proposed many decades ago by the US Economist Tobin, who suggested that the increasing volume of foreign-exchange transactions could be curbed by a small tax on each transaction. Putting a restraint on currency transactions was popular among governments and regulators because money-trading was increasingly being undertaken as a punt for profit rather than to make currencies available to 'real' businesses to fund their purchases. To impose such a tax on all finance transactions would make access to banking business and mortgages more costly for ordinary people and small businesses: which could push some of them into insolvency in the hard times that followed the credit crunch.
A Tobin tax could be appropriate for 'inessential' foreign-exchange trading: were it possible practicably to differentiate transactions that supported the real economy from 'casino transactions'. It is not possible to do this simply and clearly.

Another, more realistic, possibility is to charge the ordinary rate of betting tax on all categories of casino transactions [derivatives, swaps, futures, etc]. Betting tax has the huge advantage that it is payable when the contract is made, so the state would receive the revenue regardless of the outcome from the deal. It could be provided in the regulations that if the parties to any transaction could demonstrate that it genuinely enabled a real-world non-financial firm to spread properly-identified risk, the contract could then be exempted from betting tax. These cases could be dealt with retrospectively, with the tax repaid after any successful appeal.. This proposal directly tackles the need to differentiate the casino from real-world banking, and to discourage excess. So I will refer to it on future occasions

No Surprise about Barclay's

Barclays has surprised nobody with the huge profits that have been announced today. This company cleverly stayed out of the tighter government 'safety net', while benefitting from effectively-unlimited almost-free credit that the government and the Bank of England made available to maintain the whole banking sector.
They bought the US operations of Lehmans for a  token sum, without having to accept any of the embedded liabilities.
Their management is tough and intelligent.They have done absolutely nothing wrong; but they are widely reported as having somehow abused their resources and opportunities. That nonsense doesn't hurt the company, or reduce the principals' pay.
Attention will now focus on bonuses to be awarded to the people who do the clever stuff in 'casino banking'. They have a huge turnover, doing things that make no contribution at all to the material economy; but which are intellectually demanding and institutionally stressful. Their pay comes from the profits that are made on 'retail' - real world - banking, and from the corporate banking area that manages corporate mergers, acquisitions, share issues and bond sales; these also require intelligence, attention to detail and huge investment in contacts.