Weird 

Doug Nolan 


The President is diagnosed with COVID-19, with rapidly worsening symptoms prompting a Friday evening Marine One flight to Walter Reed Medical Center. By Monday, he is back to the White House apparently feeling spryer than when he was a man 20 years younger. 

Reversing course on Tuesday, the President abruptly calls off stimulus negotiations “until after the election”. Negotiations were back on Wednesday, with the administration pursuing piecemeal stimulus (airlines, individual stimulus checks). 

By midweek the President was referring to his COVID infection as “a blessing from God.” 

Thursday President Trump was calling for a “skinny” stimulus package. Friday morning saw the White House suddenly “open to going with something bigger,” and by lunchtime Larry Kudlow was on Fox News saying, “the President has approved a revised package. 

He would like to do a deal.” Appearing with Rush Limbaugh later in the afternoon, it was “I would like to see a bigger stimulus package, frankly, than either the Democrats or the Republicans are offering.” A little Weird.

Meanwhile, Senate Majority Leader McConnell on Friday stated an agreement on a stimulus package was unlikely prior to the election. If the week wasn’t Weird enough, with 54 million watching, a fly lands on the vice president’s head during the VP debate and - to the delight of comedians everywhere - made itself at home for a full two minutes.

At least for now, for the markets its Weirder the better. 

The S&P500 gained 3.8% this week, its strongest advance in four months. The Banks (BKX) jumped 6.4%, and the Transports rose 5.0%. Curiously, the Utilities gained 4.8%. 

The broader market outperformed. 

The small cap Russell 2000 surged 6.4%, with an 11-session rise of 12.8%. The S&P400 Mid-Cap Index gained 4.9% for the week and 11.4% over 11 sessions. 

Jumping 8.0% this week, the Semiconductors ended the week at all-time highs. The Biotechs (BTK) advanced 5.7%.

Post the presidential debate and the President’s COVID infection, Joe Biden has further extended his lead in the polls. The possibility of a “blue wave” has become real – and markets are fine with it (why do I sense markets would be just as fine with a big Trump lead?). 

An almost certain reversal of President Trump’s large corporate tax cut is apparently more than offset by prospects for mammoth fiscal stimulus. Senator Harris’s more conciliatory comments regarding China stirred the imagination of a more constructive U.S. tone for fraught U.S./China relations.

News, analysis and punditry (i.e. “the narrative”) invariably follow market direction. 

The notion of a “blue wave” would not have been so comforting to the markets a few months back. Traditionally, higher taxes and redistribution policies were anathema to equities. Treasury and bond markets would in the past have fiercely protested today’s massive structural deficit spending (as far as the eye can see).

I hold out some hope markets have not completely turned history on its head. The formidable Biden lead raises the odds of a decisive election-night outcome, averting the awful scenario of a contested election, a drawn-out court fight and potentially violent protests across the country.

I have posited the U.S. election is history’s single largest event for market hedging (“Brexit” not as clearly an individual event). The possibility of an unwind of hedges creates uncertainty and the distinct possibility of confounding market reactions to election developments. 

With Biden’s lead appearing increasingly insurmountable (with less than four weeks to go), we can assume there was this week significant buying associated with the partial reversal of market hedges. 

Especially in such a highly speculative market environment, the prospect of an unwind of a massive hedging position stokes speculative zeal (to get ahead of this train). Throw in prospects for yet another brutal short squeeze and one can explain the impetus behind this week’s manic markets. 

It’s worth noting stocks this week surged 5.0% in Mexico, 3.7% in Brazil, 4.7% in India, and 2.6% in China (CSI 300). In EM currencies, Brazil’s real rallied 2.8%, Mexico’s peso 2.3%, Russia’s ruble 1.8% and Poland’s zloty 1.7%. China’s renminbi surged 1.58% in Friday trading, in what Bloomberg called “its biggest rally in more than 13 years.” 

From U.S. small caps and Utilities to EM equities and currencies, market operators have been attempting to identify vulnerable markets that would be expected to suffer in the event of U.S. election mayhem (with traditional hedges, including Treasuries and equities put options, less than appealing). 

Well, “par for the course” in the Age of Market Dysfunction. This trade has blown up in everyone’s face. 

Markets these days are much more a reflection of speculative dynamics than underlying fundamentals. 

October 5 – Associated Press (Andrew Taylor): “New, eye-popping federal budget figures… show an enormous $3.1 trillion deficit in the just-completed fiscal year, a record swelled by coronavirus relief spending that pushed the tally of red ink to three times that of last year. 

The Congressional Budget Office released the unofficial 2020 figures…, saying the deficit equaled 15% of the U.S. economy, a huge gap that was the largest since the government undertook massive borrowing to finance the final year of World War II. 

The government spent $6.6 trillion last year and borrowed 48 cents of every dollar it spent, CBO said. The numbers amount to a 47% increase in spending, led by $578 billion for the Paycheck Protection Program for smaller businesses, and a $443 billion increase in unemployment benefits over the past six months alone.”

Will the bond market remain okay with the “blue wave” scenario? Is a repeat of this year’s stunning $3.1 TN (15% of GDP!) fiscal deficit possible? My baseline would be annual deficits approaching 10% of GDP for the next few years – although a fiscal 2021 deficit again exceeding $3 TN is a distinct possibility in the event of multiple stimulus bills from a new administration working together with a Democratically controlled House and Senate.

The stock market now relishes the thought of ongoing massive deficit spending. This is to feed incomes and corporate earnings, all without the traditional fear of rising policy rates, surging bond yields and general market instability. “Crowding out” is the latest time-honored concept relegated to history’s ash heap.

