Are Valuations Really Too High?

By John Mauldin 

May 10, 2014
The older I get and the more I research and study, the more convinced I become that one of the more important traits of a good investor or businessman is not simply to come up with the right answer but to be able to ask the right question. The questions we ask often reveal the biases in our thinking, and we are all prone to what behavioral psychologists call confirmation bias: we tend to look for (and thus to see, and to ask about) things that confirm our current thinking.
I try to spend a significant part of my time researching and thinking about things that will tell me why my current belief system is wrong, testing my opinions against the ideas of others, some of whom are genuine outliers.
I have done quite a number of media interviews and question-and-answer sessions with audiences in the past few months, and one question keeps coming up: “Are valuations too high?” In this week’s letter we’re going to try to look at the various answers (orthodox and not) one could come up with to answer that basic question, and then we’ll look at market conditions in general. This letter may print a little longer as there are going to be a lot of charts.
I am back in Dallas today, getting ready to leave Monday for San Diego and my Strategic Investment Conference. I’m really excited about the array of speakers we have this year. We’re going to share the conference with you in a different way this year. My associate Worth Wray and I are going to do a brief summary of the speakers’ presentations every day and send that out as a short Thoughts from the Frontline for four days running. Plus, for those who are interested in my more immediate reactions, I suggest you follow me on Twitter. There are still a few spots available at the conference, as we have expanded the venue, and if you would like to see who is speaking or maybe decide to show up at the last minute (which you should), just followthis link. Now let’s jump into the letter.
Take It to the Limit
First, let’s examine three ways to look at stock market valuations for the S&P 500. The first is the Shiller P/E ratio, which is a ten-year smoothed curve that in theory takes away some of the volatility caused by recessions. If this metric is your standard, I think you would conclude that stocks are expensive and getting close to the danger zone, if not already in it. Only by the standards of the 2000 tech bubble and the year 1929 do you find higher normalized P/E ratios.
But if you look at the 12-month trailing P/E ratio, you could easily conclude that stocks are moderately expensive but not yet in bubble territory.
And yet again, if you look at the 12-month forward P/E ratio, it might be easy to conclude that stocks are fairly, even cheaply priced.  
In a Perfect World
Earnings are projected to grow rather significantly. Let’s visit our old friend the S&P 500 Earnings and Estimate Report, produced by Howard Silverblatt (it’s a treasure trove of data, and it opens in Excel here.
I copied and pasted below just the material relevant for our purposes. Basically, you can see that using the consensus estimate for as-reported earnings would result in a relatively low price-to-earnings ratio of 13.5 at today’s S&P 500 price. If you think valuations will be higher than 13.5 at the end of 2015, then you probably want to be a buyer of stocks. (Again, you data junkies can see far more data in the full report.)
But this interpretation begs a question: How much of 2013 equity returns were due to actual earnings growth and how much were due to people’s being willing to pay more for a dollar’s worth of earnings? Good question. It turns out that the bulk of market growth in 2013 came from multiple expansion in the US, Europe, and United Kingdom. Apparently, we think (at least those who are investing in the stock market think) that the good times are going to continue to roll.
The chart above shows the breakdown of 2013 return drivers in global markets, but this next chart, from my friend Rob Arnott, shows that roughly 30% of large-cap US equity (S&P 500) returns over the last 30 years have come from multiple expansion; and recently, rising P/E has accounted for the vast majority of stock returns in the face of flat earnings.
The Future of Earnings
What kind of returns can we expect from today’s valuations? There are two ways we can look at it. One way is by looking at expected returns from current valuations, which is how Jeremy Grantham of GMO regularly does it. The following chart shows his projections for the average annual real return over the next seven years.
If you go back to the very first chart we looked at, which showed the Shiller P/E ratio for the S&P 500, you can see that it is quite high. If you break returns down to 10-year periods for the last 86 years and rank those returns from the highest to the lowest in 10 groups, you find out that, reasonably enough, if you start out at a low price-to-earnings ratio, your returns for the next 10 years are likely to be quite high. If you start from where we are today, though, the same methodology suggests that your returns might be anywhere from -4.4% to +8.3%, or less than 1% on average, not exactly a projection likely to warm an investor’s heart.
I was talking with my good friend Ed Easterling of Crestmont Research, as I often do when I’m thinking about stock market valuations – he’s one of the most thoughtful analysts I know. We were looking at some charts on his always-useful Crestmont Research website, and he offered to modify one of the reports for this letter. You can see the updated version at Crestmont P/E Report.  Here’s what he wrote to accompany the table below:
The outlook may be uncertain, but that does not make it unpredictable. The current secular bear could remain in hibernation. The inflation rate could remain low and stable, thereby sustaining P/E in the range of 20 to 25. The current secular bear could succumb to a period of higher inflation or deflation, thereby P/E declines to levels associated with the end of typical secular bears (at or below 10). Alternatively, P/E might begin to migrate along its secular bear course, only to arrive near its historical average around 15. The outlook may be uncertain, yet we can assess the range of potential outcomes using these three scenarios.
Consistent with a foggy crystal ball, the horizon is likewise variable. Some people may want to see the impact of a fast path (say, 5 years), while others may take a somewhat longer view of a decade or more.
The result is a forecast providing a matrix of outlooks based upon your assumptions. Pick your time, pick your ending P/E, and add in dividend yield for the expected total return from the stock market. Figure 7 shows that secular bear markets are periods of below-average returns. The magnitude of the annualized return (or loss) depends upon the investor’s time period. Most notably, however, is that none of the scenarios provide average or above-average returns. As history has shown, average or above-average returns cannot occur from levels of relatively high valuation without the multiple expansion of a rising P/E. From today’s lofty levels, bubble conditions would be required… and that’s not a reasonable assumption for any investor’s portfolio.
Figure 7. Crestmont Research Outlook (S&P 500 Total Return)
AS OF: MAR 31, 2014

