Hidden Bailouts for GM and Chrysler Continue

As an investor and future economist primarily concerned with the role of credit in business cycles, the release of new data always provides for some intriguing reading. Courtesy of Zero Hedge:

As the just released G.19 confirmed, in September, households once again reduced their credit card debt, which declined by $2.9 billion to $852 billion. This was the fourth such decline in six months, confirming that at the discretionary level where banks have supervision over borrowings, the consumer is still nowhere near willing to relever. Where, there was leverage, a lot of it, was once again in the government sector, which funded $13.8 billion of the total $14.6 billion rise in NSA credit, and where non-revolving credit: read loans for Government Motors, at least those that have not been record channel stuffed (as reported previously) and Federal Student Loans, which are now over $1 trillion, rose by $14.3 billion in one month. Of course, the difference between revolving and non-revolving credit is that while banks expect the former to be paid off eventually, Uncle Sam has no such illusions on any low APR debt it hands out to anyone who asks for it (and if the proceeds from student loans are used to purchase iPads, so be it).

Aside from the notion that most new credit growth stems from the federal government (e.g. student loans), the degree to which credit is extended for car purchases/leases remains troubling. When one considers the extension of credit for housing, investments or education, there is a clear path by which that investment could generate positive returns and make future repayment of principal and interest easier. However, when it comes to spending on automobiles (or consumption goods) there is presumably no expectation for a positive return since cars lose a significant portion of their “value” once driven off the lot. Hence auto loans are seemingly granted on the basis that borrowers face short-term liquidity issues or will experience increased future returns from other investments.

Assuming the above mentioned reasons for providing auto loans are largely correct, there is clearly an opportunity for market participants with excess liquidity (e.g banks) to offer loans in hopes of earning a profit. In doing so, the private participants (ideally) also accept the risk of losses stemming from non-repayment. The market price (again, ideally) adjusts to reflect the most current expectations of risk and reward, as seen through supply and demand.

How does this relate back to the government? As most people know, during the financial crisis, the U.S. government took control over General Motors (GM) and placed it through a managed bankruptcy. What many may not be aware of, is that the U.S. government also bailed out and took a controlling stake in Ally Financial Inc., formerly known as GMAC (General Motors Acceptance Corporation). Today that stake remains at ~74% and is even higher if one includes GM’s nearly 10% stake. To demonstrate the importance of Ally to GM, and now Chrysler (the other bailed out auto company), here is a pertinent portion of the 2011 Annual Report:

We financed 79% and 65% of GM's and Chrysler's North American dealer inventory, respectively, during 2011, and 78% of GM's international dealer inventory in countries where GM operates and we provide dealer inventory financing, excluding China.

Given the enormous percentage, it appears Ally’s terms of credit are well below other market participants. While this strategy implicitly held a government backing prior to the crisis, it’s failure has now resulted in an explicit backing from the government (i.e. the public bears the risk).
 
We could argue over whether or not the federal government should be subsidizing credit at all, but I want to put that debate aside for the moment. If governments are set on encouraging investment and/or consumption through extension of credit at below-market prices, is the auto sector really the most productive use? Is it even close?

Whether or not the auto bailouts were a success, remains an open question for many. Unfortunately the costs associated with Ally Financial, especially the opportunity costs of credit, are often overlooked. Going forward, consideration of the success or failure of the auto bailouts must account for the ongoing costs of directing scarce resources towards that sector and future losses on loans. Hopefully these factors will also play a role in determining how long the current environment is allowed to persist.

Related posts:
Is the Return of Auto Subprime Lending and GM "Channel Stuffing" Connected?
Liberals Demonstrate Conservative Bias for Manufacturing
An American Icon Returns

How Out-of-Control Credit Markets Threaten Liberty, Democracy and Economic Security

Think back to the Great Depression. What we lost then and now and what we need to regain is trust. To be frank, I don't know how we can win that trust in our system back. But, when it comes to credit markets, I know where we can start.