How did enormous deficits become integral to the stock market miracle? Why does the Treasury market not shudder at the prospect of unending Trillions of new supply? 

Federal Reserve Credit expanded $3.294 TN over the past 56 weeks. Multiple Fed officials this week made it clear the Fed was willing and able to continue this experiment in unbridled Federal Reserve “money” creation.

October 6 – CNBC (Jeff Cox): “Federal Reserve Chairman Jerome Powell called… for continued aggressive fiscal and monetary stimulus for an economic recovery that he said still has ‘a long way to go.’ 

Noting progress made in job creation, goods consumption and business formation, among other areas, Powell said that now would be the wrong time for policymakers to take their foot off the gas. 

Doing so, he said, could ‘lead to a weak recovery, creating unnecessary hardship for households and businesses’ and thwart a rebound that thus far has progressed more quickly than expected. ‘By contrast, the risks of overdoing it seem, for now, to be smaller,’ Powell added… 

‘Even if policy actions ultimately prove to be greater than needed, they will not go to waste. The recovery will be stronger and move faster if monetary policy and fiscal policy continue to work side by side to provide support to the economy until it is clearly out of the woods.’”

Chairman Powell made his contribution to Weird Week. For the record, note that Powell endorsed massive fiscal deficits just as the Treasury had closed the books on fiscal 2020 (with a deficit surpassing $3 TN) and with election day only a few weeks away. 

In a key week for stimulus negotiations, the Fed solidified its now tight fraternity with fiscal policy. This transformational development did not go unnoticed by the Wall Street Journal editorial board.

October 7 – Wall Street Journal (Editorial Board): “Federal Reserve officials understandably, and righteously, invoked their need for independence last year when President Trump berated them on Twitter to keep interest rates low. But what if the Fed itself decides to compromise its independence by snatching an ever-greater role in fiscal policy that is usually reserved for elected officials? 

That’s the question teed up by Jerome Powell’s extraordinary political intervention on Tuesday into the coronavirus relief talks. The Fed Chairman delivered a speech… in which he urged Congress to pass what he called more ‘policy intervention,’ both fiscal and monetary. Mr. Powell didn’t mention specific fiscal measures. 

But the speech… was clearly made with an intention to influence debates on Capitol Hill. 

This put him publicly on the side of House Speaker Nancy Pelosi, who wants to spend $2.2 trillion more on all and sundry federal programs. It’s important to understand how unusual this is. 

The Fed’s job is monetary policy and financial regulation.”

Monetization has become the Fed’s main job – and it would appear at this point a lifetime appointment. 

Why is the bond market not in a tizzy over the prospect of a “blue wave” and years of massive Treasury supply? Because of the assumption the Fed will sop up whatever quantity necessary to peg bond yields at extremely low levels (prices in the stratosphere). 

Markets may today celebrate the prospect of massive cost-free 2021 fiscal spending. 

But there is an immense institutional price to be paid for the Federal Reserve as it presents the appearance of siding with the Democrats and redistribution policies. 

With the Fed having bestowed Washington a blank checkbook, how will Republicans now view enormous handouts for the troubled blue states? 

It was inevitable – and certainly spurred on by COVID: The Federal Reserve has interjected itself into the deep divide of social and political acrimony and conflict. 

From 2008 to the present, the Federal Reserve faced no serious pushback to its QE experiment. 

Why do I imagine the Republican Party emerging from a traumatic election as born-again monetary conservatives?

The country is struggling – many of our citizens and businesses are suffering. But at this point I’m leery that potential benefits justify the enormous risks associated with unchecked fiscal and monetary stimulus. 

A deeper and more problematic crisis awaits when this runaway Bubble has finally run its course. And don’t for a second succumb to the notion that more “money” and spending will resolve problems. 

I fear the nightmare scenario where market confidence in the Fed and Washington falters right when the system is in the throes of a bursting financial Bubble.

The World Health Organization Friday reported a one-day record 350,766 global COVID infections. 

The rate of new COVID cases doubled in a week in England to record highs. 

France reported a record 19,000 infections on Wednesday. 

Germany and Italy posted their largest increases since March. 

Spain’s government imposed an emergency lockdown on Madrid. 

Friday saw one-day infection records in Russia, Ukraine and Poland. 

WHO’s Dr. Mike Ryan summed it up: “This virus is clearly showing that it has a lot of life left in it.”

According to Bloomberg, “the seven-day average of new [U.S.] cases climbed to 46,824 on Thursday, the most since Aug. 19… Thursday’s single-day total of 56,145 was the second-highest since the June-August Sun Belt surge.” According to Johns Hopkins data, 28 states are demonstrating rising infection trends while only two are showing declines. Trends are troubling, COVID fatigue is an issue, and we’re heading into the winter months.

Much remains unclear. 

When does a vaccine become widely available? 

What percentage of the population will be willing to be vaccinated? 

How effective will the vaccine prove to be? 

At this point, a return to a semblance of normalcy still seems months away. 

Even with another major shot of stimulus, long-term unemployment will be a serious issue. 

Business failures will continue to mount. And it is difficult to envisage a scenario where Credit losses don’t mount.

October 6 – Reuters (Marc Jones): “The COVID-19 shock will double company default rates across the United States and Europe over the next 9 months, ratings agency S&P Global said…, although it noted that the record downgrade pace of recent months was now slowing. S&P predicted U.S. corporate default rates would rise to 12.5% from 6.2% and saw Europe’s rate going to 8.5% from 3.8%. 

This year’s crisis has already seen more than 2,000 companies’ or countries’ ratings or ‘outlook’ scores cut and nearly $400 billion worth of debt drop into ‘junk’ territory, but in the months ahead focus will shift to defaults and survival. 