(nominal returns)

P/E Ratio (P/E10)






Notes 1-5: see footnotes in Figure 1; also, includes dividend yield of 2%

Copyright 2008-2014, Crestmont Research (
How Did We Get Here?
I think we have to admit that quantitative easing on the scale that it has been practiced by the Federal Reserve for the past few years has had a great deal to do with the rise in the prices of stocks. We’re not seeing the massive inflation that was predicted with the swelling of the money supply, except in asset prices, as the chart below shows.
The tapering by the Fed is well underway and will be completed sometime this fall. It would not surprise me if they come to October and just go ahead and take off the final $5 billion along with the expected $10 billion reduction. It would seem pretty pointless to maintain just a $5 billion QE program. (Thanks to Josh Ayers at Paradarch Advisors for the following chart.)
It’s Not Only Stock Market Valuations
Bonds are beginning to get a little stretched as well. This note from MarketWatch pretty much tells the story:
If it’s not happening immediately, when will it happen? Valuations are getting pretty high, prompting junk bond guru Martin Fridson to say the asset class is in a state of “extreme overvaluation.” Credit is in such high demand right now that it’s prompting big name investors like DoubleLine Capital’s Jeffrey Gundlach to declare that the asset class is too crowded.
Citi credit strategist Matt King, who is out with an extensive report this week about the current state of the credit market, has this chart to show:
It will be interesting to see what Jeff Gundlach says at our Strategic Investment Conference this week. As well as David Rosenberg, Lacy Hunt, Gary Shilling, and others who will always opine on the bond market. As I mentioned at the beginning, we will be sending you updates from the conference, and you really should follow me on Twitter.
San Diego, Italy, and Nantucket
I leave Monday morning for San Diego to prepare for the conference (co-sponsored with Altegris) and to spend a day with my partners planning and shooting videos. I have really been anticipating this conference, not only because of the speakers but because this is the place where I catch up with so many friends and meet new ones. This really is just about my favorite week of the year. While we may have trouble finding value in the stock market, I always find that time with my friends is about the most valuable time I can spend. Right now, my daughter Tiffani is scheduled to come, as well as most of my staff. Tiffani has not been to the last few conferences, and she is looking forward to catching up as well.
I’ve been working on my presentation for about eight weeks now. The theme for the conference is “Investing in an Age of Transformation,” and I want to try to really focus our attention on the large trends in the world, both economic and technological, that are going to have rather massive implications for our investment portfolios.
Following the conference, I’ll be home for a few weeks before I take off for a working vacation in a little town in Tuscany called Trequanda. I will also be in Rome June 14-17, where I will be joined by Christian Menegatti from Roubini Global Economics. We plan to spend time with various businessmen, investors, central bankers, and politicians to get a better understanding of what is really unfolding in Italy. We are actively looking for people to visit and especially for business associations with whom we can meet. Drop me a note if you’re interested.
Then I’m home for another month before I have a speaking engagement in Nantucket, Massachusetts, in the middle of July. And of course the first Friday of August will find me in Grand Lake Stream, Maine, where I will once again be trying to outfish my youngest son on our annual fishing trip to “Camp Kotok.”
I am often asked how I can travel so much. I admit that from time to time it can be a bit physically wearing, but I have come to the conclusion that it’s early mornings and insufficient sleep that is the main culprit in travel weariness. I find that if I get enough sleep and can find a gym, then I seem to be okay. I guess it’s just important to stay away from those early-morning meetings if you’re going to be out late the night before.
It is time to hit the send button. The gym is calling. Have a great week!
Your just trying to keep up analyst,
Do yo unwanted emailsHelp spread the word. Click hereCopyright 2014 John Mauldin. All Rights Reserved.