First, we need to make sure there are no more bailouts. While the bailouts have prevented a Great Depression for now, they have engendered a deep sense of cynicism and resentment which has negatively impacted credit and growth. Second, we need to know that our largest financial institutions are well-capitalized enough to withstand large economic shocks. Without this knowledge, no one can separate liquidity from solvency — exactly the problems banks had during the Great Depression. Third, we need to enforce regulations through sound regulatory oversight and civil or criminal penalties. Self-regulation is a pipedream promoted by corporatists. And we see that time and again where regulations are not enforced, financial institutions turn to excess that leads to panic and crisis.

Doing these three things will not magically turn our economy around and get credit flowing again. But these steps are essential to restoring trust in our financial institutions and government. Restoring that trust is the first and most important step in getting our credit markets to work the way they are supposed to — in a way that enhances and insures our individual liberty, rather than the false privileges of corrupt financial institutions.

Read it at Naked Capitalism
How Out-of-Control Credit Markets Threaten Liberty, Democracy and Economic Security
By Ed Harrison

In trying to understand our modern monetary system and the problems at the heart of the current crisis, the most important aspect is credit. Although I currently believe demand for credit is a greater issue, problems within financial institutions remain serious. Harrison’s third point, which seems to contrast an earlier view about the need for more regulation, is worth highlighting. In the US there are already thousands of regulations for financial institutions. The trouble is that many are simply not enforced or hold penalties so small as to make breaking the rule still worthwhile. Greater transparency and enforcement are clearly needed in light of the recent PFG bankruptcy, LIBOR scandal and countless other known and unknown transgressions.

Subordination in Spain will cause pain

Citing Sony Kapoor's post on the myth of seniority in the Spanish bank bailout, Felix Salmon concludes that

Basically, channelling new money to a liquidity-constrained debtor is always good for existing creditors, even if the new money is senior. That’s obviously the case if the new money prevents insolvency, but it’s also the case if it doesn’t:

Imagine a country has an NPV of expected future primary surpluses equal to x euros, which defines its sustainable debt carrying capacity and that its debt stock is y euros; we don’t need to say whether x is bigger than y or not. Now on a date say the 1st of Jan 2013, it gets a public bailout equal to z euros. Its debt repayment capacity is x+z euros as it now has the equivalent of z euros in a bank and its total debt is now y+z euros. If y>x then y+z>x+z and nothing changes. Assume x = 0.8 y, then bondholders would face a 20% haircut, whether before or immediately after the public injection of z euros.

Now imagine that the z euros bailout is at a concessional rate of interest. Then it will improve the sustainability of debt, all else remaining the same and increase the potential pay out to private bondholders. Equivalently, if the country invests the z euros it obtains in NPV positive projects, the sustainability of its debt improves, making the outcomes for private bondholders more positive.

Reading this section I was struck by the presumption of a positive “NPV of expected future primary surpluses.” What if the NPV is negative (ie. the entity is insolvent)?

Felix continues with the following quote from Kapoor:

There is one exception to this rule, which is when the conditionality accompanying a public bailout is so flawed that it makes the recipient country adopt policies that actually hurt growth prospects and reduce its debt carrying capacity thus increasing the likelihood of insolvency and the size of private sector losses. This is a big and legitimate fear given the current excessive focus on austerity in the Eurozone and may play some part in the panic around Spain.

So the question of current insolvency remains unanswered but Felix points out that the real problem is implied austerity from the bailout, not the seniority of public sector funds.

While I agree with Felix and Sony that austerity (a reduction in deficits) is negative for short-term economic growth and therefore repayment, I still have reservations about how decisively positive public bailouts are being described. After clicking through to Sony’s blog, I found the answer to my question:

The only circumstances under which a public bailout will make private investors worse off is if the public bailout money is ‘wasted’ or spent on items that are NPV negative.

This sentence, which appears in between the sections selected by Felix, was clearly omitted on purpose. Both Sony and Felix appear to be downplaying the possibility that bailout money could be “wasted”, however reality appears to suggest otherwise.

