Lessons from Lagarde - St.Gallen Symposium

Christine Lagarde, Managing Director of the IMF, gave a rare 50min long Q&A session at the St.Gallen Symposium. Tough questions regarding the survival of the Eurozone, whether the IMF is in fact the World Government, and others pertaining to global policy decisions were posed. Lagarde is aware that the current system is flawed, especially when she goes silent to the mention of some smaller countries within (or thinking of joining) the Eurozone, and whether or not they should be involved in such a collective group that is clearly not working for the generation of unemployed youth.

The argument is that the Eurozone in its current form, is not sustainable; which is why it must continue to evolve with not just increased oversight, but an improved structure that is quick to realize problems in its critical banking system. With that foundation, according to Lagarde, structural problems should be addressed on an individual basis - no one size fits all approach. The conversation shifted to austerity and whether or not it is acceptable to call it a failure; especially given that it was pushed by the IMF for nearly all constituents in its program last year. 

Austerity was not balanced, and it is true that the results show a prolonged economic dip instead of painting a path to recovery like many officials hoped for. The quick and painful cuts and higher taxes just to receive the next credit tranche was the problem. Now Lagarde suggests a slower pace of austerity in which structural issues are addressed for the long term. This is how it should be done, and frankly the pressure of competing authority with the Troika and IMF rushed a lot of these fiscal snaps. Hopefully with some time granted after the German election, we could see some organizational structure and better thought out policy on the country level. Lagarde says the same stands for the US in its austerity measures, although we still don't have a sensible budget in place to do so. 

Lastly, Lagarde's comments on Japan were interesting. Abe's promise of structural change seems like the best approach, but the monetary side still leaves many in question. Lagarde would like to see better utilization of Japanese talent - particularly women. The demographic imbalance in Japan is very worrying and will definitely skew the dependency structure. 

-- Also, the third prong approach of the IMF caught my attention. Providing technical assistance to emerging countries for better surveillance of their financial markets is a key investment. That sums up a few main points, but the full video is definitely worth watching. 

Concerning LIBOR

via Dantes Outlook Facebook Page

Once again the issue of accountability is questioned in the banking system. In finance, the line between accountability and responsibility becomes fuzzy as the system grows more complex. The real question is whether or not Barclays and other major banks are to be held accountable for manipulating LIBOR to their advantage, or if they are in fact responsible to be fair and honest in reporting. 

Explaining the Euro Deal

The Euro Group delighted us all late last week with hints of progress. The plan expands the scope of the European Financial Stability Fund (EFSF), European Central Bank (ECB), and International Monetary Fund (IMF). It also includes strict measures to enforce fiscal stability, but is gridlocked at the will of member country politics. The proposal places more hope in the ECB and Central Banks to liquidate our way out of the mess, but does nothing to solve structural issues, and places a heavy burden on the IMF. It is essentially a transfer of responsibility (the bad bank(s) method). It could work, but it involves a lot of risk. Let's step back and understand how the system works.

The two videos  accurately explain the European capital markets. 

The ECB strategy is to become a lender of last resorts. There is clearly an imbalance between surplus central banks like Germany and deficit central banks like Ireland and Greece. Too many Euro-zone countries riddled in financial misery have a high dependency on stronger countries to provide liquidity. The strong national central banks loan money to the ECB, which in turn loans to the deficit central banks in greater amounts than received. The new strategy is to tap the inter-bank market and borrow just enough funds from private banks in strong countries like Germany. These borrowed funds are then loaned to the private banks in deficit countries. The hope is to sure up the private banks, while reducing exposure to the deficit national central bank.

Solving the Collateral Crunch comes in when surplus national central banks loan to the IMF. The IMF then buys sovereign debt from the private banks in deficit countries. Euro group system lending by the surplus national central banks is also acquired by the IMF. Again, the hope is that the private banks, with cleaner balance sheets, will sure up the system. The trash held in the IMF and ECB will then regain value, and the IMF will now be equipped with collateral that was purchased by the surplus national bank sellers.

