In Whom We Trust

25^th October 2009

The Malta Independent - Friday Wisdom
Alfred Mifsud

IN GOD WE TRUST is the bold declaration on each US dollar currency note. I always found this motto, which is also the national motto of the United States, somewhat out of place on Caesar’s money and goes against the advice given by the Lord Himself to give Caesar what is Caesar’s and to God what is God’s.

But even beyond this undesirable mix of religion with Mammona’s basic stuff, declaring trust in God on dollar bills implies that we do not trust anyone else. This goes against the very basic concept of such money bills which are nothing else than IOU’s issued under a fiat monetary system which obviously can only work if holders of such bills trust their issuer, the central bank of US.

Fiat money means that the central bank can issue and print as much money as it considers necessary for the execution of its policies without any need to keep any specific reserve or tangible backing for the money its creates. Hence why the system is termed ‘fiat’, as money is created as if by magic without the need to provide any specific backing.

The basic question is whether we should trust the US dollar in spite of the implied warning they carry that we should only trust God.

In my article in this series published at the bottom of the financial crisis on 13 March 2009, I had remarked as follows on this subject:

This will not be without consequences on the US side. Without the Chinese readily financing their deficits, the US will have to finance their own by promoting less consumption and more saving. So US economic recovery can no longer depend on consumer demand and has to switch to export demand which is the other side of the coin of the shift in China from export-led growth to domestic-led growth. For this purpose we have to see a sharp reversal of the strength of the US dollar seen since the financial turmoil began.

If you want a marker of whether there is progress being registered in resolving this crisis, the value of the US dollar is a good marker. If the US dollar keeps strengthening it means that things are getting more serious. If things stop getting more serious we will see the US dollar weakening, eroding the strength it has artificially accumulated these last six months, giving a chance for the US economic engine to shift from consumption mode to productive mode.

At the time this was written, US$ 1.25 were needed to buy e1. Six months later and with the world confident that the financial system has been stabilised and that the economic recession has hit bottom it takes US$1.47 to buy e1. That means a fall of some 17.5% in six months despite various assertions during this time from the Treasury Secretary that the US administration still believes in a strong dollar policy. What the Treasury Secretary probably means but cannot expressly state is that the administration believes in a stable dollar policy but only after the dollar undergoes an orderly re-adjustment of its external value by falling substantially against major currencies to make the US economy export competitive. This will help to address the macro economic imbalances that led to the financial crisis by excessive consumption in the US and excessive savings in China and Japan.

Incidentally crude oil prices at the time was around US$40 and have since increased by 75% to US$70. However because of the fall in the value of the dollar, the increase in Euro terms was ‘only’ 49%!

Coming back to the trust issue, I cannot help noting that a very unorthodox situation is developing in the world of finance which is forcing the unobtrusive development of the fourth branch of government in most large economies. The executive branch, with the explicit or implicit approval of the legislative branch, has used fiscal policy to the hilt in order to stabilise economies from the negative impact of the financial crisis. Space for further fiscal injections is now very limited given that as a result of the huge emergency stimulus injections that had to be made, the public deficits and accumulating debts have reached very worrying levels.

If anything, governments have to worry about how to restore sanity to their finances on a medium term basis.

This leaves the main burden to engineer a recovery on monetary authorities, particularly the central banks of the major trading blocks i.e. the US, the EU, Japan and China.

Central banks are managed by unelected officials who have much more room for manoeuvrability than governments. The president of the United States can respond instantly to a missile attack with America’s military might but he cannot respond to a financial crisis with real money unless Congress acts. The Federal Reserve Bank, America’s central banking system, with no direct accountability to the nation’s voters, did not need anybody’s approval to flood the financial system with fiat money to address the illiquidity created by the banking crisis.

The same applies to the European Central Bank, the Bank of England, the Bank of Japan and the central bank of China. These institutions treasure their independence from the executive branch and proclaim that their freedom of direct accountability to the electorate gives them the facility to do what’s right not what’s popular.

In some ways these central banks have contributed to the financial crisis by focussing their inflation control mandate strictly on retail inflation and disregarded the asset price inflation in equities and real estate that brought two financial bubbles in this first decade of the new millennium. This has to change. In future central banks have to account for asset price inflation in their objectives.

But for the immediate future should we accept to have this unelected fourth branch of government, who did not protect us from the bubbles which have caused so much pain, to be responsible for leading us back to stable non-inflationary growth backed by a well regulated financial system which does not lead us from one bubble to another?

This question is somewhat rhetoric. In truth we have no choice. The central bankers have to make the judgements when to roll back the monetary easing to avoid an inflation explosion but without suffocating the fragile economic recovery. This is not unlike expecting them to perform complicated surgery with a carving knife and a spade. They need not just our trust but also our prayers.