Under the terms of the proposed Spanish bank bailout, the funds will be provided either directly or through a sovereign fund to Spanish banks that are probably (certainly?) insolvent at the moment. It is not a stretch to infer that these banks have been engaging in negative NPV activities, which led to their insolvency. Now the hope is that after receiving bailout funds, these banks will cease those actions and begin making smarter, profitable decisions. But why should we expect the banks to perform any better going forward? Having been bailed out once (and gaining implicit future protection), why not increase the level of risk taking and/or double-down on previous actions?
By bailing out the banks, there is a non-trivial probability that public funds will be “wasted”. In that case, private creditors currently facing potential haircuts will have their holdings subordinated as the assets from which they will be repaid are allowed to dwindle further. Subordination therefore will negatively impact current creditors, along with the technocratic stipulations tied to future bailouts.

Related posts:
Unending Subordination of Private Creditors Continues

"Easy money has morphed into financial repression"

Think of it this way, just after the Euro came into being, the German economy was in what I labelled a soft depression due in large part to Germany’s own post-unification credit excesses. So the ECB decided to prop up the German economy with low interest rates, rates that produced negative real interest rates and housing bubbles in Ireland and Spain. This was a policy designed to "bail out" the indebted German economy. We called it easy money then because it allowed massive speculation to be funded by cheap loans in credit markets. Now that the bubbles have popped, easy money has morphed into financial repression. But the goal is the same as it ever was: to "bail out" the indebted by ‘repressing’ interest income that creditors can receive.

The interesting bit about this policy is that economic policies right across the indebted developed economies have been extremely favorable to creditors in bailing financial institutions out of their lending excesses at taxpayer expense. Yet, at the same time, creditors are being savaged by the sharp downturn in net interest income due to the easy money policy we are now calling financial repression.

Read it at Credit Writedowns
Chart of the Day: The smoking gun showing how the ECB wrecked the Spanish economy
By Edward Harrison

A couple months back I wrote a couple posts about how The Economy Needs a Bubble!
when interest rates are held below the growth rate of an economy (See also The Economy Needs a Bubble, but Treasuries are NOT it!). One point I might add to Edward’s post, is that the groups of creditors benefiting from bank bailouts and being hurt by financial repression may very well represent different groups based on income/wealth. In my opinion, this is an important distinction for understanding the political motives behind each policy and assessing any likely changes to policy down the road.

ESM Flaws Emerge Prior to Ratification

On Monday, in Unending Subordination of Private Creditors Continues, I noted that the terms of Spain’s bank bailout had yet to be determined. More specifically, it remains unclear if the funds will come from the EFSF or ESM:

If funds for Spain's banks come from the EFSF, the new loans would not explicitly be senior to other private claims but Spain would no longer be able to guarantee the previous loans to Greece, Ireland and Portugal. If the funds come from the ESM (which has yet to be ratified by Germany), the new loans would explicitly be senior to other private claims, however Spain could continue to guarantee loans from the EFSF and ESM.

Although these questions remain unanswered, Mike ‘Mish” Shedlock sheds light on the ESM and asks if there are Any Rabbits Left in the Hat?

Assuming the treaty passes, please turn your attention to Article 41.

ARTICLE 41 ... payment of paid-in shares of the amount initially subscribed by each ESM Member shall be made in five annual instalments of 20 % each of the total amount. The first instalment shall be paid by each ESM Member within fifteen days of the date of entry into force of this Treaty. The remaining four instalments shall each be payable on the first, second, third and fourth anniversary of the payment date of the first instalment.  

Mish’s reader, Brett, who pointed out the above article then offers a breakdown of each country’s contribution in the first year.