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Now, structural issues still remain. Public trust is not evident in Europe as savers deposit less money into banks. These banks have less cash on hand to make loans; the hope is that the IMF and ECB can offset this. With new cash on hand, will private banks lend? Not quite. Just like int he US with QE, banks know that there is greater risk of default among borrowers. Austerity and further slowdown is a big factor, and growth is still nowhere in the agenda.

In the UK, Prime Minister Cameron chose to veto the decision to join in the Euro Group proposal. The plan calls for tougher fiscal surveillance and high standards; if the UK does not perform up to par it faces the risk of financial sanctions. London is all it's got at this point, with finance being its economic life-support.

Bottom line - we still have major work to do. But, the plan makes sense. It just lacks the structural gut to make sure that it is executed as planned, and that the private banks realize the economic uptick to actually perform. That economic uptick is unfortunately political.

The US markets turned soar on Monday as the Dow dropped 162 points. The Euro declined as well, as the dollar strengthened giving rise to Gold and Crude Oil. Gains from last week Friday were virtually lost. Moody's warned that the EU Summit does not decrease the chances of a downgrade - citing political and structural constraints as the big factor (the European culture). S&P raised a red flag again as it now looks to review Germany and France.

Historic US Downgrade Adds Pressure to Liquidity Trap, Markets Signal Trouble

This past week, the markets have provided useful indication that trouble is brewing. The private sector has gone rogue, and the message is clear that enough is enough. The economy has been poisoned by political dithering and government crowd out, and now it is time to fess up with the consequences. In the midst of a liquidity trap, safe haven depletion, structural problems, fiscal insanity, and now a historic downgrade of the used up global superman (that is the US), the world sits to drown in worry about what will happen next.

The United States debt ceiling debacle completely missed the golden opportunity to introduce a complete overhaul to reverse the years of folly that got us into this mess. Lawmakers failed to realize the underlying problem - the US has been abused, and it is time to heal it for good. A while back, this blog reported that talks were in progress to craft SDRs (a basket of currencies) to replace the US Dollar as the world's reserve currency. My analysis of this was that the US was beholden to the world's demand in spite of its domestic issues. Issues that included fiscal woes following the decision to leave the gold standard and accumulate an unsustainable supply of dollars to fuel world demand for more US debt. The cycle continued as the world progressed (case in point: the emerging economies off the back of US pain -- China, the biggest holder of our debt). Congress, given the constitutional power of the purse, has yet to realize that we are being played continuously. Recently, Russia's Putin stated that the US is a parasite to the world. China continues to lecture us on how to reverse our addiction to pleasing the world with debt, because it is no longer sustainable for their country as it moves past our problems. And now, our own private markets have raised the alarm. Standard & Poors steps into the debate.

The downgrade from AAA to AA+ is primarily because of the deficit deal reached by lawmakers one day before the debt ceiling deadline. It was merely a band-aid approach to calm markets, and shifts responsibility to a committee that must use politics to decide what government program will receive a cut. With something so nonsensical, a downgrade is inevitable, no need to be shocked. The structural problems have yet to be addressed. 

Lower GDP, and what seems to be better jobs numbers at face value, sent lawmakers reassuring the American people that this is just a short term thing, and the economy will get better...in their hands. Almost laughable to watch this play out. A deeper look into the data shows that the labor market has continued to decline, and because of our messy approach to employment statistics, a drop in the labor market means that the troubled Americans in search of work have left the pool, and the active few (some of whom successful in finding employment) provide a boost to the data. This is correlated to a structural problem, in which the supply of labor is due to an unskilled workforce. Businesses need skilled thinkers to cut through the problems created by the government, and pave the way to recovery. Instead, we have many Americans who are the result of failed government programs with no where to go. And now lawmakers must accommodate for this weird skew with budget shifts. 

The structural problem is not entirely American. The European Union continues to struggle with a way to balance the needs of constituents and bond holders. EU's Rehn recently urged everyone to stay calm and breathe deeply as officials try to craft a plan for Greece to continue borrowing at low costs, with less fiscal burdens due to austerity measures, all while making sure that current bond holders receive their fair share. It's a complex mess that will take time to correct. The markets are not impressed.