Alexandra Dimitrijevic, S&P’s Global Head of Research, said that with the number of firms on downgrade warnings at record levels -- 37% of the companies S&P rates and 30% of the banks -- and credit quality dropping, default rates are set to jump.”

A 12.5% U.S. corporate default rate would be incongruous with record stock prices. It would certainly conflict with current corporate bond yields (and ETF share prices). 

Why the extraordinary divergence between ebullient markets and a depressing spike in corporate defaults? 

In spite of the dismal Credit backdrop for many companies, overall financial conditions remain extraordinarily loose. Weird. 

The vast majority of companies today enjoy ultra-easy access to cheap finance – compliments of bountiful monetary and fiscal stimulus. Yet the system is acutely vulnerable to any de-risking/deleveraging dynamic and attendant tightening of financial conditions.

How might this play out around the election? 

The dollar should be vulnerable to prospects for ongoing egregious monetary and fiscal stimulus. One would think massive supply on the horizon makes Treasuries susceptible, although bonds glare at the Weird stock market and see a Bubble very much on borrowed time. 

One of these days, instability in the dollar and Treasury market might have the Fed thinking twice about boundless QE. 

A clean sweep by the Dems might prove more of a test than currently anticipated by an irrationally exuberant stock market. 

Wirecard: the scandal spreads to German politics

Angela Merkel and other leading politicians continued to lobby for the payments group even as the warning signs grew

Guy Chazan in Berlin and Olaf Storbeck in Frankfurt 

     © FT montage/Shutterstock | Angela Merkel and Olaf Scholz


In September 2019, Angela Merkel’s top economic adviser, Lars-Hendrik Röller, met a delegation from payments group Wirecard, which at the time was still seen as one of Germany’s most successful tech companies.

One of Mr Röller’s visitors in the chancellery in Berlin was Burkhard Ley, a strategic adviser to Wirecard and its former chief financial officer. A year later, Mr Ley is in police custody, accused of fraud, embezzlement and market manipulation. He denies any wrongdoing.

The get-together highlighted the extraordinary access the payments group enjoyed to Germany’s top decision makers until shortly before its collapse this summer — access which has shone an unforgiving light on the influence of lobbyists over German politics.

Wirecard has gone down as the most spectacular case of financial misconduct in postwar German history. But it is now fast becoming a political scandal too. Earlier this month the Bundestag decided to launch a full parliamentary inquiry into the affair, ensuring that it will continue to capture headlines well into 2021 — a year when Germans go to the polls to elect a new parliament — and potentially cast a shadow over Angela Merkel’s final months as chancellor.

One key area of interest for MPs is why the authorities seemed so slow to recognise the gravity of the situation at Wirecard. The Röller-Ley meeting took place months after whistleblowers had raised serious concerns about fraud at the payments processor that triggered a police probe in Singapore. 

Members of the German government — including Ms Merkel herself — continued to lobby for Wirecard, despite mounting doubts about its accounting practices.

The scandal has also exposed the weaknesses of Germany’s system of financial regulation, and in particular the toothlessness of its markets watchdog BaFin. 

Opposition MPs are still incredulous that instead of investigating the substance of the allegations against Wirecard, BaFin and criminal prosecutors in Munich went after the very journalists and short-sellers who had highlighted suspicious activities at the payment provider.

“With the knowledge we have today, this is an utterly hair-raising situation for us,” a senior German official told the Financial Times, conceding that “the level of [alleged] criminality at Wirecard by far exceeded the power of my imagination”. Government bodies as well as private-sector institutions such as auditors had, he said, all failed miserably.

For Germany’s opposition parties, it is the political failures which are particularly egregious. Many MPs single out Olaf Scholz, finance minister and Social Democrat candidate for chancellor in next year’s Bundestag elections, who oversees both BaFin and the Financial Intelligence Unit, Germany’s anti-money laundering agency. The FIU has come under fire for failing to pass on dozens of Wirecard-related suspicious activity reports to the German public prosecutor’s office.


The links between German finance minister Olaf Scholz, centre, and deputy finance minister Jörg Kukies and Wirecard are being scrutinised in the wake of the scandal © Tobias Schwarz/AFP/Getty


“No government agencies played any role in uncovering the crime — neither BaFin, nor the FIU, nor the public prosecutor,” says Florian Toncar, an MP for the pro business Free Democratic party. “The state made zero contribution to getting to the bottom of the Wirecard affair.”

The Bundestag’s committee of inquiry is not yet constituted, its remit still unclear. But it is already obvious what kind of questions might interest MPs.

Why, for example, did Ms Merkel lobby for Wirecard while on an official trip to China in September last year when her own finance minister was aware of continuing investigations into the company? Why did deputy finance minister Jörg Kukies visit Wirecard boss Markus Braun at his Munich headquarters last November, on the day of the chief executive’s 50th birthday?

Why did BaFin appear so reluctant to investigate a company that had been generating negative headlines for months? Why were BaFin employees able to trade Wirecard shares while the agency was investigating the payments group?

And why did BaFin respond to FT articles alleging accounting fraud by banning investors from betting against the company’s shares for two months, and later filing a criminal complaint against two FT journalists who had authored the reports?

Fabio De Masi, an MP from the hard-left party Die Linke, who was one of the few lawmakers to take an early interest in Wirecard, says the signal Bafin’s actions sent was “just terrible”. “It was a message to all critics of the company that they were spreading malicious rumours,” he says. “And it was a message to German journalists to be very, very careful before you write anything negative about Wirecard.”