Capital Contribution Analysis

ESM Member	Capital subscription (EUR)	2012 Contribution (20%)
Kingdom of Belgium	€ 24,339,700,000.00	€ 4,867,940,000
Federal Republic of Germany	€ 190,024,800,000.00	€ 38,004,960,000
Republic of Estonia	€ 1,302,000,000.00	€ 260,400,000
Ireland	€ 11,145,400,000.00	€ 2,229,080,000
Hellenic Republic	€ 19,716,900,000.00	€ 3,943,380,000
Kingdom of Spain	€ 83,325,900,000.00	€ 16,665,180,000
French Republic	€ 142,701,300,000.00	€ 28,540,260,000
Italian Republic	€ 125,395,900,000.00	€ 25,079,180,000
Republic of Cyprus	€ 1,373,400,000.00	€ 274,680,000
Grand Duchy of Luxembourg	€ 1,752,800,000.00	€ 350,560,000
Malta	€ 511,700,000.00	€ 102,340,000
Kingdom of the Netherlands	€ 40,019,000,000.00	€ 8,003,800,000
Republic of Austria	€ 19,483,800,000.00	€ 3,896,760,000
Portuguese Republic	€ 17,564,400,000.00	€ 3,512,880,000
Republic of Slovenia	€ 2,993,200,000.00	€ 598,640,000
Slovak Republic	€ 5,768,000,000.00	€ 1,153,600,000
Republic of Finland	€ 12,581,800,000.00	€ 2,516,360,000
Total	€ 700,000,000,000.00	€ 140,000,000,000
Less Spain		-16,665,180,000
Total Less Spain		€ 123,334,820,000
Less Greece		-3,943,380,000
Total Less Spain + Greece		€ 119,391,440,000
Less Portugal		-3,512,880,000
Total Less Spain + Greece + Portugal		€ 115,878,560,000

Brett argues that Spain, Greece and Portugal will not be able to contribute given their current public debt troubles. This may be true, but it seems to ignore a specific advantage of the ESM over the EFSF (as noted above), which is that countries can continue to provide guarantees while receiving loans from the fund.

Assuming that Spain contributes their portion, the contributions of Greece and Portugal remain dubious. Would the EU provide new bailouts so that those countries could meet their commitments? Also, what about Ireland and Cyprus? Having been shut out of debt markets, will those countries increase their public debt further in order to provide capital to the ESM?

Even if all €140 billion is obtained, the current Spanish bank bailout of €100 billion will deplete most of the current funds. Given that Irish banks remain insolvent and Spanish banks will require far greater sums, where will the next round of funding come from? Yields on Spanish and Italian debt are already unsustainable and rising fast, even before these large capital contributions are made. What happens if Spain or Italy requires a bailout for their public debt later in the year?

When the ESM was proposed, the notion of a €700 billion bailout fund sounded impressive. It’s now clear that the structure of subordinating private debt places upward pressure on yields and the sum is utterly inadequate for the task at hand. Whether or not the ESM gets ratified in the near future, the crisis will continue.

John P. Hussman - The Heart of the Matter

The ongoing debate about the economy continues along largely partisan lines, with conservatives arguing that taxes just aren't low enough, and the economy should be freed of regulations, while liberals argue that the economy needs larger government programs and grand stimulus initiatives.

Lost in this debate is any recognition of the problem that lies at the heart of the matter: a warped financial system, both in the U.S. and globally, that directs scarce capital to speculative and unproductive uses, and refuses to restructure debt once that debt has gone bad.

Specifically, over the past 15 years, the global financial system - encouraged by misguided policy and short-sighted monetary interventions - has lost its function of directing scarce capital toward projects that enhance the world's standard of living. Instead, the financial system has been transformed into a self-serving, grotesque casino that misallocates scarce savings, begs for and encourages speculative bubbles, refuses to restructure bad debt, and demands that the most reckless stewards of capital should be rewarded through bailouts that transfer bad debt from private balance sheets to the public balance sheet.

What is central here is that the government policy environment has encouraged this result. This environment includes financial sector deregulation that was coupled with a government backstop, repeated monetary distortions, refusal to restructure bad debt, and a preference for policy cowardice that included bailouts and opaque accounting. Deregulation and lower taxes will not fix this problem, nor will larger "stimulus packages." The right solutions are to encourage debt restructuring (and to impose it when necessary), to strengthen capital requirements and regulation of risk taken by traditional lending institutions that benefit from fiscal and monetary backstops, to remove fiscal and monetary backstops and ensure resolution authority over institutions engaging in more speculative financial activities, and to discontinue reckless monetary interventions that encourage financial speculation and transitory "wealth" effects without any meaningful link to lending or economic activity.