Europe’s Political Transcendence


MAY 9, 2014

WASHINGTON, DC – This month, European citizens will head to the polls to select the 751 members of the European to represent 507 million people. The way the election campaign has unfolded marks a small but significant step in the emergence of the first transnational political space in European – indeed, world – history.

To be sure, the European Parliament elections have been bringing smaller shares of voters to the polls: 43% in 2009, compared to almost 60% in 1978-1994. Nonetheless, the participation rate over the last decade is comparable to average turnout in American congressional elections. Given the perceived remoteness of the European parliament and widespread frustration with the European Union’s bureaucracy, the level of participation and the movement toward transnational politics is remarkable.

The transnational nature of the election is stronger this time because the major pan-European political parties have, for the first time, nominated specific candidates for the presidency of the European Commission, and the candidates are campaigning, including in televised debates. The European Council, as mandated by the Lisbon Treaty, will have to take into account the election results in selecting the candidate to put forward for parliamentary endorsement.

The campaign for the Commission’s presidency may turn out to be as significant as the final selection. The first debate, held late last month, included Jean-Claude Juncker of the center-right European People’s Party (EPP), the Green Party’s Ska Keller, Martin Schultz of the center-left Progressive Alliance of Socialists and Democrats, and Guy Verhofstadt of the centrist Alliance of Liberals and Democrats. Alexis Tsipras, representing the Party of the European Left, is expected to participate in the final debate this month.

All of the candidates spoke flawless English – though the debate was translated into 16 languages. Given the United Kingdom’s reservations about European integration, it is somewhat ironic that English is playing such a critical role in facilitating the creation of a transnational political space.

The debate attracted significant social-media attention, with tens of thousands of tweets on the subject reflecting the passion that some Europeans – especially the younger generation – feel about Europe’s political evolution. More generally, while public interest in the campaign remains far below that seen in national political contests, it has become stronger than in recent pan-European elections, despite the rise of nationalism and Euro-skepticism.

In this context, it would be strange if the European Council tried to nominate the Commission president without regard for the public’s response to the campaign. And yet there is a risk that the selection process becomes no more than an exercise in political horse-trading, with Council members awarding leadership positions, including seats on the Commission, purely on the basis of national political considerations. Such an approach would deal a powerful blow to the citizens who took their European ballot seriously – and to the credibility of the EU as a whole.

Could this really happen? Or has the transnational European space – however young – already grown to the point that it cannot be ignored?

Much will depend on the election results. First and foremost, the participation rate will be critical. If it were to fall below the 43% attained in 2009, the Council could more plausibly argue that the preferences of a decreasingly interested public can be largely ignored. A substantial increase, however – say, toward the 45-47% range – would make it much more difficult to ignore the outcome of the campaign.

The relative performance of the pan-European parties will also matter. If, for example, the Socialists won 215 seats, compared to 185 for the EPP, the substantial difference would make their leader, Martin Schultz, a very strong contender, even though no party came close to an absolute majority of 376 seats.

If the outcome turns out to be closer, with a difference of only five or ten seats between the two top parties, it could be argued that neither of the leading candidates had “won.” This would give the Council more space to consider an “outside” candidate (for example, Pascal Lamy, who is closer to the center left, or Christine Lagarde, who is closer to the center right, both of whom are extremely experienced European policymakers whose names have already been raised in the media).

To bolster the legitimacy of such a move, the Council would have to select the candidate more closely associated with the party that gained more votes, however narrow the margin. Moreover, an outside candidate must be likely to generate backing by a sufficiently large coalition in the parliament. Alternatively, with neither of the larger parties able to declare real victory, they could decide as a compromise to indicate preference for one of the other leaders who had campaigned – perhaps Verhofstadt, the liberal centrist.

As Jean Pisani-Ferry has explained, despite the European Parliament’s substantial – and increasing – power, it cannot be the central actor in Europe’s economic-policy debates in the short term. Real decision-making power will remain largely national.

But, given the parliament’s position at the center of a nascent transnational European space that could, over time, transform Europe’s politics and help the continent overcome resurgent and dangerous chauvinism, this first European election with a transnational flavor should not be ignored. When they meet on May 28, European leaders would do well to encourage the strength of European institutions by choosing both competence and legitimacy.