Italy rushed through an entire austerity package in one week, under pressure by the EU to make sure that the country is in good shape in case of contagion disaster. Italy is a major route for European debt, so there is big internal worry that they remain solvent. Yields on Italian debt surged as investors panicked and withdrew money from its bonds. The backroom deals sent a message that there are more problems to come. There is hope in Spain as yields decreased with an improving stock market. But, these spreads between Italian, Spanish, and German yields show that the movement of cash within Europe is due to uncertainty. 

US markets experienced a significant decline this week, as the Dow Average moved into the red for this year. Safe havens are now at risk of a price drop too. Margin calls were a major factor in the drop in Gold and Silver prices as investors needed to exit positions in commodities for liquid cash to cover riskier investments in stocks, all to maintain a balanced portfolio. The intense movement of cash to Switzerland caused the Swiss Franc to rally. However, the Swiss Government saw this as too cumbersome a risk to foreign banking demand; thus in an effort to remain stabilized, its Central Bank cut rates to calm the markets. 

US Treasury bills are still in hot demand, and this is somewhat problematic. Investors have no where to go, and Treasuries will continue to be a safer alternative. However, with the US now on "negative outlook" by S&P, the supply and demand of Treasury Bills at auction is uncertain. States have already started buckling up with less debt accumulation. The lower supply of municipal bonds are good for the state's sustainable budget goals, but leaves investors hoarding more cash. 

The Financial Times accurately calls this a liquidity trap - the 2011 deposit crisis. Banks like BNY Mellon are charging more for services that are costing them. The service of hoarding depositor cash in savings is not feasible. Banks have the duty to utilize your savings to provide interest returns. However, with no utilization of cash because of global uncertainty, they rather avoid having to be pressured into risk. 

So, what can be done? The government should shift from spending to investment. As much as there is a spending problem, governments are in desperate need of revenue to please bondholders. Taxes should not be the only source of revenue. Government services need to be measured by its affect on producing a good supply of labor, which will in turn utilize the assets created by government (infrastructure, education, etc) to enhance their well-being. Every project must have ROI in mind. States are in a better position to do this well by making sure that each municipal bond issued must have a plan of repayment with ROI instead of new debt.   We desperately need to send a signal to the markets that the US is back in business. 

Investors Finding Safety in the Swiss Franc and US Debt

Out of all the general safe haven investments during US troubles, the Swiss Franc has performed the best this year. Whether it be the threat of Mid East oil supply disruptions during the Arab Spring, or the continuing worries of a messy budget situation in the US, investors have shifted to the franc as their safe haven currency. As we see further in the post of charts; investors may not want our currency, but they still like our debt.

The first chart on top shows the US Dollar's 3 month decline against the Franc.The bottom chart shows  a fast increase in volatility in the EUR/CHF (euro to swiss franc) pair, against the decline in volatility in Gold. This is quite interesting. Investors seem to be demanding more franc than Gold during the US deficit mess. 

FT Alphaville has a nice feature today on this topic. The article states that mortgage borrowers in Poland and Hungary held Swiss Franc denominated debt taken out prior to the 2008 financial crisis, as an extra hedge. Even Central Bank policies have centered around the Franc. 

In a world of uncertainty, investors are realizing that during times of crisis, you must reserve your spot in the haven where the frantic crowd heads. At that point, you'll be prepared to collect what essentially is a rent-seeking cost. The funds from this strategy can eventually offset the losses from bad exposure. 

Now this is where it gets interesting. Treasury yields (which basically signal the inverse movement to and from T-Bills, as T-prices rise with demand, yields fall) have risen throughout the latter part of 2010 as investors got out of treasury bills. Now, so far this year, yields have been on a decline as investors are buying back more T-Bills. Is this confidence? Or are investors busy fleeing riskier investments and settling for the somewhat safer US debt? More so of the latter. There's no risk free rate here, but given the intense measures taken (hence the high publicity and frantic government), this shows that the US is concerned about bondholders, and will probably continue issuing more debt which is apparently in demand. No talk about how we pay for it until the next debt ceiling date (see the cycle?) Sad, but true. US debt will always be in the mix of a safe haven portfolio, until that time comes -- when someone with a stiff spine paves a correct path towards fiscal sanity at home, in which bondholders are paid back with ROI instead of debt, and spending is on a sustainable level. 