Read it at Hussman Funds
The Heart of the Matter
By John P. Hussman

Related posts:
Tax Law Made Financialization Happen

Despite Bailouts, Irish Banks Remain Insolvent...Spain Too?

The 2011 annual reports for Bank of Ireland, AIB/EBS and Irish Life reveal the scale of losses that will be in store if our economy doesn’t turn around and grow. Each of these three financial institutions published two valuations for their loan-books – a “carrying value” which is what is reported in the accounts and represents the book value of the loans less a convoluted provision for impairments and a “fair value” which represents what the loans are worth today if they were called in and the underlying asset was used to pay off the loan. Here is the summary of the loan books in 2011 which show that the overall difference between “carrying value” and “fair value” for these three institutions is an almighty €38bn which if it materialised would wipe out the entire capital base and need nearly €20bn in additional capital to boot, just to keep banks solvent. To give them adequate capital buffers might involve a further €20bn. So €40bn, all told on top of the €72bn current and projected cost. (my emphasis)

And take a look at the loan books the previous year in 2010.

There has been a major deterioration in the “fair value” and the gap between the “carrying value” and the “fair value” which is what you would expect when the economy is still in recession, where residential property fell by 16%-plus in the past year and commercial property fell by 10%-plus, and where unemployment is now at a current-crisis record of 14.8%.

Read it at NAMA Wine Lake
2011 annual reports for Irish banks reveal potentially catastrophic losses and additional bailouts requirements
(h/t FT Alphaville)

So much for those stress tests, huh? It is already pretty widely accepted that Portugal will need a second bailout later this year and it appears Ireland isn’t out of the woods yet either. Optimistic expectations for growth are nice to look at, but can have terrible ramifications when used for policy making. Growth prospects for the PIIGS remain extremely weak, looking out over the next few years, which means banking shortfalls in the countries will probably increase further. If the necessary size of Ireland’s bailouts offers even a reasonable comparative estimate for Spain, instead of 100 billion euros, the ultimate total may be upwards of 400-500 billion euros.   

Unending Subordination of Private Creditors Continues

Surprising virtually nobody, Spain officially requested a bailout this past weekend. Unlike the bailouts of Greece and Portugal, but similar to that of Ireland, these funds will be directly used to bailout Spanish banks. Although the final sum will only be determined after independent reviews of Spanish banks have been completed, the initial sum being reported is a maximum of 100 billion euros. While equity markets continue to rejoice at the sign of any and all bailouts, credit markets are finally waking up to the reality of the situation and sovereign yields are already higher throughout most of Europe.

I continue to be (foolishly?) surprised by the mainstream media optimism, touting each successive bailout as bringing an end to the crisis or one step closer to a full fiscal union. The simple fact that, after three years, Europe is now finalizing details of the sixth bailout should be a clear sign that previous optimism has been badly misplaced.

Looking beyond the initial optimism, there remain numerous aspects of the newest bailout that are troublesome for the sustainability of the EMU. For beginners, Spain is apparently going to receive funding for its banks without having to make any further fiscal commitments. On a positive note, the peripheral countries are finally recognizing the strength of their position and will not be speeding up attempts to reduce deficits. On the other hand, Ireland has already asked to renegotiate the terms of its previous bailout and the trend of weaker conditions to receive funds continues.

Apart from the fundamental currency issue at the heart of the crisis, at this point Europe is also suffering from too much aggregate debt (compared to incomes). Unlike the last Greek deal, this bailout will not reduce the amount of outstanding debt. Instead, the debt of Spanish banks will effectively be shifted to the public sector via loans from the EFSF/ESM. These new loans will become senior claims, once again subordinating the outstanding debt currently held by private creditors. Private creditors are slowly coming around to the fact that a possible endgame in Europe leads to the complete subordination and eventual writedown of privately held debt. While the structure of Spain’s bailout may encourage private creditors to lend to banks, it will likely further discourage creditors from owning sovereign debt.

