Big Banks’ Tall Tales

Simon Johnson

25 April 2013

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WASHINGTON, DCThere are two competing narratives about recent financial-reform efforts and the dangers that very large banks now pose around the world. One narrative is wrong; the other is scary.
At the center of the first narrative, preferred by financial-sector executives, is the view that all necessary reforms have already been adopted (or soon will be). Banks have less debt relative to their equity levels than they had in 2007. New rules limiting the scope of bank activities are in place in the United States, and soon will become law in the United Kingdom – and continental Europe could follow suit. Proponents of this view also claim that the megabanks are managing risk better than they did before the global financial crisis erupted in 2008.
In the second narrative, the world’s largest banks remain too big to manage and have strong incentives to engage in precisely the kind of excessive risk-taking that can bring down economies. Last year’s “London Whaletrading losses at JPMorgan Chase are a case in point. And, according to this narrative’s advocates, almost all big banks display symptoms of chronic mismanagement.
While the debate over megabanks sometimes sounds technical, in fact it is quite simple. Ask this question: If a humongous financial institution gets into trouble, is this a big deal for economic growth, unemployment, and the like? Or, more bluntly, could Citigroup or a similar-size European firm get into trouble and stumble again toward failure without attracting some form of government and central bank support (whether transparent or somewhat disguised)?
The US took a step in the right direction with Title II of the Dodd-Frank reform legislation in 2010, which strengthened the resolution powers of the Federal Deposit Insurance Corporation.  And the FDIC has developed some plausible plans specifically for dealing with domestic financial firms. (I serve on the FDIC’s Systemic Resolution Advisory Committee; all views stated here are my own.)
But a great myth lurks at the heart of the financial industry’s argument that all is well. The FDIC’s resolution powers will not work for large, complex cross-border financial enterprises.  The reason is simple: US law can create a resolution authority that works only within national boundaries.
Addressing potential failure at a firm like Citigroup would require a cross-border agreement between governments and all responsible agencies.
On the fringes of the International Monetary Fund’s just-completed spring meetings in Washington, DC, I had the opportunity to talk with senior officials and their advisers from various countries, including from Europe. I asked all of them the same question: When will we have a binding framework for cross-border resolution?
The answers typically ranged from “not in our lifetimes” to “never.” Again, the reason is simple: countries do not want to compromise their sovereignty or tie their hands in any way.

Governments want the ability to decide how best to protect their countries’ perceived national interests when a crisis strikes. No one is willing to sign a treaty or otherwise pre-commit in a binding way (least of all a majority of the US Senate, which must ratify such a treaty).
As Bill Dudley, the president of the New York Federal Reserve Bank, put it recently, using the delicate language of central bankers, “The impediments to an orderly cross-border resolution still need to be fully identified and dismantled. This is necessary to eliminate the so-calledtoo big to failproblem.”
Translation: Orderly resolution of global megabanks is an illusion. As long as we allow cross-border banks at or close to their current scale, our political leaders will be unable to tolerate their failure. And, because these large financial institutions are by any meaningful definitiontoo big to fail,” they can borrow more cheaply than would otherwise be the case. Worse, they have both motive and opportunity to grow even larger.
This form of government support amounts to a large implicit subsidy for big Banks. It is a bizarre form of subsidy, to be sure, but that does not make it any less damaging to the public interest. On the contrary, because implicit government support for “too big to failbanks rises with the amount of risk that they assume, this support may be among the most dangerous subsidies that the world has ever seen. After all, more debt (relative to equity) means a higher payoff when things go well. And, when things go badly, it becomes the taxpayers’ problem (or the problem of some foreign government and their taxpayers).
What other part of the corporate world has the ability to drive the global economy into recession, as banks did in the fall of 2008? And who else has an incentive to maximize the amount of debt that they issue?
What the two narratives about financial reform have in common is that neither has a happy ending. Either we put a meaningful cap on the size of our largest financial firms, or we must brace ourselves for the debt-fueled economic explosion to come.
Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario. He is the co-author, with James Kwak, of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.

Markets Insight

April 23, 2013 6:11 pm
Markets Insight: Global banking and regulation already fractured
System diversity is reduced by pushing banks in a monoline direction
Is it more than sabre-rattling? The response by Michel Barnier, the EU commissioner in charge of financial services, to US plans to force foreign banks to hold more capital in their US subsidiaries certainly sounded bellicose. The Frenchman even threatened Ben Bernanke, chairman of the Federal Reserve, with “a protectionist reaction”.

This is an odd way to manage relations with the central bank that provided emergency liquidity to European banks in New York after the collapse of Lehman Brothers in 2008 and subsequently eased the European banks’ dollar funding problems. The Fed is also just one of many regulators seeking to trap foreign capital and liquidity in their own jurisdiction.