Another Chance to Get it Right - The US Debt Ceiling

A deficit deal must be reached before the August 2nd deadline. In a press conference this morning, President Obama stated that he will meet with his budget team, Vice President Biden, and House Speaker Boehner. The US is in desperate need of a strict budget overhaul, and this could be its chance to do so. In an ideal, somehow unrealistic situation, the debt ceiling will remain and the US will agree to make the necessary cash adjustments to remain solvent in both the current and long term. The US needs a strict force to whip it into shape; the debt ceiling is that force.

White House officials, economists, and pundits in the media use scare words like catastrophic consequences, disaster, the end of the US - if the debt ceiling is not raised. President Obama even lashed out against those that disagreed with him on the debt ceiling issue as irresponsible. Laughable that the ones who were irresponsible are now clinging for political and economic survival. The blame game, and further dithering is not the heart of the matter, as some in the media cleverly make apparent. As daunting as it might be, the numbers deserve more light.

Keeping the debt ceiling at its current level will force us to make serious sacrifices, and operate within our limits, for once. Now is our chance to reverse the status-quo and allow the nation to freely grow without the strangles of debt and bad budgetary practice. Let's delve deeper into what's at stake.

US default is not as scary as the media makes it out to be. It's nowhere close to what Argentina experienced, or what we see now in Greece. The US simply does not have enough cash to cover its debt payments, which fuels the government machine behind the economy. There have been 16 consecutive occasions since 1993 in which the debt ceiling was raised. The decision to open up allow a little more debt to keep up with unsustainable government services adds up, and now we find ourselves at what should be the debt peak. The argument rests in the decision of whether or not to default on bond interest or the principle. We seldom hear of the debate to stay within the set limit and introduce a budget overhaul to correct the mistakes we clearly made after budget plan that came out of the previous debt ceiling lift. Now that's irresponsible.

Here's an option on the table. The not so scary default could be tamed if the Treasury department rolls over maturing issues, so long as the overall stock of outstanding debt does not rise. The term rollover means that the Treasury uses money from the sale of new T-Bills to fund the rollover of maturing debt. It's essentially replacing debt due with new debt, instead of paying for it in cash (which we don't have). The treasury already does this every Monday -- $30 billion worth of T-Bill due for payment are rolled over with the issuance of new debt. See the cycle? It's all virtual faith. The safe haven is made more of an idea every Monday, when the  underlying asset is clouded. The continuing pattern after the gold standard (in which every dollar was backed by gold).

According to ICAP data made public by The Economist, interest payments can be covered. In August of 2011 (the debt ceiling deadline), the US will have an estimated $185 billion in cash receipts, $37 billion in interest due, and $340 billion in other outlays, equating to a ($192 billion) deficit. If the government fixes its budget so that these outlays (which fund government services, bank transfers, bond payments, etc) decreases to allow cash to cover interest, we can avoid less harm. The Prompt Payment Act enforces penalties on late interest payments - yet another expense to worry about. This is a clearly unbalanced position, and the ICAP estimates see a continuing deficit problem with outlays becoming an increasing burden. The problem is obvious - the US is not using its cash receipts in a responsible manner. Giving out more than we have, while creating more of what we don't have is just nonsensical, and it must stop.

If we are forced to default, Treasury will use less scare rhetoric and will explain what we are defaulting on exactly. T-Bills come in periods, so we still have some room to get our act together, broken up by each issuance and disbursement of debt. But a grand overhaul to orchestrate each minuscule (billions are actually big) payment is essential. The US will be forced to create a strategic game play in which the Treasury is held responsible for a balanced budget of inflows to outflows, which means that the government must act with what's given. If the requester of Treasury funds needs more, then they should create more through revenue generation. That will help the budget of each municipality, state, and in a broader sense, the federal government. Creating $3 with $1 requires innovation, and better use of the private sector. Allowing people to do what they do best (create value), will increase cash receipts. It's up to the local politicians to get this right.

The government must be forced to balance its budget. Austerity is painful, but it's clear that the economy needs a step back to leap forward; the US recession needed that J-Curve. If the debt limit does not provide this force, the economy will naturally seek responsible action. And this is exactly what bond investors are thinking. Let's tap into the thought process of the investor.