By accepting funds from the EFSF/ESM, Spain also removes itself from the group of countries contributing funds to back loans from those entities. Although this slightly improves the position of Spanish public debt (outweighed by the new bailout sums), the liabilities of all other countries will increase. This is especially troubling for Italy, which is already paying interest rates on its sovereign debt that are unsustainable. The combination of increasing debt and discouraged private creditors may drive yields on Italian debt higher at increasing pace.

Lastly, the supposedly maximum amount of this bailout (100 billion euros), while three times larger than recent estimates, still almost certainly undershoots the necessary amount by a wide margin (maybe 200 billion?). By only providing half-measures, Europe continues to shoot itself in the foot. The preliminary bailout of Spanish banks buys Europe a bit more time, which I fully expect to be used in an unproductive manner. Since the fundamental problems remain unaddressed, after this moment of optimism subsides, Europe’s problems will once again resurface with a vengeance.


Update - Clarifying a couple errors from above: If funds for Spain's banks come from the EFSF, the new loans would not explicitly be senior to other private claims but Spain would no longer be able to guarantee the previous loans to Greece, Ireland and Portugal. If the funds come from the ESM (which has yet to be ratified by Germany), the new loans would explicitly be senior to other private claims, however Spain could continue to guarantee loans from the EFSF and ESM. It appears the details of Spain's bailout are much murkier than initially reported...

Crisis Events in Europe Speeding Up

Following weak demand for 5 and 10-year Italian debt in today’s auctions, yields are once again spiking. Italy’s 5-year yield is over 5.5% and the 10-year breached 6% again. Meanwhile, Spanish yields are rising sharply as well. Spain’s 5-year yield is now over 6% and the 10-year is quickly moving towards 7%.
As the chart displays, the curves are becoming flatter outside of 3 years, where the LTRO wasn’t focused.

Yesterday, Sober Look offered the following chart showing the similarities between Spain and Portugal's 10-year yield spread to Germany. As the post notes:

On April 1st, 2011, Portugal's 10-year spread to Germany went above 5% for the first time. Two weeks later Portugal formalized its request for assistance from the EU/IMF.

Spain’s 10-year spread to Germany surpassed 5% for the first time on Monday and today reached 5.5%.

Without any imminent promise of further easing by the ECB or stimulus from the EU, it appears investors are not waiting to test the Troika’s limits. Even if the ECB were to attempt another LTRO, many of the European banks are already heavily underwater from their sovereign debt purchases in the first couple go a rounds. Will the banks be willing to triple down on the same risks?

Apart from the severe costs of bailing out Spain, which may require more funds than previous bailouts combined, the decision also removes Spain from the group of countries promising capital to back the ESM/EFSF. Without Spain’s contributions, the burden of the bailout mechanisms will fall even more squarely on Germany. France and Italy will also see their shares increase, which the latter can ill afford at this moment.

It is unclear exactly what conditions must be met for a country to officially request a bailout from the Troika, however Spain seems to be moving rapidly in that direction. If two weeks is a reasonable estimate, than it appears highly unlikely the EU can come together on an alternative option in such a short time. The events of the European crisis are speeding up and have finally reached countries that are seemingly too big to fail and too big to bail out. Risks of a larger fallout are finally being priced into the US stock market, though it remains significantly detached from Treasuries, the dollar and commodities. Which direction the crisis will turn next is anyone’s guess, but either way it should be a bumpy ride.   Related posts:
Pain in Spain is Only Beginning
Nouriel Roubini - Get Ready for the Spanish Bailout
Private Debt Continues to Drag Down Europe

Krugman Reveals New, Flawed Definition of Austerity

For the fact is that you can’t just look at spending levels to ask what is happening to spending programs. Here in the United States spending on unemployment insurance and food stamps has risen sharply, not because the welfare state has expanded, but because a lot more people are unemployed and poor. Similar effects are at work in European countries, which have stronger safety nets than we do. Also, some spending represents banking bailouts, not exactly what people have in mind when they talk about big government.