Kemal Derviş, former Minister of Economic Affairs of Turkey and former Administrator for the United Nations Development Program (UNDP), is Vice President of the Brookings Institution


The Fed's "Growth-Buying" Scheme Is Failing

By SHAH GILANI, Capital Wave Strategist, Money Morning · 

 May 13, 2014

The numbers are in. And they are ugly...
Based on preliminary first-quarter data, U.S. GDP (gross domestic product) growth is 0.1%.

That's not much.

But then again what do you expect for $3.4 trillion dollars of Federal Reserve spending to boost the economy?

So the question is, how is it possible that we've got nonexistent economic growth, or worse, negative growth and possibly another recession looming, when the Federal Reserve since September 2008 has spent $3.4 trillion to prime the economic pump?

This could push the whole economy past the brink...

The Ugly Truth on Fed Intervention

First of all, the preliminary GDP number, which is the total output of goods and services produced by labor and property minus imports, will be revised on May 29, 2014.

A majority of economists are already revising their estimates down into negative territory.

The consensus view expects the revised or "second" GDP number will actually show the economy contracted by 0.5% to 1% in the first quarter.

Not that the second quarter is expected to be bad just because of a slow first quarter. In fact, a majority of pundits, including the Federal Reserve itself, are saying because the first quarter was so bad the economy will bounce robustly in the second quarter.

But if they're wrong and the second quarter shows negative growth, that's really bad.

It's bad because two consecutive quarters in a row of negative GDP growth is the definition of a recession.

Why has the Fed intervention failed so miserably in spurring growth? It's an ugly truth but needs to be told.

Since the credit crisis, which spawned the Great Recession, the Federal Reserve has been trying to build a bridge to growth. The truth is they've spent trillions on their bridge efforts, but they can't deliver the destination.

Here's what's frightening: What seems like misguided Federal Reserve policies to stimulate economic growth by printing egregious amounts of money was never a misguided policy of trying to stimulate the economy. It was a massive liquidity and profit-making program designed to first save, then enrich, the nation's biggest banks.

Economic growth was the expected byproduct of the Fed's "trickle-down" banking bonanza.

Why It Didn't Work

The reason we're not seeing that trickle-down growth is because the banks aren't lending as they were expected to.

They aren't lending robustly into the economy because they've had to pay out billions of dollars in fines and legal costs.

That plus their former freewheeling speculative trading gambits with depositor money are being shut down thanks to Dodd-Frank and the Volcker rule, and they are facing their worst free-market enemy, a flattening yield curve.

It's common knowledge that all the nation's too-big-to-fail banks would have all failed if the Fed hadn't bailed them out. Any one of them collapsing, after what happened when Lehman Brothers imploded, would have brought down all of them like a professional bowler throwing a 50-pound ball down an alley with gutter guards.

It's impossible for there to be any economic activity if there are no banks. So, the Fed did what it had to do to save the big banks.

It flushed them with trillions of dollars.

To get their footing back, the Fed took bad loans off their books and opened up its discount window to all comers for all they needed.

They also took in underwater mortgage-backed securities (MBS) and bad loans as collateral for the cash they lent them. To ensure their return to massive profitability, the Fed then embarked on quantitative easing, or QE.

QE is another giveaway program for the big banks. The Fed buys tens of billions of dollars a month in treasuries and MBS from the banks.

The banks in turn get cash, and they lend overnight at the fed funds rate. The Fed set the fed funds rate to essentially zero, and with their borrowed cash the big banks buy more treasuries and MBS to sell next month to the Fed.

It's a great way to make risk-free money and for the big banks to improve their capital ratios and reserves and profits. All of which makes them flush enough to raise dividends, which makes their equity stock look better to investors. And the icing on the cake is that they get to raise dividends to entice more investors. It's a great game.

Too bad the banks are the only ones benefiting directly. The whole trickle-down thing isn't working.

What Has the Big Banks Terrified

Besides hoarding money to pay ongoing and future fines for criminal activities, all the big banks are terrified of the shape of the yield curve.

The yield curve is a graphical representation of interest rates. On the vertical left axis are interest rates rising from zero to whatever height they attain. The horizontal axis is time, with one day all the way on the left and going out to 30 years on the right end of the axis.

Banks borrow from each other, usually for a day at a time, at the fed funds rate, which is a market rate but a rate that the Fed largely controls. The fed funds rate is somewhere between zero and .025% now, as that's where the Fed manipulated it to. As the line that traces interest rates moves to the right, it trends higher. That's because you pay a higher interest rate to borrow money you intend to pay back over a longer time.