Fragmentation in global banking is already an established fact. A shortage of dollar funding has already brought about a dramatic decline in European banks’ share of Asian trade finance, which is substantially dollar based. They have also been obliged to retreat from US businesses because the US banks have a funding advantage on their domestic territory.

With capital under pressure and markets becoming tougher, many banks across the world have been forced to go back home, where returns are superior thanks to the benefits of scale and stronger distribution, and funding is easier.

In the eurozone, fragmentation is apparent in the huge difference in borrowing costs for comparable companies in Germany and France as compared with Spain and Italy. Banks have also deliberately set out to protect themselves from redenomination risk if a member falls out of the monetary union by matching assets and liabilities on a country basis.

That risk is perceived to have diminished since the Cyprus bailout. Yet despite growing optimism, witnessed by the fall in Italian government bond yields this week to levels not seen since before the eruption of the sovereign debt crisis, the eurozone remains the biggest threat to global financial stability. This is not least because of the toxic and incestuous embrace between the banks and sovereign debtors. The desire to match subsidiaries’ balance sheets on a country basis has not diminished.

Looked at from Mr Bernanke’s point of view European banks are still over-dependent on wholesale funding. EU policymakers have been slower than their US counterparts to force banks to strengthen their balance sheets.

The US move is widely reckoned to be directed specifically at Deutsche Bank, and it is not difficult to see why. Its report and accounts for 2012, published last week, show a leverage ratio of only 2.7 per cent. In other words, it would take a fall of only 2.7 per cent in the value of the assets to wipe out the bank. That is unnerving given the widespread scepticism about the valuation of bank assets and the significant discount to net asset value at which Deutsche’s shares trade.

Against that background the Fed could be excused for asking what would happen if Deutsche’s US subsidiary, which is reported to have negative equity, were to run into any kind of trouble. Parental backing in this case does not look as substantial as it should.

Of course, everyone assumes that the German government would regard Deutsche Bank as too big to fail. But if this became an issue in the midst of a rip-roaring eurozone crisis, the government’s ability to move might be more heavily constrained than it appears today, as might the ability of the parent. It is, after all, the job of central bankers to consider such extreme scenarios and to balance the need for financial stability and the protection of domestic taxpayers against the promotion of economic growth.

The European banks are in a tough place. They have not been helped by the instinctive desire of EU policymakers and regulators such as Mr Barnier for forbearance, nor by a stagnant eurozone economy for which the latest data hold out little hope of an immediate upturn. The wholesale and investment banking arms of the European banks are having great difficulty covering their cost of capital. By contrast their US competitors have the benefit of a stronger economy, stronger balance sheets and more buoyant profits.

Should we worry about the accelerating retreat from the globalisation of finance and capital flows? It is surely right that taxpayers are being protected from weak bank balance sheets and excessive risk-taking. Yet there are disadvantages. A nationally segmented system reduces financial capacity. That is a concern in emerging markets as well as in the developed world.

Perhaps more worrying about this trend towards regulatory financial protectionism is that it reduces the diversity of the system by pushing banks in a monoline direction. They thus become more vulnerable to shocks, with potentially nasty systemic implications. The trade-offs here between the different interests tend inevitably to be rough and ready.

Copyright The Financial Times Limited 2013.

World factory orders flash warning signals despite booming markets

A rash of weak manufacturing data from America, Europe and Asia has cast serious doubts on the strength of the global economy and was starkly at odds with surging stock markets in the West.

By Ambrose Evans-Pritchard

8:17PM BST 23 Apr 2013

A view showing the dashboard being fitted on the production line of the Nissan Leaf electric car at the Nissan Plant, Sunderland
Germany’s 'composite' PMI index for services and manufacturing fell into the contraction zone again in April Photo: PA

Markit’s PMI factory index for the US suffered the biggest one-month fall in almost three years as the most sudden fiscal tightening since 1946 starts to bite.
While the gauge remains above the expansion line 50 at 53.6, there was a sharp drop in new order growth and an ominous rise in inventories.
“The picture has already begun to darken again. The fall raises concerns that the manufacturing expansion is losing momentum rapidly,” said Markit’s Chris Williamson.
But the markets were dancing to an entirely different tune. Wall Street brushed aside Tuesday’s data, focusing instead on bumper earnings from the cable network Netflix and news that US house prices have risen 7.1pc over the past year. The S&P 500 index jumped 16 points to 1,579 in early trading.
The FTSE 100 in London closed at 6406, up 2pc, and there were similar rises in European bourses as investors bet that more evidence that the Continent is mired in recession will force the European Central Bank to cut rates.