The German police’s wanted poster, pictured last month, for Jan Marsalek, the fugitive former Wirecard COO © Clemens Bilan/EPA/Shutterstock


‘Fig leaf’ inquiry

Wirecard was once seen as a rare German tech success story. In 2018 it replaced Commerzbank in the prestigious Dax index and a year later dreamt of taking over Deutsche Bank. But that fantasy unravelled in June when it admitted that €1.9bn in cash was missing from its accounts. Within a week Wirecard had collapsed into insolvency, and €13bn in stock market value had been wiped out.

At least seven of its former top managers are suspected of running a criminal racket that defrauded creditors of €3.2bn. Four people are in police custody and Jan Marsalek, Wirecard’s fugitive former second-in-command, is on Interpol’s most wanted list.

For Lisa Paus, MP and finance spokesperson for the opposition Greens, there is a pattern to this. “Wirecard is the latest in a whole series of financial scandals in Germany that BaFin failed to uncover,” she says. “You need a really tough watchdog with proper investigative skills to identify fraud, and that’s the opposite of what we have right now.”

She cited the “Cum-Ex” fraud scheme, the controversial share trades which exploited a design flaw in Germany’s tax code to rob the country’s exchequer of billions of euros in revenues. Then there are the various misconduct scandals at Deutsche Bank, which were unearthed by US and UK regulators, and the Volkswagen diesel affair, which was uncovered not by German authorities but by the US Environmental Protection Agency.

Some suspect that the German authorities were motivated by a desire to shield a national tech champion from external criticism. “You have the impression the regulators said — hey, we have this model German company, . . . it’s a victim of attacks by foreign hedge funds, and the FT is their tool,” says Mr Toncar. “And that was a grave miscalculation.”

Asked by the FT if it was true that the government and BaFin deliberately sought to protect the payments processor, Mr Scholz said there was “no evidence” of that.

He also brushed off the claim that the government could have done more to uncover wrongdoing at Wirecard — implicitly pointing the finger instead at EY, the accounting firm that gave the disgraced tech group unqualified audits for more than a decade.

Mr Scholz drew parallels between the Wirecard debacle and the Enron scandal in the US. There was not only a “gigantic accounting fraud”, but in both cases, “auditors who checked the company every year failed to identify this manipulation”.

That is why, he said, he was pushing for reform of the accounting industry. One finance ministry proposal would force large companies to switch auditors more frequently, and for accountancy firms to better separate their audit units from their consultancy businesses.

BaFin, too, has tried hard to fend off criticism that it failed to act. Felix Hufeld, its president, has argued that German capital markets laws left the agency no alternative but to act as it did. The authority, he told the German parliament, lacked a legal mandate to supervise Wirecard as a whole and instead oversaw only Wirecard Bank, a small subsidiary of the group.

Meanwhile, he argued, under German law BaFin did not itself have the right to launch a special audit of Wirecard’s accounts. All it could do was to turn to a body called the Financial Reporting Enforcement Panel, a private sector organisation which monitors the accounting practices of listed companies on behalf of the government, and ask it to investigate Wirecard. This is what happened in mid-February 2019.

BaFin then hunkered down for a long wait. Under Germany’s so-called “two-tier procedure”, the regulator cannot initiate its own investigation into a company until it has received the results of a Frep probe. Yet Frep, which has only 15 employees and an annual budget of just €6m, is ill-equipped to conduct the kind of forensic investigations required to uncover fraud.


Felix Hufeld, president of BaFin, argues that Germany’s capital markets laws left the watchdog agency no alternative but to act as it did © Hayoung Jeon/EPA/Shutterstock


When Wirecard went bust, the Frep probe was still continuing. Only after the company's insolvency did Frep formally conclude that its financial statements were inadequate, according to a person with first-hand knowledge of the situation.

The slowness of Frep’s work had far-reaching consequences. Over the summer of 2019, Wirecard was able to raise €1.4bn in new debt from external investors. While the cash was partly needed to fund the company’s cash-burning operative business, prosecutors also suspect that hundreds of millions were siphoned out of the group.

Wirecard and the missing €1.9bn: my story

In any case, critics dispute the assertion that BaFin’s only option was to request a probe by Frep: they argue that the Wirecard situation was so serious that BaFin should have considered more drastic action — and that it had the option to do so.

“BaFin did not take the allegations seriously,” says Rudolf Hübner, a capital markets lawyer at Quinn Emanuel Urquhart & Sullivan in Hamburg. “Commissioning Frep was just a fig leaf, as that body has neither the remit nor the resources for a forensic audit.” He argues that German law provides BaFin with several options to intervene decisively to uncover accounting fraud. “The problem wasn’t a lack of power,” says Mr Hübner.

Just days after Wirecard filed for insolvency, the government announced sweeping changes to the way accounting is policed in Germany. It terminated its contract with Frep and promised to give BaFin more investigative and forensic powers.

“[BaFin] used the powers that it had at the time [when it commissioned a Frep probe] — but they weren’t enough,” Mr Scholz tells the FT. “That’s why we now want to give [it] the capabilities it needs to act with more bite.”


Former defence minister Karl-Theodor zu Guttenberg. His advisory firm Spitzberg Partners counted Wirecard as a client © Michael Dalder/Reuters


Chinese move

It is not only Mr Scholz and the finance ministry who have come under scrutiny over the Wirecard affair. Ms Merkel, too, is in the spotlight.

On September 3 last year she received a visit from a former colleague, Karl-Theodor zu Guttenberg, according to a timeline of contacts provided by the chancellery. He had once served as German defence minister, but was forced to resign in 2011 over a scandal about plagiarism in his doctoral thesis. He now works for an advisory firm, Spitzberg Partners: one of its clients was Wirecard.