   

Bankers` Bonus Bogus

20^th September 2009

The Malta Independent on Sunday

As the G-20 world leaders prepare for their next meeting in Pittsburgh, one gets the impression from their pre-summit rumblings that they seem to think the financial crisis that constrained them to take acute measures to save the world’s financial system, following the collapse of Lehman Brothers this time last year, was caused by excessive bankers’ bonuses and that a recurrence can be avoided merely by controlling bankers’ pay packet.

To me this sounds nothing more than politicians seeking scapegoats to cover up their own and their regulators’ failure to keep the financial system on the straight and narrow.

The remuneration paid to some ‘bankers’ remains scandalous by any standard. But one has to define who these bankers were, who were creaming off multi-million dollar bonuses, and why they were being paid so handsomely.

Let it be made clear that the vast majority of bankers earn a normal salary and modest bonuses, if any at all. The banker of all bankers, the chairman of the Federal Reserve Bank of the US, has a salary of less than $200,000 – modest compared to the bonuses paid to lesser banking mortals and rather on the low side compared to the weight of the decisions he has to take.

In reality, those bankers who helped themselves to the millions are not real bankers in the traditional definition of the term. Those who earned these scandalous millions fall into three categories. The most obvious category is that composed of very senior executives of banks who were responsible for the overall remuneration policies of their institutions. This is probably the most offensive category. Rather than controlling their underlings when it came to from excessive risk-taking with the bank’s capital, they pumped their organisation to leverage levels that any real banker would never have allowed. Jimmy Cayne and Dick Fuld, the CEOs under whose watch Bear Stearns and Lehman Brothers collapsed, were no real bankers, but gamblers who brought their experience in poker to investment banking and turned the investment banks with which they were trusted into huge un-hedged hedge funds.

The other two categories of bankers drawing multi million dollar bonuses are middle and low rank operators in the investment banking divisions. Banks without strong investment banking divisions, such as Maltese banks, do not pay multi-million dollar pay packages because, like anything else, bankers’ pay is driven by market forces and it is in investment banking where there is a shortage of talent that, unless paid well, will skip ship to competitor organisations.

The Mergers & Acquisitions (M&A) departments of large investment banks are staffed with highly talented executives, mostly in their late twenties and early thirties, who are experts in corporate finance and who are prepared to spend the best years of their life working 90-hour weeks, under the severe stress of delivery deadlines and often sleeping in a different bed every night because their duties call them to travel extensively. Generally, by the time they reach 40 they are burnt out and either retire completely or move to less demanding jobs.

These executives have never put their organisation at any risk, as they do not use its capital, merely its brand and infrastructure. They earn their organisation lucrative fees and, on a net basis, make a substantial contribution to their banks’ profitability.

Politicians have no business trying to control the remuneration packages of such executives. If they do, what will happen (it is, in fact, already happening) is that such talent will merely migrate to boutique M&A organisations, leaving their banks worse off. It is like meddling with the remuneration package of a hotel’s highly successful and skilled executive chef merely because the hotel is incurring losses in its Rooms Department, in spite of the profits made by the Food & Beverage Division. What solution to the Rooms Department’s problem can the restriction of the executive chef’s remuneration provide? More than likely it will force the executive chef to move to a more successful competitor organisation, compounding the problems of his/her present employers.

The last category of investment bankers that benefited from notorious bonuses are traders, those whiz kids who were allowed to trade the bank’s capital many times over, using overnight money to trade in complex and illiquid securitised assets, booking short-term profits leading to huge bonus claims without any regard for the fact that, in the process, they were stuffing the bank’s balance sheet with toxic assets that ultimately exploded and wiped away multi-year profits in one fell swoop.

There are traders and traders. Traders who make real profits without compromising the bank’s capital and balance sheet are a resource to be treasured. Attempting to cap the bonuses of such talent will lead to its flight to hedge funds and shadow banking organisations that escape the Regulators. We have had an inkling of this just this week, when Barclays announced the hiving off of some £12 billion of assets from its balance sheet to a “detached” vehicle against a 100 per cent loan. There is no evident benefit for Barclays in such a move, except to avoid having to mark to market such assets on its balance sheet, doing away with wide fluctuations in its profit performance. It could well be that Barclays are anticipating the regulatory tightening up of remuneration for traders’ talent and have taken early steps to transfer this talent to such “detached” vehicles, beyond the reach of the Regulators bonus controls.

Regulation of banks’ bonuses could be only a very small part of the new regime required to avoid a recurrent blow-up of the world’s financial system. It should be restricted to senior executive pay. This should be controlled through full disclosure, deferred payment, blocked stock options and claw-back provisions, rather than through quantitative limits. Of more importance for effective regulation are capital requirements, limits on leverage, the outlawing of off-balance sheet assets transactions and controls over the overall size of the institutions to ensure that none of them are too big to fail.