Germany’scomposite PMI index for services and manufacturing fell into the contraction zone again in April, and there was a nasty fall in new orders that is hard to reconcile with claims by Berlin that recovery is gaining strength.

Howard Archer, from IHS Global Insight, said the fresh slide in eurozone factory orders implied a seventh consecutive quarter of recession.

If the long-awaited recovery fails to materialise this spring, it will play havoc with public finances and push debt levels in southern Europe further into the danger zone. Eurostat data this week showed that public debt ratios jumped from 108pc of GDP to 124pc in Portugal last year despite austerity cuts, with a rise from 69pc to 84pc in Spain. The slump itself is driving the rise in debt.

Asia is still above water, but momentum is fading. China’s PMI factory gauge slipped back from 51.6 to 50.5 in April, led by a fall in export orders. This confounded widespread expectations for a pick-up in growth.

Bellwether data from Taiwan have been flashing warnings for weeks, with industrial output down 3.3pc in March from a year before. Taiwan is worth watching closely as an early indicator of the Asian business cycle, and so is Singapore. We think Asia has got off to a very soft start this year,” Julian Callow, from Barclays, said.

Zhiwei Zhang, from Nomura, said the Chinese economy was weakening by the month and would “trend down” from 7.7pc in the first quarter to 7.2pc by the end of the year despite efforts by Beijing to keep the ship afloat. “The effectiveness of policy easing has been diminished by aggressive stimulus over the last five years,” he said. Credit has risen from around 120pc of GDP to 200pc over the past four years to $23 trillion (£15 trillion), including the shadow banking system, leaving an overhang of unstable debts.

The Shanghai bourse fell 2.2pc on Tuesday and has given up almost of half the 20pc gain since Beijing turned on the spigot again last autumn with fresh loans and a spending spree on the railways. It is down by three quarters in real terms since its pre-Lehman peak.

Analysts at EPFR Global said foreign investors have pulled money out of the offshore China Equity Fund for the past eight weeks in a row as they discount a “new normal” of much lower growth.

This is a mirror image of inflows over the winter. A further $477m was withdrawn last week. TrimTabs in New York says iShare’s China ETF has the biggestshortposition since June 2007, with 3.2pc of total shares sold short.

Such “crowding” on one of the trades can be a buy signal. Europe’s stock markets also rallied on reports that Italy may have found a saviour in Matteo Renzi, the mayor of Florence. Mr Renzi has won the support of the Democrat Party and is tipped to take charge of a caretaker government. Yields on Italian 10-year bonds fell below 4pc, touching pre-crisis lows.

The populist comedian Beppo Grillohead of the Five Star movement – said nobody can rescue Italy, predicting statebankruptcy” by October as the treasury runs out of money.

Hopes that the ECB might cut rates or take direct action to alleviate the credit crunch for small business were lifted this week when board members Vitor Constancio and Benoit Coeuré both signalled that lack of recovery had become a worry.

Mr Callow said markets were ignoring the economic fundamentals because they were awash with money. “They are being pushed higher by the “high voltage QE” of central banks. There are powerful spill-overs from the Bank of Japan’s stimulus, as well as from the Fed. The money is looking for yield and the bad news is not bad enough,” he said.

The sugar rush of easy money will not last forever. America’s M3 money supply has flattened over the past three months. It is no longer signalling robust growth 12 months ahead.

5 Factors That Will Push Silver to $250 an Ounce

By Peter Krauth, Resource Specialist, Money Morning

April 25, 2013

All bull markets go through periods of consolidations and corrections. And precious metals are no exception.
There has been plenty about gold's swan dive, but less talk about silver. And at this point there's more potential for silver than gold...significantly more.

Because the global silver market is relatively small,
silver prices tend to be more volatile; the pounding selloff we witnessed in silver this past month is a testament to that fact. But volatility works both ways, so when silver rises, its price can explode higher.

That's exactly what happened in April 2011, when silver prices rose by 170% in the space of just 7 months. That's why silver investors say investing in silver is like buying "gold on steroids."

And right now, it looks like the silver market is on the cusp of doing the same thing all over again. According to our research, the next stop could be $40 by year's end, and $60 by the end of 2014. And much higher after that.

Here are five key factors that will drive silver higher - significantly higher - in coming years.

Silver Driver No. 1: Relentless Buying of Physical Silver

Despite the drubbing that silver took in mid-April, there's one fact that most observers are ignoring: the physical silver market.

While gold and silver prices took a pounding, silver investors were not running to unload their silver -- quite the opposite. In fact, savvy investors were flocking to buy physical silver.