Mr zu Guttenberg brought up Wirecard in his chat with the chancellor and shortly afterwards emailed her adviser Mr Röller to say Wirecard was planning to enter the Chinese market by acquiring a Chinese payments company, the Beijing-based AllScore Financial, and needed the approval of the regulator, the People’s Bank of China.

A couple of days later, Ms Merkel flew off on a state visit to China, and, while there, brought up Wirecard and the planned acquisition. After the trip, Mr Röller wrote to Mr zu Guttenberg promising “further political support”, according to the chancellery’s timeline. Wirecard announced the acquisition of AllScore, which came with a price tag of up to €109m, in early November 2019.

Ms Merkel has defended her lobbying for Wirecard. “It’s common practice, not only in Germany, to bring up the concerns of companies on foreign trips,” she said in August. Wirecard was, after all, a “Dax 30 company”, and at the time of the China trip she had “no knowledge” of irregularities at the payments provider.

But that argument does not wash with the opposition. “She essentially did her former cabinet colleague zu Guttenberg a favour by bringing up Wirecard during the China trip,” says Mr Toncar. “And she did it without checking what was happening at the company.”

Some are now calling for a sweeping reform of lobbying in Germany. “The question is: who has access to the chancellor?” says Ms Paus, the Green MP. “There doesn’t seem to be any sensible criteria. No one is checking who knocks on the door and who’s let in.”

Mr zu Guttenberg was not the only ex-government member lobbying for Wirecard. On September 11, Klaus-Dieter Fritsche, a former chancellery official who co-ordinated the work of the German intelligence services, introduced Mr Röller to Wirecard’s current and former CFOs — Alexander von Knoop and Burkhard Ley. According to the chancellery timeline, the meeting was a “getting-to-know-you session” and a chance for Wirecard to inform Mr Röller about its “business activities in the Far East”.

Others were more circumspect when it came to the payments company. Mr zu Guttenberg approached the German embassy in Beijing in late 2019, asking it to help Wirecard win Chinese regulatory approval for the AllScore acquisition.

But in November of that year a financial attaché at the embassy emailed the ambassador, Clemens von Goetze, warning him not to support Wirecard “at the present time”. He said it would be better to wait until the accusations of accounting fraud had been “cleared up unreservedly”, according to a copy of the email seen by the FT.

“[The attaché] clearly had a better sense of what was up at Wirecard than almost everyone who was dealing with the issue at BaFin,” says Mr Toncar.

Angela Merkel with Premier Li Keqiang on a state visit to Beijing last year. During the trip the chancellor brought up Wirecard’s planned acquisition of a Chinese payments company © Roman Pilipey/AFP/Getty


Beefing up BaFin

Since early September, an army of experts from Roland Berger, a management consultancy, has been sweeping through BaFin’s headquarters in Bonn.

Commissioned by the finance ministry in Berlin, they have been asked to figure out the lessons that Germany’s financial watchdog needs to learn from the Wirecard affair.

Critics say BaFin was asleep at the wheel, targeting short-sellers and journalists who raised concerns about Wirecard rather than investigating the substance of the allegations they made.

One thing that is already clear is that in any future reform, BaFin will be given the power to launch its own investigations into potential balance sheet manipulations by any listed company in Germany.

A member of the financial committee of the Bundestag in Berlin, Hans Michelbach, during a press briefing in July © Felipe Trueba/EPA/Shutterstock


However, according to people familiar with the discussions, it is increasingly unlikely that the country’s two-tier regulatory system, in which Frep, the private-sector institution, played a semi-official role, will be abolished completely. 

Frep is likely to negotiate new arrangements, though its role will be limited to conducting routine checks of corporate annual reports to ensure they are in line with legal requirements and accounting standards.

The big change is that BaFin will have greater freedom to launch its own forensic audit of a company at any time without being required to wait for the outcome of any Frep investigation.

In addition, BaFin is considering the creation of a new internal unit better able to identify unsound banks and insurance companies. This would pay special attention to institutions that have particularly risky clients, have grown extremely fast over a short period of time or are part of a larger, complex group that faces allegations of accounting fraud.

A third focus of reform is possible changes to the way BaFin deals with information from whistleblowers. People familiar with the matter say that the authority needs to improve its capacity to analyse data and connect the dots between separate pieces of information provided by different whistleblowers.

The German finance ministry is already making progress on another key reform — restricting BaFin employees from trading in shares of companies they supervise. The revelation that many of them had been dealing in Wirecard shares in the months leading up its downfall has only added to the political scandal around the company.

Feeling the pulse

American banks’ earnings will gauge customers’ financial health

Is the pandemic leading to a marked rise in defaults on loans to firms and households?


THE HEALTH of America’s economy and that of its banks are closely intertwined. 

Sometimes, as in the global financial crisis of 2007-09, hazardous behaviour by the banks leads to the whole economy being laid low. 

But even when, as now, the banks are not the source of the country’s economic ills, their vital signs still tell you something about the broader picture—about the ability of people and businesses to repay debts, their willingness to borrow and the appetite of companies to raise capital in public markets. 

The banks’ third-quarter earnings season, which begins on October 13th, is the next opportunity to take the banks’ pulse and gauge how America’s economy is faring in its recovery from the ravages of covid-19.

The economic turmoil caused by the coronavirus has cut both ways for banks. Commercial banking (basically, the business of taking deposits and lending) has suffered as the economy slumped, but investment banking has boomed. ´

As markets see-sawed when the pandemic took hold, investment banks’ trading volumes soared, because in volatility lies the chance of profit. In the second quarter, trading revenues at the biggest banks hit a record $26.9bn, up by 70% year on year.

Banks’ bosses have expressed doubt that this bonanza could continue into the third quarter. But the astonishing run in tech stocks and the boom in public share offerings it has fuelled have probably kept moneymen busy over the summer. 