Read it at The Conscience of a Liberal
Austerity, Safety Nets, and Spending
By Paul Krugman

Krugman continues to argue against austerity but this time makes his distinction of the term a bit clearer. Basically, in his perspective, government spending that counts is limited to funds used for consumption and investment. All that government spending on “capital transfers” (bank bailouts) and “social transfers” (e.g. unemployment benefits and food stamps) doesn’t count as an expansion of government. While I certainly don’t oppose some “social transfers”, this separation of government spending strikes me as odd.

As I understand the situation, the purpose of governments increasing spending (or the deficit) is to add income to the private sector, alleviating the deflationary effects of private sector deleveraging. Whether spending money on bank bailouts or investment, both sources add income in the current period to the private sector. This is not to suggest that the longer-term effects of the two policies is the same or that I don’t prefer the latter to the former. The point is that either form of spending is the choice of (generally) elected political leaders. If the Spanish government decides tomorrow to spend a few hundred billion euros to recapitalise its banks, then in my mind it is electing not to pursue austerity.

The real issue here seems to be that government spending is not being directed to the types of uses that are favored by proponents of Keynesian stimulus (presumably because those uses have a larger multiplier). This may very well be true (bank bailouts, as structured, were an awful idea) but that is an argument against the current political institutional framework by which those decisions are made. Arguing simply for more government spending in no way guarantees, or even implies, that governments will choose to direct funds towards consumption or investment and away from “capital transfers” or “social transfers”.

The discussion is moving in a positive direction, away from abstract claims of general spending and towards specific policy measures. This distinction of austerity, however, simply dismisses some aspects of government for the sake of trying to prove a point. In my view that is no better than the comments from the other side Krugman rails against. Yes there were spending cuts in some areas. Yes there were spending increases in others. Neither argument explicitly proves or disproves austerity (especially when we all mean different things.) Let’s focus on where the spending is going and then, if we decide it’s not ideal, figure out how to make politicians alter the composition.

(Note:  I definitely have in mind bank bailouts when I talk about “big government”.)

Nouriel Roubini - Get Ready for the Spanish Bailout

And yet despite the clear signs of failure in the existing bailout countries, the EU looks set to pursue an unchanged plan in Spain. But the crucial difference between Spain and the bailout countries is size. If things go wrong in Greece, Portugal and Ireland, a second bailout is affordable. But there can only be one roll of the dice for a country as large as Spain.

Read it at EconoMonitor
Get Ready for the Spanish Bailout
By Nouriel Roubini

Paul Martin, the Former Prime Minister of Canada, spoke at the recent INET conference in Berlin about the importance of governments getting policy right the first time. More specifically, he was discussing policies related to stimulus or bailouts. From his perspective the first attempt must provide enough firepower to resolve the situation, otherwise support for future attempts will dwindle along with the potential to vastly increase resources.

In the case of Europe, Greece needed multiple bailouts before actually defaulting and yet remains likely to need further bailouts or risk another default. Portugal may very well need a second bailout later this year. Given these missteps, support for a substantial bailout of Spain is already going to be a difficult sell. It’s hard to envision the EU/ECB/IMF garnering enough firepower in the first go around to recapitalize the Spanish banking system and stabilize public debt concerns. The downside risks in Europe remain very present.


Paul Martin: Keynote Address: Reflections on the Politics of Deficit Reduction:

"Stress" Tests Succeed as Bank Marketing Tool

Last Tuesday, JP Morgan announced plans to increase its dividend and buy back stock after passing the Federal Reserve’s stress tests, which were set to be reported two days later. Since the announcement, JP Morgan’s stock has rallied over 10%. Other banks followed suit, forcing the Fed’s hand in announcing all their results early. In total, 15 of the 19 banks analyzed officially passed the test. Bank of America’s stock has risen nearly 25% since passing and is up over 75% so far this year, leading a more than 20% year-to-date rise in the broader financial sector.

From the perspective of improving sentiment, the stress tests are clearly a roaring success. However, investors should remember that the purpose of the stress tests was to inspire confidence and NOT to test the liquidity or solvency of banks in a crisis. As Bloomberg’s Jonathan Weil highlights in Class Dunce Passes Fed’s Stress Test Without a Sweat:

“Citigroup Inc. (C) was deemed well capitalized under the government’s methodology when it got bailed out in 2008. So was CIT Group Inc. when it filed for bankruptcy in 2009.”