Even as silver prices dropped, buyers stepped up, and supply became so scarce, premiums nearly quintupled from 8% to 37% above spot prices. And that's if you could even get your hands on it. Essentially, no one was selling, yet a lot of buyers recognized that silver was "on sale" and decided to stock up.

In the first three months of 2013, the U.S. Mint sold more tan 15 million American Silver Eagle bullion coins. That's the first time ever the Mint has sold this many coins so early in the year, setting a record in the 27-year history of the series.

Coin dealers across the U.S. have been regularly selling out of their inventories, desperate to get new allocations.
With investors buying 56 times more physical silver tan physical gold, Main Street is setting the pace, while Wall Street is oblivious to the trend.

Silver Driver No. 2: Silver ETFs Are Bulking Up

As savvy retail investors have been soaking up physical silver, so have the silver exchange traded funds (ETFs).

In the first quarter of 2013, over 140 tons of gold was sold by physically backed gold ETFs. But remarkably, silver ETFs bucked that trend.

In that same slice of time, the world's silver ETFs actually added 20 million ounces to their vaults. That's nearly $600 million worth of silver being bought within just three months, all while silver prices were steadily declining.

Now, silver ETF shareholders are a combination of both retail and institutional investors. But 20 million ounces flowing in is a clear sign of recognizing value and steady hands.

This kind of action is especially revealing. It signals that once an ounce of physical silver is bought, its owners have "sticky" hands, and they are very reluctant to sell.

Silver Driver No. 3: Sentiment is So Bearish, It's Time To Buy

Investor sentiment is often a great indicator - a great contrarian indicator, that is.
That's because the herd usually does the right thing at exactly the wrong time. It's what we call the Dumb Money.

Silver contracts are traded on futures exchanges. And one of the most useful gauges of investor sentiment is something called the Commitment of Traders Report (COT), produced weekly by the Commodity Futures Trading Commission.

When the speculators' (dumb money) net short silver positions reach a major high, it's nearly always a perfect contrarian signal. That's typically when the silver price
is either at or very near a major low.

And it's exactly how things played out in 1997, 2000, 2001, and 2005. Each and every one of those instances marked exact or near-term lows from which silver prices either quickly shot higher, or began an extended rally.

In the weeks surrounding the April silver price selloff, silver short positions reached their highest levels in nearly 20 years. That's an extremely bullish indicator for higher silver prices ahead.

Silver Driver No. 4: Obama's Back, And He's Good for Silver

The president has been very good for silver prices. In fact, he was so good, he helped make silver the best-performing major financial asset during his first term.
Now that Obama has sealed another four years, and
Federal Reserve Chairman Ben Bernanke's still in place and relying heavily on the printing press, I'm fully expecting a repeat performance. Thanks, guys, for more of the same.



Silver Driver No. 5: Insurance Against Government Theft

Back in 1933, President Roosevelt seized privately held gold by signing into law Executive Order 6102.

FDR's official motive was to "provide relief in the existing national emergency in banking, and for other purposes..."

That single act criminalized the "hoarding" of gold by the public, giving people less than a month to turn in their gold.

Fast forward to 2013, and 80 years have gone by. Today, the 1933 gold confiscation is no longer common knowledge. But students of history realize the risk of a similar threat surfacing again.

Interestingly, silver was not targeted by Executive Order 6102. Now, we can't know if there will ever again be anything akin to this Oval Office edict - much less what it might cover and might say.

But going on the past, and considering the size of the silver market relative to gold, silver could be a way to own a precious metal that just might sidestep any risk of future confiscation.
Silver is much less widely owned than gold, and that could help keep it off the official radar.

Where will silver ultimately peak?

The bull market in silver is far from over. Given how silver has reacted after a strong selloff in the past, we could easily see the precious metal regain the $40 level by year's end. And in 2014, $60 silver is looking very attainable.

If the 1970s bull market in silver is any indication, we could see silver reach $125 by the time this bull market finally peaks.

But this time around, if the fundamental drivers are so entrenched, and global demand is so powerful, we could actually see silver at double that level, finally reaching $250 per ounce.

Needless to say, I've been following this story for a while and in Real Asset Returns I keep my readers ahead of all the risks and opportunities in precious metals, the miners and the various instruments that you can use to make the most out of your strategic metals positions. And they've profited mightily from it.

But there's a lot more upside to come.
And we're not the only ones thinking silver has much, much higher to go.
Eric Sprott, the billionaire Canadian resource guru, recently said:

"I think silver will be the investment of this decade whereas gold was the investment of the last decade. Silver will outperform gold. I believe silver will trade down 16:1 ratio to gold...Your return will be 300% more. If you have the patience and can stomach the volatility, I think silver will by far be the better investment going forward."