Morgan Stanley and Goldman Sachs, the two big banks that make most of their revenue from investment banking, may not repeat the second quarter’s blow-out, but are still expected to report growing revenues and steady profits in the third. 

(Though both have done well from investment banking this year, they have for some years been trying to reduce their dependence on it—Goldman by building a retail bank, Morgan Stanley by bulking up in asset management. On October 8th Morgan Stanley said it would buy Eaton Vance, an asset manager, for around $7bn in cash and shares.)

Strong investment-bank results have, so far, helped offset the damage from the real economy. In the first two quarters of 2020 America’s four biggest lenders wrote down the value of their assets by $50bn, as they made provisions for expected losses on loans. 

Bank of America, Citigroup and JPMorgan Chase, which have big investment banks as well as giant commercial banks, ended up in profit. At Wells Fargo, which does not, and at other, smaller banks, these write-downs resulted in losses in the second quarter.

The question now is whether actual loan losses will outstrip those provisions, or turn out to be less bleak than the banks have prepared for. In the past, slipping bank profits, partly reflecting provisions in anticipation of loans turning bad, have tended to be followed by the worst loan losses (see chart).

So far, no big losses have accrued, partly because of official measures to support the economy. Cash has been doled out to businesses through the Paycheck Protection Programme (PPP). Households have been handed payments of up to $3,400 and unemployment insurance was boosted by $600 per week. 

The Federal Reserve has kept policy super-loose (which has also gingered up the stockmarket). Charge-offs—ie, write-offs of loans in default—at the four biggest lenders rose by 22% year on year in the second quarter, but still amounted to just $4.9bn. The same was true of delinquent loans (those more than 30 days overdue) and charge-offs industry-wide, which hardly ticked up in the second quarter.


Whether loan defaults will climb more sharply depends on a couple of factors. One is the course of the economy. Most states have begun to reopen, permitting businesses to bring in more revenues than they were during the stricter isolation phase in early 2020. 

If recovery continues, they are more likely to pay their debts; if it stalls, they are likelier to default.

The other is the prospect of further economic stimulus from the federal government. The effects of the measures that kept consumers and businesses afloat through the summer will have faded in the third quarter. Five in six PPP borrowers said they had spent their entire loan by the end of August. 

The additional unemployment payments expired at the end of July. Democrats and Republicans in Congress have not yet agreed on a second support package. If they ever do, that may stop some anticipated losses materialising.

If losses do turn out to be smaller than expected banks, which already hold $2trn of equity capital, may end up sitting on a lot more—and far more than they need to satisfy regulatory requirements. 

But with the memory of 2007-09 still raw, the Fed wants them to keep their shock absorbers well padded. On September 30th the central bank said that the 33 banks with more than $100bn in total assets would remain barred from making share repurchases in the fourth quarter. 

Unlike banks in Europe, they are still paying dividends, but these will be capped at a level based on recent income.

Extra capital and the return of buybacks would be welcome news for banks’ shareholders, who have taken a beating in 2020. Even as the S&P 500 rallied to all-time highs through the summer, banks’ shares remained unloved. The KBW index, which contains a selection of the big listed banks, is worth 30% less than it was at the beginning of the year.

Banks are forking out some cash—but to the authorities. This week two will report the cost of regulatory infractions. On September 29th JPMorgan Chase agreed to pay almost $1bn to settle allegations of “spoofing”: market manipulation through fake trades. Then, on October 7th, Citigroup was fined $400m for failing to fix deficiencies in its risk-management system. 

These follow a $3bn fine Wells Fargo paid to settle its fake-accounts scandal in February and a $3.9bn settlement between Goldman Sachs and Malaysia in July for the bank’s role in the defrauding of 1MDB, an investment vehicle. 

Any more of this, and bank shares will surely remain unloved.

The Fighting in the Caucasus

By: George Friedman


Fighting has broken out again over Nagorno-Karabakh, an enclave inside Azerbaijan nominally controlled by Azerbaijan but governed by ethnic Armenians. 

Since the fall of the Soviet Union, it has been beset by low-level, intermittent skirmishes, but this round seems to be more serious, with reports from either side suggesting more than 500 Armenian servicemembers and 200 Azerbaijani troops are dead, not to mention that vehicles and other equipment have been destroyed. 


The unusually high body count makes this episode of fighting important, but Nagorno-Karabakh’s geographic location in the Caucasus makes it geopolitically relevant. 

Empires have fought over this territory for millennia – the most frequent belligerents were Russian, Turkish and Iranian – but now that the states within the Caucasus are independent, it is more of a proxy battleground over precious global real estate. 

This year, Turkey expressed its support for Azerbaijan, a country with which Turkey has linguistic and cultural affinities. Russia tends to play both sides but has troops based only in Armenia. 

Iran has a very large ethnic Azeri population, some of whom, including Supreme Leader Ayatollah Ali Khamenei, hold high positions of power. Azerbaijan’s government is basically secular and mistrusts Iranian intentions. 

Iran is equally cautious; though it has an interest in trade, it has satisfied that interest through Armenia. (Georgia, which fought a war with Russia in 2008, has had closer ties to Azerbaijan and Turkey)

Russia’s interest in the Caucasus is simple: It was one of the only effective avenues of invading the heartland. (The other, from the west, creates a need for strategic depth, hence Moscow’s enduring interest in Belarus.) 

The Caucasus is divided into two parts by a river valley. Russia lost the southern portion when the Soviet Union fell, but it still de facto controls the northern portion, and so long as it does, Russia can rest a little easier. 

However, much of the North Caucasus is rebellious by nature, often because of the radical brand of Islamism that is bred there, which is why Moscow has ruthlessly suppressed movements in places such as Dagestan and Chechnya. 