Are the bond markets really worried about default? So far, there is no demand for higher interest rates to compensate for default. Yields are lower, while treasury prices rise, signaling increased demand for T-bills as a safe haven. Investors are not fleeing the bond markets, because the general picture is still sluggish growth (again, the economy will naturally push for responsible leadership). The safe haven is still viewed as a risk-free asset.

However, the number of Credit Default Swap (CDS) contracts are up from 600-1,000 so far this year. The one year to 15 year spread has tightened, as it is now more expensive to insure a one year bond compared to a fifteen year bond against US government default. Even though investors are buying more Treasuries, they are insuring against default by relying on CDS. Playing it safe. China is also diversifying its reserves outside of US Treasuries.

The Economist interviewed a bond strategist about the patterns she sees in the markets:

Priya Misra, head of US rates strategy at Bank of America Merrill Lynch, says anyone who thinks America might default for several weeks this summer should sell a bond with interest due on August 15th and buy one with interest due on November 15th, which would result in the price of the first bond falling relative to the second. But, she says, neither market pricing nor the chatter of clients shows such a trend.

The debate should focus more on a budget overhaul, and the debt ceiling issue will follow these standards.

What to do about Greece

Greece isn't so much of a headache as it an opportunity for traders. It allows us to step back and think like an economist; evaluating the what ifs of contagion and speculating the fate of the Euro. The task list is complex.

Last week, the Prime Minister successfully passed a confidence vote, but voters outside his elite backing remained angry. Protesting outside government buildings continued, spreads on Greek/Spanish yields widened, and traders sold off on the Euro sending the currency on a decline. The markets are one step ahead, as the value of the Euro rises ahead of key meetings and votes just to show that expectations are rising, only to increase fears about the next step.

The fact is that Greece is and will continue to be a burden on the Euro zone - lower GDP per person coupled with higher government debt as a percent of national GDP. The country is in desperate need of a 12 billion euro life-line loan by mid-July. This, along with a plan for further austerity measures will be the next task for Greece. The Prime Minister and his cabinet must balance the interest of pleasing bond holders and pleasing voters. This battle is essentially the same, as voters, who want to continue life as it once was (living beyond their means) are the major holders of Greek debt.

Contagion is based mainly on fear rather than the actual. Although the euro zone is becoming entangled in the mess of Greece through its Central Bank (a bad bank of debt) and the flows of bail out cash extending a line of dependency, the risks are greater at home. Greek banks will ultimately feel the pain in the event of a default. The National Bank of Greece, Piraeus Bank, and Eurobank EFG, all have 6-8% of capital tied up in Greek government bonds. However, outside banks such as BNP Paribas and Dexia group, have 2-5% of capital in Italian and Spanish bonds. This is a big problem.

Banks within the euro zone and around the world don't have to be tied up in Greek debt specifically. If the balance sheet has Italian, Irish, and Spanish bonds, it is indirectly affected by Greek default or other types of restructuring. Yields will fluctuate in response, as investors display emotion with their dollars. Banks around the world that have holdings in funds that are exposed to European debt face risk. Similar to the financial crisis, in which investment banks struggled to determine counter-party risk -- who the heck owns the stuff? Eventually, the knot becomes too tight to untangle, and we end up with a Lehman style collapse. Not so much the case here. Transparency is much greater with government debt, but still, exposure and contagion fears remain.

Investors are already evaluating exposure. Shares of Dexia Group, a Belgian bank with major holdings of euro zone debt, have declined significantly (down 24% YTD). However, banks like Dexia are insured through credit default swaps. Back in June, Dexia joined other banks to rollover a combined 30 billion euros of Greek debt for an emergency package. On the other hand, taxpayers and public workers have savings in Greece, and they should worry. The people of Greece can begin with tightening their belts so that the government can get on with tackling its fiscal woes.

So, what are the options.

A second bail out will continue the spiral of dependency and will only succeed if its backed by strict austerity measures. Voters even see a second bail out as a continuing problem. Investors will see this as some certainty, but only short term.