Failure must remain the ultimate punishment for reckless bankers, just as for any other profession. What top management pays to their individual executives should be of no concern to the Regulators, even if it were possible to control such pay polices, which often it is not – as the Barclays experience is already showing. But the consequences of bad remuneration policies should be borne by shareholders, not by taxpayers, and this is only possible if banks are constrained to a size where failure would be possible without causing systemic risk. The Regulators’ primary responsibility is to ensure that taxpayers no longer provide implicit guarantees for reckless bankers. Keeping banks too big to fail, while trying to regulate their remuneration policies, will prove to be a very ineffective solution.
 

The good the bad and the ugly of the property market lull

18^th September 2009

The Malta Independent - Friday Wisdom

I have been careful not to define the current downturn in the local property market as a crisis, merely as a lull. The distinction between a lull and a crisis is that the former is cyclical whereas the latter tends to be more structural.

So far it is fair to define the problem as a lull as it follows a rather long period of strong growth and as yet we are not seeing distressed selling on a major scale leading property prices to drop below their replacement cost. There is nothing however to stop a lull from developing into a full blown crisis if the downturn gets more pronounced and extended.

It would be wrong to attribute the downturn in the local property market to the international financial crisis. Certainly the financial crisis did not help and has deterred foreign buyers from making investments in the local property market at a time when bargains are available in countries where there is a real property crisis like in the UK, Spain and Ireland. But the sources of the local property downturn are more homegrown.

It can be merely defined as an excess of supply from property developments that were initiated years back when the boom was at its peak. This is forcing property units to come on to an over-supplied market that has gone soft. The excess supply is super-imposed on withdrawal of demand from investors who are now holding back waiting for property prices to fall before they make their next move. Purchase of property for investment purposes has largely disappeared and demand for property for own use is low and cannot support prices in an over-supplied market.

Normally a situation of excess supply and falling demand gets equated by a fall in price. So far the fall in prices we have seen has been relatively modest leading observers to believe that developers are holding out and carrying inventory waiting for better times.

It would be unreasonably optimistic however to assume that better times are anywhere round the next corner. Once potential buyers and investors have been put in a frame of mind that waiting can lead to a better deal, demand is unlikely to show up at a tempo which could underpin property prices. The carrying costs of inventory will eventually force developers, often pushed by their bankers who hate non-performing loans more than turkeys hate Christmas, to dump property at distressed prices. This process will be accentuated as many unsold inventory approach the fiscal five year time limit to avoid 12 per cent of the sale price as final withholding tax. The risk of having to pay a turnover related withholding tax on property sales undertaken at little or no profit, will be another factor which could turn a property lull into a full blown property crisis.

Should we let the market to clear itself either through a lull or through a crisis or should the government intervene in order to restore some sort of stability and orderly adjustment without risking a fully dysfunctional property market?

This was the question that Minister Tonio Fenech broached of his own accord when addressing a pre-budget business breakfast meeting this week. Minister Fenech posed more questions than provide answers and attendees were left with the distinct impression that government had no clear idea of what it should do, if anything at all.

The minister tried to put a positive twist on it arguing, quite rightly, that this property lull makes life easier for first time home buyers and makes property more affordable. He said government should hardly be expected to intervene to support property prices when during the boom accusations were made that government is letting property prices rocket up beyond the reach on many first time home buyers, causing social problems. Now that the wheel has turned, government should not be expected to disrupt the market from price falls that restore eroded values to social justice.

What’s good for social justice is however bad for property developers, especially those that bought at the peak of the market and now have to carry unsold inventory incurring finance carrying costs and risking slippage into the 12 per cent withholding tax regime. But business is business, and developers who picked rich rewards during the boom cannot complain when the markets turn against them. So I agree that government should refrain from intervening to interfere in market adjustments which allocate the good and the bad between property developers and property buyers.

What government should not refrain from is intervention to ensure that the bad does not turn into ugly. There would be few winners and many losers if the lull were to turn into a crisis. Passive property owners would suffer seeing the value of their residences fall even though they have no intention to sell. Banks would see an explosion in nonperforming loans and given the exposure of the local banking system to property as security, the stability of the system would be more directly challenged than it has been by the international financial crisis. With a de-stabilised banking system the whole economy would suffer.

So while government should allow the market to undergo the necessary tactical adjustments, it should be on its guard to do what it has to do to ensure that the market remains orderly. And what should it do? In the very least it should extend or lift the artificial five years limit for slippage into the 12% withholding tax regime, which was a tax amendment conceived on the wrong premise that property prices will go up forever without any downward adjustment. Secondly it should freeze for some time all new permits for new development to give time for the market to clear the excess supply which has been allowed to accumulate.

The good and the bad of the property market are fair game. The ugly is to be avoided.