The stress tests then and now continue to use Tier 1 Capital ratios, which is simply the amount of Tier 1 capital divided by a firm’s risk-weighted assets. Risk-weightings are often decided by the regulator based on credit ratings. Many AAA-rated securities are assigned 0% risk and removed from the calculation. As various assets are downgraded during a crisis, total risk-weighted assets rise and the Tier 1 Capital ratio declines. Rating changes, which played a major role in both the financial and European debt crisis, depict one of many flaws in using Tier 1 Capital Ratios to assess a bank’s health.

Although the Fed continues to use this poor indicator, Weil notes that:

“Tangible common equity became the capital benchmark of choice for many investors during the last U.S. banking crisis, because the government’s main capital measures lost credibility.”

Expanding his investigation into the current realistic health of banks, Weil found that:

“if it weren’t for the inflated loan values, [Regions Financial’s] tangible common equity would have been less than zero, with liabilities exceeding hard assets.”

Despite still not having paid back TARP funds and potentially being insolvent, Regions passed the stress tests.

Apart from testing somewhat irrelevant capital measures, the stress tests also provided an estimate of bank losses during the projection period (Q3 2011-Q4 2013). During that year and a half the Fed projects these 19 banks will, on net, lose nearly $250 billion. These estimates are almost surely optimistic and don’t account for future losses on these assets, among other things. Daniel Alpert of Westwood Capital, LLC has great, detailed report on the expected losses over time,  Deconstructing the Federal Reserve’s 2012 Comprehensive Capital Analysis and Review: What Does the CCAR Really Tell Us About the Big 4 Commercial Banks? As the title suggests, the Big 4 banks may be significantly more vulnerable than many expect.

One final point of interest regarding the stress tests relates to the underlying assumptions made by the Fed. The following graphs outline the assumptions made (courtesy of Zero Hedge):
Reflecting similarities to the most recent crisis, GDP and the stock market move sharply upward after the initial decline, while unemployment and housing prices languish. The aspect I’ve yet to see mentioned with these assumptions is that the bailouts (Fed and TARP) along with stimulus measures are supposedly the reason behind the rebound. One might then infer that the Fed’s stress tests assume future bailouts and stimulus measures, of similar proportions, to achieve comparable results.

Overall the Fed’s stress tests have been wildly successful as a promotional tool for the largest banks. Many of these banks are now increasing the return of capital to shareholders that will prove critical in the next crisis. Maybe after the next round of bailouts regulators will be forced to change their approach.

Points of Public Interest

1. The Complexity of Hayek - Greg Fisher comments on similarities and differences between Hayek’s work and complex systems. Complexity theory is a fascinating subject I hope to study in the future.
2. Social Security, the Financial Crisis & Modern Monetary Theory - John Carney continues to display how MMT, in focusing on the monetary system, forgets the many ways in which government can harm real economic growth and wealth.
3. US Credit and Economic Views: It’s the Housing Market Stupid - Constance Hunter wisely notes the deflationary pressure of over $1 trillion in underwater mortgage debt. This remains a key aspect of my view that inflation will remain muted for several years.
4. Tuning In to Dropping Out - Alex Tabarrok draws attention to the lack of college graduates in STEM fields and the disappointing level of dropouts both in high school and college. Focusing subsidies on STEM majors and offering “vocational” programs are a couple potential solutions for improving education within the US.
5. GAO: Almost Half of Bailed Banks Repaid the Government With Money “From Other Federal Programs” - Matt Stoller examines the truth behind Treasury’s claims that “TARP made money.”
6. For Profit Education, Pigs at the Trough - Russ Winter looks at how For Profit Education programs are abusing the government system to earn massive profits, while loading students with debt and only graduating around 33%.
7. Josh’s Twenty Common Sense Investing Rules - Joshua Brown provides a great outline for individual investors, not traders.