In the long run, the euro zone will continue to funnel money through a stabilization fund (essentially a little IMF of their own). Countries need to get away from this. The money just stalls time.

Default will ripple the markets, but will force people to get serious. If this happens, Greece should think about a gradual exit from the euro zone to focus on creating an organic model that will be more sustainable.

Restructuring is the best bet. First, greater privatization should be considered. Already, Greece is selling shares of its ports and an immediate sale of state assets. Second, a private 'bail-out' focused on restructuring debt should occur. Give Germany and the rest of the euro zone a break, and consider this:

SWFs [Sovereign Wealth Funds] have the might and the risk appetite, but do they have the interest? China has repeatedly pledged support to Europe’s periphery, motivated by the prospect of currying favour with Europe in order for its domestic firms to gain greater access to the European markets.

Norway’s sovereign fund—the world’s second largest—also has an interest in the euro area’s speedy recovery, given its home country’s proximity and links to the euro zone. Although the fund largely tracks public equity and bond indexes, it leaves some room for active management. Recent statements from government and fund officials suggest that the fund may use its discretion to buy more euro area peripheral debt. As of the third quarter last year, Norway’s SWF held US$3.9bn in Spanish sovereign debt, its seventh-largest individual bond position. -- Economist Meg, SWFs: the euro zone's white horse? (May 2011)

For now, we wait. Honestly, I enjoy the buzz among my Twitter and Facebook friends as we frantically try to make sense of this mess. Traders will continue to monitor these events, taking pulse of the Euro. In the meantime, the US should prepare for a shift of interest and get its budget deficit under control to show investors that the country is serious about becoming solvent.

The Future of Toxic Assets

Once again, a Facebook discussion inspired me to think further. The banking idustry will face many challenges ahead, as outlined in last week's Special Report in The Economist. The culprint behind it all are "toxic assets". It's not as toxic when viewed in the long run, but for now bankers and regulators are still trying to find a place for it. The US went through this, and is slowly recovering with cleaner balance sheets. Europe is starting to experience similar troubles, especially Spain with its housing bubble. The question remains, what's next for these troubled assets (troubled is a better term than toxic).
In general, it is still too early to forecast the future of the banking system. The US, the source of the financial crisis, is still in the idea phase. The Dodd-Frank Bill is essentially a long list of proposals on what regulators intend to accomplish. Once a specific action plan full of regulations is introduced, analysts will surely weigh the pros and cons. We are starting to see the plans leak out, begining with consumer protection, and regulations on small things such as debit card transaction fees. The industry as a whole will be tightened, with higher capital and reserve requirements, cutting into profits. This might also force banks to venture into new exotic investments, and spill over risk from the shadow banking system - financial dealings with investment banks and other non-deposit institutions.

The initial plan, and what remains to be the first resort, is to set up a bad bank. The government purchases troubled assets and places them in a 'bad bank' where they sit and wait to be bought at a higher value. The government also collects payments in the form of a core capital ratio from the banks. The tricky part is valuing these assets and figuring out book values. The market for troubled derivatives is essentially dead, and there is little transparency, no source of ownership, and no demand pressure to set an actual price. The government has actuaries who assume the price, and we have some faith in this value. I think that the cost of the lump sum of purchases should equal to the amount of cash desperately needed to free up the bank's balance sheet.

The underlying asset that sets the value of these derivatives such as credit default swaps and mortgage baked securities are mainly consumer debt and homes, respectively. Currently, the US housing market is sluggish, as many homes remain vacant, foreclosed, and on a tightrope amidst mortgage loan restructuring. Some banks are desperately extending loan terms to help buyers by decreasing mortgage payments, in hopes to hold on to income producing properties. Other banks have lost hope and started a wave of short-sales, accepting small losses, but still face low demand from buyers. An empty home is...an empty home, and the derivatives that are fueled through the payments of borrowers are empty too, dead, or as some like to call it - toxic.