Normally the yield curve slopes upward steadily, so that interest rates to borrow for a day might be .25% (on an annualized basis) and 5% or 6% or more for a 30-year mortgage.

But the yield curve is flattening, not steepening, for a few reasons.

Investors are buying 10-year and 15-year and 30-year bonds because their yield is better than what they would be paid if they bought shorter maturity bonds.

One reason that longer-term interest rates aren't as high as they are expected to be is because rates are so artificially low (courtesy of the Fed' manipulation) that investors are going further out on the "risk spectrum," meaning they're willing to lend out money for longer to get more yield.

But another reason there's so much interest in longer-dated bonds is that investors are seeking a safe place to park their cash in anticipation of falling yields because of a market crash or some global macro-event that panics markets.

In other words, investors are fearful.

One of the reasons is that they don't believe the Fed's low interest rate policies are creating growth and that the economy could fall back into recession, which would cause yields to fall even further.

So they want to lock in whatever higher yields they can get now.

The flattening of the yield curve is bad for banks.

When they lend out for a long period of time, they want to charge as much interest as they can.

But if the yield curve is flat and investors are willing to take less interest, they can't charge as much interest as they would like.

If you're a bank and you make loans, you price them according to your risk of being paid back and how long you're making the loan for.

Banks don't want to make long-term loans and not get paid; that's too much risk. That's why they're not making loans hand over fist, even though they have the money to lend.

Thanks to the Fed's QE, banks are better off doing business with each other and the Fed than the public. If there's no credit, there's no economic growth.

And that's the dilemma we're facing.

And most frightening of all, the consequences of no growth and the Fed's money printing are about to devastate equities (again), some bond investments, commodities, real estate (again), and other asset classes.