The Russian strategy is to prevent a threat from the south by holding the north and keeping the south off balance.

Turkey’s northeastern frontier is anchored in the South Caucasus, bordering Georgia and Armenia. Historically, its interest there has been Russia. Though it still considers Moscow a direct competitor, the fall of the Soviet Union has made the Kurds, who occupy various parts of the Caucasus, Turkey’s number one security interest. 

Armenia and Turkey have been bitter enemies over what the Armenians regard as a Turkish genocide that took place after World War I, and which the Turks bitterly deny. 

The distrust between the two countries is intense. 


Northern Iran was occupied during World War II by the Soviets. The area they occupied was largely Azeri, but when they left they kept what is now Azerbaijan while northern Iran was returned to Iran proper. 

Iran has a complex relationship with Azerbaijan, which is far less Islamic than Iran, and which has energy resources Iran wants. Iran has little interest in Caucasian conflict but is interested in dealing with each of the countries.

These are just some of the reasons that alliances in the Caucasus, already ambiguous at best, shift quickly. Armenia has maintained close ties with Russia, which uses it to maintain a balance of power in the region. Also supporting Armenia is Iran, an important trade partner and buffer state. 

Turkey is increasingly working with Azerbaijan, a move that is linked to efforts to expand regional Turkish influence. Georgia is close to the U.S. but not as important a priority as the Georgians would like, and it too is moving close to Turkey, with which it has transportation links and mutual interests in the Black Sea.

None of these relationships is fixed in stone and all of them are coupled with complex relations with other countries. No doors are locked, but at the same time wars in this region cannot be waged intensely without the support of either Russia or Turkey (Iran would play a role as a subsidiary of Russia). 

In that sense, the recent fighting in Nagorno-Karabakh is, much like Syria and Libya, another dimension of the Russo-Turkish rivalry. Already there are reports that Turkey has sent mercenaries from Syria to support Azerbaijan.

The fighting might well die down. Neither Azerbaijan nor Armenia wants to pay a steep price for Nagorno-Karabakh, and neither Russia nor Turkey is ready for a serious test of power, even if they were confident in where they stood. 

What is most interesting is the absence of the U.S. Washington has a long record of intervening in areas where it has limited interests, and where the price for achieving little will be high. 

This is why it was involved in the 2008 Russian-Georgian war, on Georgia’s side. 

It is now content to let Russia, Turkey and Iran balance each other.

 The Curse of Falling Expectations

When a society goes from broadly shared growth to a state of malaise or decline, the ensuing pain is not just economic but psychological. Now that tens of millions of people in developing countries are suffering precisely such a reversal of fortune, the political fallout is sure to be tumultuous.

Nancy Birdsall



WASHINGTON, DC – Until COVID-19, many people in the developing world felt good about their futures. Overall, developing countries had recovered quickly from the 2009-10 Great Recession, and many – especially in Africa and Latin America – were enjoying the benefits of China’s ever-growing demand for oil, minerals, and agricultural commodities. Expectations were rising.

Not so in the US, where the benefits of economic growth since the 1980s have been funneled to the already rich, with the middle class and the poor increasingly falling behind. Many analysts attribute the rise of the populist right and US President Donald Trump’s election in 2016 to these trends. 

While the middle class has shrunk, a growing cohort of working-class white people has fallen into despair. Many are angry and frustrated over globalization-induced job loss, government neglect in the face of an opioid epidemic, underfunded social programs, and even profit-driven capitalism itself. (The interesting exception to working-class malaise is among black and Hispanic people, who have become more optimistic about the future as they close the gap with working-class whites.)

The end of rising expectations in America came slowly, over the course of many decades following the post-war boom, during which longstanding political institutions and established norms made the US liberal-democratic system relatively resilient. 

But in the current century, social cohesion (at least for whites) and a shared sense of moral progress began to decay, leaving the body politic increasingly vulnerable to the appeal of illiberal populism (and worse).

This experience holds lessons for developing countries. Dashed expectations are bad not only for individuals’ health and wellbeing, but also for a society’s ability to build and sustain democratic norms and institutions.

Economic growth in the developing world has generally been stronger and steadier than in the US for more for than a generation. China and India took off in the 1990s, and most other developing regions followed suit by the early 2000s, including – most dramatically – Sub-Saharan Africa. 

This growth has been inclusive enough to lift tens of millions of people out of extreme poverty ($1.90 per day), yet it has not necessarily secured their place in the middle class. Instead, there is a massive new class of “strugglers” whose families get by on $4-10 per day per person.

Though strugglers are better off than the poor, they lack regular paychecks and social insurance, and are thus vulnerable to household shocks such as a health crisis or a sudden loss of employment. 

Most are self-employed or informal workers in the food, transportation (ride-hail drivers), and retail sectors within expanding urban centers. Comprising more than three billion people in developing countries, they are both ambitious in pursuing a better future and anxious about the constant risk of falling back into poverty.

Over time, economic growth has lifted some strugglers (most likely those with some secondary education) into a large and fast-growing middle class, with daily incomes of $10-50 per person. 

Still, working-class struggler households predominate in the developing world, making up about 60% of people, with middle-class households constituting another 20%, and the extremely poor and the rich accounting for about 12% and 8%, respectively. 

Among these, it is the struggler and new-middle-class households that face the greatest risk from the pandemic-induced macroeconomic shocks that developing countries are experiencing.

Andy Sumner of King’s College London and his co-authors estimate that a COVID-19-induced contraction in developing countries of 10% of 2020 GDP would push about 180 million people below the $1.90/day extreme poverty threshold. 