Fast forward a decade into the future. By this time, these troubled assets will be worth something. Governments can sell them off for profit, but I feel like there is a better way for banks to deal with this on their own. Consider this:

Banks establish a bad bank of their own and bear the costs involved in doing so (no initial sale, no cash). The government is artifically valuing the assets, when given some time, these instruments can arrive at a fair market value. These bank owned 'bad banks' will be managed by a team in charge of re-structuring the assets for a gradual launch throughout the recovery years. The assets are already structured for a good economy with cash flows from income generating properties and debt accumulation. The problem that caused systemic collapse was when the economy went sour, these instruments became toxic because they were not created to yield positive results during default. No matter how many parties insured the risk of default, the process of capital payment to borrowers and faulty ratings trumped all other pre-cautionary measures. Also, the web of insurers grew to large, that a collapse was inevitable, because no one could pinpoint the source of risk.

When these assets are structured, they need boundries. These derivatives should perform similar to options. It must come with a start date, and most important, maturity. The maturity period should arrive when the economy gives signals of exhaustion. Next, the assets should be split into groups of investors so that transparancy can flow easily. This is a better alternative because it is re-structured to be sustainable. Sitting on the government's books does nothing, and will only leave the new investors in more pain.



Possible Effects of Basel III

Central Bank leaders from around the world came to a consensus on September 13, 2010 about new banking requirements. Basel III calls for an increase in common equity, which banks use to absorb losses. In addition to that safety net, internationally active banks must hold levels of common equity equal to at least 7% of their assets. The current international standard is 2%, with the US at 4%, Basel III will be a significant increase.

The WSJ reports:

"Some changes will go into effect as soon as 2013, but others won't be in place until the beginning of 2019. Technical changes to the definitions of capital won't be fully in place until 2023.

Banks will be allowed to phase in these new standards over a period of years, so they will have more time to comply. By 2015, banks will have to begin building a 2.5% "buffer" of capital that must be fully in place by Jan. 1, 2019. 

If banks fall below the buffer, regulators could force them to hold onto more of their earnings to augment their capital, which means the companies will have less money on hand to pay dividends or offer large compensation packages. Some analysts believe the new standards could essentially force banks to shrink their loan portfolios or shed other assets in order to improve their capital positions."

Despite the gradual implementation of the conservative requirements, banks claim that the costs will be transferred over to borrowers and employees. This will mean higher lending standards causing a decrease in loans, and higher fees. Employee bonuses, under intense media and shareholder scrutiny will likely decrease; although several analysts expect this to remain steady. Academics argue that according to past data, increased reserve requirements have little to no effect on lending productivity.

Although this is very much needed, there is still the risk of moral hazard. Knowing that there is a safety net, despite it being their own cash, banks might continue risky investments. Surely, if they grow large enough, the state will provide additional funds lacking in common equity reserves - that being the mentality of the crisis. Whatever the case, banks will find themselves scrambling for cash. Inter-bank short term lending might pick up and banks will flock to more liquid investments; those that seem attractive in yield but also pose risk. Banks will find a way to get the cash they need. Government will find it difficult to tackle a new system that grants liquidity, if it poses systemic risk that is.

Another risk is that banks might gradually decrease their stake in government debt. In the US, banks are utilizing bail out cash to purchase Treasuries and other forms of hedging. Since then, the Fed has been active in quantitative easing to try to crowd out the treasury market and encourage banks to transfer their cash to borrowers.

Update: The Fed's latest QE3 program will  provide liquidity to mortgage providers through MBS purchases. However, the underlying disappointment in Wells Fargo's recent earnings report due to lower than expected revenue is concerning. With Basell III approaching, Wells Fargo is in a good position with mortgage banking non-interest income up 53% due to fees associated with the productive mortgage market. However, with low rates providing an incentive to borrower's choosing to refinance, banks like Wells Fargo are seeing interest income plunge. Again, the hope is that QE3 MBS purchases will help compensate for the decreasing returns stemmed from a low rate environment. Currently, Wells Fargo sits on $127bn of MBS, up from $106bn reported in the previous year. There's more to be sold, thus more liquidity to be provided.

In sum, for the US this still means we have more work to do. Basel III is an international standard meant to secure the banking system, but domestic responsibilities of each country still remains. Now that in the long run banks will have to reserve more cash, we need to figure out a way to encourage lending. That starts with a healthy economy of both borrowers and lenders.