2 Banking Giants Implore U.S. Authorities to Go Easy

Jean-Laurent Bonnafé, chief executive of BNP Paribas.Gonzalo Fuentes/ReutersJean-Laurent Bonnafé, chief executive of BNP Paribas.
Two of the world’s biggest banks, facing the threat of criminal charges, are mounting final bids for leniency.
To avoid the fallout from pleading guilty — no giant bank has done so in more than two decades — BNP Paribas and Credit Suissemade last-ditch appeals to prosecutors and regulators in recent weeks, according to people briefed on the talks. The private meetings came after prosecutors sought guilty pleas from the parent companies of both banks: BNP of France over doing business with countries like Sudan that the United States has blacklisted, andCredit Suisse for offering tax shelters to wealthy Americans.
While BNP and Credit Suisse proposed more modest guilty pleas from their subsidiaries rather than parent companies, the people briefed on the talks said, prosecutors appeared to balk at those overtures, challenging broader public concerns that banks have grown so important to the economy that they are effectively “too big to jail.”
In the case of Credit Suisse, which recently created a subsidiary to house the “U.S. offshore business,” prosecutors have privately indicated that they are unwilling to charge the newly formed unit. The bank is now expected to strike a deal with prosecutors as soon as this week, the people briefed on the talks said.
BNP made its own appeals. Underscoring the gravity of a guilty plea for the bank, BNP’s chief executive and two of his top lieutenants traveled to Washington and New York to make their case last week, the people said.
They reserved last Thursday for meeting BNP’s regulators in Manhattan — the Federal Reserve Bank of New York and Benjamin M. Lawsky, New York State’s top financial regulator. At a morning meeting in Mr. Lawsky’s conference room overlooking the Statue of Liberty, according to two of the people briefed on the talks, the regulator explained his plans to penalize at least a dozen BNP employees for their role in processing transactions for Sudan and Iran.
But the crucial meeting occurred two days earlier in Washington, the people said, on Tuesday afternoon at the Justice Department’s headquarters. It was there that the executives outlined concerns about a guilty plea to the three prosecutors leading the case: David A. O’Neil, head of the department’s criminal division; Preet Bharara, the United States attorney in Manhattan; and Cyrus R. Vance Jr., the Manhattan district attorney.
At the meeting in Mr. O’Neil’s second-floor conference room, the BNP executives — Jean-Laurent Bonnafé, the chief executive; Philippe Gijsels, chief strategy officer; and Jean Clamon, head of compliance and internal control coordinator — discussed the potential reverberations of a guilty plea, the people briefed on the talks said. The bank’s lawyers at Sullivan & Cromwell — H. Rodgin Cohen, a dean of the Wall Street legal world, and Karen Patton Seymour, a partner at the firm — accompanied them. Patrick Fitzgerald, a partner at Skadden, Arps, Slate, Meagher & Flom and a former top federal prosecutor in Chicago, also attended the meeting on the bank’s behalf.
The pitch was simple. The executives and lawyers warned that a guilty plea could wreak havoc on BNP and the broader economy well beyond France’s borders.
The argument — playing on the fear that criminal charges could prompt regulators to revoke a bank’s license to operate, the corporate equivalent of the death penalty — helped the British bankHSBC escape criminal charges in 2012. It also stoked a public outcry that Wall Street giants have grown so large and important that they cannot be charged.
But the prosecutors appeared to brush off the concerns, according to the people briefed on the talks, having heard similar appeals in cases involving softer penalties like so-called deferred prosecution agreements. Mr. O’Neil and Mr. Bharara, in questioning the bank’s lawyers and executives, indicated they had doubts that a guilty plea would imperil the bank or the economy.
The pushback from prosecutors also stemmed from concerns that BNP did not fully cooperate with the investigation. The prosecutors have complained that BNP was too slow to alert authorities to wrongdoing, according to the people briefed on the talks, a delay that might have cost the prosecutors a chance to charge bank employees before a five-year legal deadline.
The investigation, led in part by the F.B.I. in New York, has centered on whether the bank processed transactions for countries that the United States government has placed under sanctions. BNP conducted its own internal inquiry that “identified a significant volume of transactions that could be considered impermissible” from 2002 to 2009.
Despite the evidence, prosecutors took a number of precautions when pursuing the guilty plea. In weighing the punishment, the prosecutors held their own meetings with regulators to gain assurances that a guilty plea would not cost the bank its license to operate in the United States.
Without such cooperation, guilty pleas can be elusive. Last week, in a video published on the Justice Department’s website, Attorney General Eric H. Holder Jr. remarked that “we have made great strides in improving this type of coordination between our prosecutors and other governmental regulators,” adding that “this cooperation will prove key in the coming weeks and months as the Justice Department continues to pursue several important investigations.”
In the case of BNP, prosecutors and regulators cleared the way for a guilty plea at a meeting on April 18. At the meeting, led by the New York Fed’s general counsel, Thomas C. Baxter Jr., regulators signaled that they would not revoke BNP’s charter in the event of a guilty plea. William C. Dudley, the New York Fed’s president, stopped by to lend support to the position that the bank should not escape an appropriate criminal punishment, according to one of the people briefed on the talks.
Mr. Lawsky, the New York State superintendent of financial services, also assured prosecutors that he would not pull BNP’s charter. Instead, the people said, he told prosecutors that he would consider imposing steep penalties on BNP and its employees. He might also temporarily suspend the bank’s ability to transfer money through New York branches on behalf of foreign clients.
Mr. Lawsky and Mr. Baxter later met on their own to coordinate their response to a guilty plea from BNP, according to one of the people briefed on the talks. At the meeting on Friday, at the New York Fed’s headquarters in Lower Manhattan, the regulators also discussed the potential guilty plea from Credit Suisse, the person said.
That investigation has hinged on similar deliberations between regulators and the Justice Department in Washington, the people briefed on the talks said. The bank would be the biggest financial institution to plead guilty since Drexel Burnham Lambert.
A plea would come on top of a cash penalty. The penalty, the people said, will exceed the $780 million that Switzerland’s largest bank,UBS, paid to resolve a similar case in 2009.
The BNP and Credit Suisse investigations could lay the groundwork for actions against American banks as well. While the new prosecutorial strategy applies to American banks like Citigroup, those investigations are at an earlier stage, and it was unclear whether they would warrant criminal charges.
But even if prosecutors discover criminal wrongdoing, bringing a criminal charge is hardly a foregone conclusion. Unlike BNP and Credit Suisse — and many other foreign banks with operations in New York that are regulated by the New York Fed and Mr. Lawsky — most giant American banks answer to another regulator, theOffice of the Comptroller of the Currency.
The comptroller, Thomas J. Curry, has often been critical of Wall Street misdeeds. But Mr. Curry has explained to prosecutors that he is bound by rules that could require him to reconsider a bank’s charter in the event of a criminal conviction.
The issue culminated last September in a case involving JPMorgan Chase. Mr. Bharara traveled to Mr. Curry’s offices in Washington, government records show, seeking clarity on the potential repercussions of charging the nation’s biggest bank over its ties toBernard L. Madoff.
Mr. Curry, while vowing not to interfere in the case, pointed to a federal law that requires the comptroller’s office to hold a hearing about potentially terminating “all rights, privileges and franchises of the bank” after a criminal conviction. Ultimately, JPMorgan received a penalty of roughly $2 billion from Mr. Curry and Mr. Bharara, but did not have to plead guilty.
The Manhattan federal prosecutor, however, is finding ways around the hearing, which applies only to money laundering convictions. Other charges, including wire fraud and bank fraud, do not automatically require a hearing. Even in the case of sanctions violations, as with BNP, prosecutors can charge a bank under a separate statute that does not require a hearing.
“The good news is that this dynamic is changing for the better,” Mr. Bharara said in the recent speech, “and I expect you will see hard proof of that in the future.”