And while the World Bank has based its own estimates on smaller, country-specific GDP contractions averaging 5%, it still warns that 70-100 million people could fall into extreme poverty.

Meanwhile, the poorest of the pre-pandemic strugglers may suddenly find themselves among the “extreme poor,” and an even larger number of the remaining strugglers – almost 400 million, based on World Bank estimates – are vulnerable to sharp income declines during the current recession. 

Add another 50 million people in middle-class households who are likely to become strugglers, and as many as 450 million people –more than the entire US population – are at risk.

What does it mean for millions of people suddenly to find themselves worse off than they had expected, through no fault of their own? Latin America’s experience shows that when a vocal and demanding citizenry suffers a sharp reversal of expectations, the result is US-style social tension and political polarization. 

In 2014-15, growth across the region began to flag badly, averaging below 1% per year, which implies negative per capita growth. As a result, conditions that were tolerable when the economic pie was growing suddenly became less so.

In the five years since, huge protests have erupted in Brazil, Bolivia, Chile, Colombia, and Ecuador, most of them over official corruption and the insider privileges enjoyed by political and corporate elites. Only in relatively well-off Chile were protesters successful in achieving progressive change.

In the shadow of COVID-19, the developing world is experiencing severe political and financial pressures. Without their own tradable currencies, these countries cannot borrow from future citizens (as the United States and the European Union can) to meet their immediate needs.

Given the risks of fraying social cohesion, political instability, and recrudescent autocracy and populism, the International Monetary Fund and multilateral banks need to offer far larger lending programs for middle-income countries. 

These should be simple and straightforward, designed to finance immediate cash transfers to ensure that children in poor and struggling households do not go hungry and abandon school permanently. Such investments are necessary to reap the returns in future human capital upon which development ultimately depends.

The COVID crisis is a moment when liberal democrats in the US must not only resist authoritarianism at home, but also lobby for additional support to developing countries. 

When people who believed their prospects were rising no longer do, politics can become messy – with collateral damage to freedom and civil liberties – very quickly.


Nancy Birdsall is President Emeritus and a senior fellow at the Center for Global Development.

 Quantum computing

What quantum computers reveal about innovation

Venture capital is often the last guest to arrive at the party


It is hard to choose one moment as marking the birth of a technology. But by one common reckoning, quantum computing will be 40 next year. 

In 1981 Richard Feynman, an American physicist, spoke at a computing conference, observing that “Nature isn’t classical, dammit, and if you want to make a simulation of nature, you’d better make it quantum mechanical, and by golly it’s a wonderful problem, because it doesn’t look so easy.”

Entering middle age, quantum computing is at last becoming a commercial proposition. Until recently the consensus was that practical applications would have to wait for large, stable machines, probably at least a decade away. Not everyone agrees. 

Venture capital is beginning to flow into companies built around quantum computers, as investors make a bold—possibly foolhardy—bet that even the limited, error-prone, unstable machines that make up the state-of-the-art today may prove commercially useful.

If those bets pay off, it would be good news, and not just for investors. Quantum computers can perform some sorts of mathematics far faster than any classical machine. Building them could open up entirely new vistas. They may, for instance, revolutionise chemistry. 

Most reactions are too complex for existing computers to simulate exactly, blunting researchers’ precision. Quantum machines could cut through the mathematical tangle, with applications in materials science, drugmaking, batteries and more. 

Their facility with optimisation problems, which are likewise a struggle for non-quantum machines, could be a boon for logistics, finance and artificial intelligence.

The field’s progress is interesting for another reason. Quantum computing offers a worked example of how complicated technologies develop in industrial societies. The chief lesson is to attend to every part of the process. 

The frenzy of innovation around classical computing, concentrated in Silicon Valley, has focused attention on the world of startups, venture capital and ipos. But these are things that happen late in a technology’s development, when swift commercial returns are, if not certain, then at least plausible. 

As Mariana Mazzucato, an Italian-American economist, has argued, the biggest risks are taken earlier, when it is unclear whether a technology will work at all.

The state can be one such risk-taker. The first step in building a quantum computer was to conduct plenty of abstruse mathematics on university blackboards. Collectively, governments, including those of America, Britain, China and Germany, have thrown billions of dollars at funding quantum research.

Other early work was done in the sorts of big, boring companies in which no self-respecting disrupter would be seen dead. The first useful quantum algorithm was discovered in 1994 at Bell Labs, which began life as the research division of America’s telephone monopoly. 

Another early pioneer was ibm, which also has a buttoned-up reputation—but whose researchers have, over the years, earned six Nobel prizes. Today Google and Microsoft are playing a big role in developing quantum technologies.

The trick for such super-early-stage investors is to know when to stick with a risky prospect and when to call it quits. Good venture capitalists are ruthless about culling underperforming bets and focusing on those that seem to be paying off. Their proximity to markets makes such judgments easier. 

But governments—which are, after all, spending public money—should strive for the same outlook. If the state is to back technologies that are too risky for other investors, then a high rate of failure is both inevitable and desirable.

There are other lessons, too. Quantum computing has come as far as it has on the backs of thousands of mathematicians, experimental physicists and engineers. 

That is a reminder of the limits of “great man” theories of innovation, exemplified by the cult of Steve Jobs, a founder of Apple. 

The popular image of innovation as a “pipeline”, with a stream of individual technologies proceeding smoothly from ideas to products, is likewise too neat. 

Progress in quantum computing depends on progress in dozens of other fields, from lasers to cryogenics.

None of that is to deny the importance of the people who run the last few miles, taking nascent technologies and trying to spin out profitable businesses. 

But those who want to see more of that success should keep in mind that a great deal of less celebrated, less glamorous work must come first.