Bernanke Will Testify Against Dodd's Financial Regulation Bill

Today, Bernanke will argue against Senator Dodd's proposed financial regulation bill. The square off will consist of Bernanke's testimony in front of the House Financial Services Committee.

Senator Dodd's bill will increase unneeded bureaucracy. The Federal Reserve was given the independent right to supervise banks and implement monetary policy. Supervision is one factor that adds to the Fed's overall grasp of the economy. Separating this responsibility will interrupt the Fed's process and create more confusion. Why spend money on creating a branch complete with tasks that are already delegated? This is yet another nonsensical DC policy that is purely marked with good intentions but lacks feasibility.

The biggest concern is this "emergency" fund. Prepaid bailouts does not add to the mission of getting rid of "too big to fail" and protecting the American people from financial mishaps. If anything, better supervision should decrease the need for a bailout.

Yes, the Fed messed up with supervision, but we must understand the complexities of securitization; it's difficult to pinpoint the source of the problem. With so much insurance on debt and obligations being packaged, the market was full with no real value to these products -- it was one big mess. Supervision was difficult, but a bail out should always be a last resort. I support the creation of bad banks on Wall Street, and not Main Street. The Fed made the mistake of becoming a bad bank, and Dodd's bill will call for bureaucrats to enter negotiations armed with cash.

The growth of government seems to be the inconvenient solution. The biggest shareholder in the financial system is the government, and new regulations are merely steps to protect future investments, which means increasing government. Bailouts come with moral hazards of huge bonuses and other shady practices, and government is just learning this.

Senator Dodd doesn't understand the whole scheme. The treasury bails out troubled banks, while the Fed funds these bail outs by purchasing attractive treasury bills. The return on interest and added bank fees for insurance serves as revenue for the Fed, in which about 80% is given to the Treasury. So, I beg to question the motives of these politicians. I support Bernanke's fight to keep the Fed independent.

Outlook on Regional Banks: Poised for a Comeback

I'm glad to see DC making the necessary steps of narrowing their focus on the local markets that have been overlooked from the 'Too Big to Fail' thinking. Our previous post highlighted the positive proposals of helping small businesses, and now the FDIC will be working with regional banks in hopes of encouraging lending. The big task is raising capital; and Obama stated that $30B will help them return to profitability.

This chart clearly shows a comeback for regional banks. Look closely at the growth, because that's the ultimate factor for investors. You want to move your money away from the down trending large banks--faced with more taxes and regulations from DC, big banks will experience further decline. Regional banks are a better investment.

Dantes Outlook will post a summary of our return or losses based on our investment in a regional bank as well as other notable trades.

For more info, go to: http://bit.ly/c0MSWf

Statement on Obama's proposed capital gains tax cut

"Let's also eliminate all capital gains taxes on small-business investment" --President Obama. It's about time we realize the power of small businesses. Back in 2009, Obama urged Congress to increase the capital gains tax. I'm glad he reversed his thinking & let's hope he stays true to his word. Investing by accumulating assets should be encouraged.

Regulating banks: A love hate relationship

When the government becomes a major shareholder in banks, we can expect regulations to decrease risk. The Volcker rule will limit bank investments. DC feels betrayed after banks payed back TARP, but still made profits and didn't lend. Too much responsibility is placed on banks to stimulate the economy. In this economy, banks don't anticipate a good return. They find other safe havens like treasury bonds. If DC feels this way, then they should also sneer at the Fed Bank which made record profits by making similar investments as banks as a way to crowd out the market. These asset purchases were intended to block banks from government bond investments and encourage them to lend. All done with a struggling economy that, when fixed, will provide enough incentive for banks to lend. DC needs to learn that when it comes to money, you have no friends.

CFTC proposed new regulation will hurt retail Forex traders

CFTC, a government agency which regulates futures trading (our focus of investing) plans to reduce the maximum amount of leverage to 10:1 (10 percent). CFTC better get out of the way! Is the government really too ashamed of their mistakes that they have to manipulate the vote of the markets? Central Banks need to realize that they are not in full control of their currency. The people determine the demand for your dollar. Say no to CFTC!

For more info, here's what GFT Forex had to say: http://ow.ly/YP9P