The Swiss Central Bank Conundrum: Fighting Fire with Kerosene


When the Swiss Franc started appreciating against the Euro (or was it the Euro depreciating against the CHF?) the Swiss National Bank vowed to fight tooth and nail to keep the Swiss Franc at a 1.20 parity “at all cost”.
Time to wonder how such a “fight” is fought, whether it can be successful and what are the consequences.

The currency “stabilisation” choices a central bank has

A central bank is the master of its own currency, i.e. the currency it is meant to issue.
In today’s world of unbacked (“fiat”) currencies even the Swiss Central Bank has no real restriction as to how many units of its currency it can create. It can virtually create infinitesimal amounts of it.
And indeed the Zimbabwean central bank did so until recently. In Germany the Reichsbank tried to do just that back in 1923. (Actually “money shortages” got so bad even individual cities began printing their own money.)
Both Germany and Zimbabwe “succeeded” up to a point and that point is where the currency loses all value. It then becomes unusable in any transaction and ends up as wallpaper.
There is an interesting asymmetry in this game of pegging one’s currency at a certain parity to another currency or a basket of currencies though: It means any central bank can depreciate its own currency as much as it pleases and almost as fast as it pleases but, however, could it do the opposite as well?
What decreases a price? If either supply increases or demand decreases.
The Swiss central bank’s problem was that the CHF demand increased as people were starting to buy Swiss Francs and/or Swiss Franc denominated paper as an inflation hedge in their flight from the Euro.
So the Swiss feared their country’s exporters were losing their edge if they would sell in Swiss Francs to e.g. the Euro zone.

Should a central bank set prices for individual goods?

To begin with, this strikes CrisisMaven as mighty odd. Since childhood he was under the impression that he who sells can dictate his asking price, whether that means to sell too dear or too cheap, no matter, absent price regulations any seller can dictate his asking price. (Whether he is successful with his price setting is an entirely different matter. The market will tell him if it by and large is ready to accept the price. This is called the law of supply and demand.)
But maybe these poor Swiss exporters have lost their pencil or chalk to change the prices on their price lists and therefore the Swiss National Bank needs to help them out in fixing the overall price of their currency?
Again this strikes CrisisMaven as odd – if every exporter has a different internal cost structure how can he be helped by having his prices his price for him by a third party in a sweeping fashion?
Well maybe these national bankers went to university and there were so brain-washed that they forgot the most basic workings of an enterprise or a whole economy.
Let CrisisMaven explain then (if any Swiss banker likes to ask in a comment: I can translate it to Swiss German for you if you ask nicely):
If a currency appreciates do the exported goods from that country automatically become more expensive? The answer is, however counterintuitively, a resounding: NO!

Changing foreign exchange rates do not affect an economy in uniform fashion!

And why not? Well, because the writer of his own price list can always change the sales prices.
Oh, but would he then not lose out?
Again the answer is … no, or at least not necessarily.
As CrisisMaven has explained in “Economic Fallacy I: Harmful Currency Undervaluation?” … a rising currency exchange rate, a currency appreciation always works in two ways:
While exports would become more expensive if, and only if, the exporters would not lower their prices to reflect the currency windfall profits they thus reap, immediately and to the same extentimports would become cheaper and thus might offset the rise in export prices within the national economy denominated in that national currency.
It’s not just that country’s travelers (“tourists”) abroad who now spend a cheaper holiday, no, it’s the whole economy that profits if you will.
So, all other things being equal, the exporter who uses imported intermediate goods and parts or imported raw materials to produce his exported goods profits from these cheaper imports and thus can afford, without negative effect to his bottom line, to reduce the price of his exports in tune with these reduced import costs.
Of course, how much the price of the end product can come down depends on how large the percentage of imported parts and materials is in the first place.
Let’s assume the exported good was 100% assembled from imported goods only (that were priced in the one foreign currency the central bank wants to target) and let’s assume the cost of labour etc. to assemble them to make the exported good were minimal, then it follows with mathematical precision that the exporter could afford, without losing a “cent” to reduce the price of his exports just as much as his currency had recently appreciated or, in other words, keep the price stable in the eyes of his foreign customers, i.e. the importers in that foreign country against whose currency the exporter’s currency had appreciated.
More or less no harm done.
Well, there are, as in all things economic, some side effects:

Each importer or exporter has a different cost structure that cannot be addressed by setting the foreign exchange rate

Since the imported raw materials now appear cheaper, the exporters (and indeed other industries that cater to the national market only) may be induced to increase their purchases abroad at the cost of buying “locally” and thus it would seem some of their compatriots might lose out.
But the opposite is also true – whenever something changes in an economy, and an economy always, always evolves, someone stands to gain and someone stands to lose. Such is life, actually. That certainly is no good cause to change something at the “one size fits all” global level of currency exchange rates. That would be as incompetent as making everyone wear the same jacket when winter temperatures fall. (Although, seeing how the European Union goes about standardising light bulbs and vacuum cleaners, maybe these are all pages from the same book.)
So to sum it up: when the currency exchange rate of the Swiss Franc was X at one time did anyone need to tell exporters or importers what prices to charge resp. to accept? Then why, when these prices changed (to level Y), why would one need to tell them to keep their prices stable (in their national currency) by manipulating the currency’s external value?
I have never read an answer to the question nor have I actually seen the question really asked in any clarity. But for a subject that warrants something like a yearly Nobel Prize one wonders why questions that a five-year old could understand are never asked nor answered by the respective academic professions.
So if the Swiss central bank tries to achieve something on a national scale that a) cannot be achieved and b) that individual agents (e.g. exporters) could much more easily achieve by adjusting their own prices, then what does the Swiss currency intervention actually achieve, if anything?
Well, it achieves a result that I doubt the Swiss really like: it makes every Swiss inhabitantpoorer !
And that mechanism is so simple, not only the five-year old but equally the Nobel Prize surrogate winner (the economics’ prize was not founded by old Nobel) can understand:
When you buy foreign currency by selling your own currency, you lower your own currency’s price. You also increase the foreign currency’s price (all other things being equal). That is what the intervention is for.
However, this is only the result of and at day one.

All foreign exchange rate manipulation leads to losses of overall welfare

After you bought that foreign currency you now hold these reserves for better or worse.
Three ways this can play out:
  1. Nothing happens, i.e. the relative price levels of your own currency and that reserve currency you just put into your “vaults” stay the same. If that were the price you aimed for, you could call it mission accomplished – now you enjoy that (lower) conversion rate that you thought was so crucial to your country’s exporters’ fate.
  2. The foreign currency you just bought appreciates. Now what happens? As your own central bank is judged by the assets it holds, your national currency tends to appreciate too. So you need to start selling more of your own currency, buying more foreign currency. If you buy the same currency you just bought in the first round, its price will likely even increase further. You see where we are going with this? Sheer stupidity. You cannot, not in the long run and not with the necessary precision, devalue your currency by intervening in the foreign currency markets in this way!
  3. Last possible case: your newly won assets, that foreign currency depreciates (against all or most other currencies of note). Now what happens: while the exchange rate between that individual currency and your national currency may stay roughly the same, your currency devalues on a more global scale. If you still want to uphold that “fixed” exchange rate the only two real choices that you are left with now are: buy more of that foreign currency you just pegged your own currency to or sell the currency you once bought to get rid of that peg you tied yourself to and stop the decline.
Unfortunately in each of these cases you are in a rut:
If you sell off the once-treasured foreign currency reserves, you inadvertently lower the value of the still remaining reserves in this currency that you might still. (And as a central bank you cannot get rid of all foreign reserves as you need them to supply your importers with foreign cash!) As discussed earlier, these reserves define the value of your own currency (absent any real asset backing such as gold). So you are now racing against time, but in the end you may very well end up worse than not buying this currency at all.
Or you instead buy more of the depreciating “reserve” currency. Inevitably, like grabbing a falling knife, you are now diluting the value of your national currency further as you “print” more of your own currency (or empty your coffers until you either still have to start printing or else selling off other foreign currency reserves).
To sum it up: you cannot beat the market in foreign exchange (in the long run). Yes, sometimes that strategy may seem successful, but not so: it was simply “working” by accident because other factors may have come to your aid. But even so, had you left the levers of manipulating the exchange rates well alone, these beneficial effects likely would have worked even more in your favour. You just can’t see this (absent a sound theoretical framework as given above) because you cannot experiment on such a scale and you don’t have two separate universes that you could access to try it out.
So all that the Swiss central bank could have achieved (in the long run and depending on to what excess it may by then have intervened) is creating a monster that will eventually come back to haunt the Swiss and their economy as a whole, and not just the exporters.
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