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Friday, 31 October 2008

I asked Gordon Brown a question

You can do the same here.

Why did Barclays get their funding from the Middle East?

In 2003, Roger Jenkins was paid more than £19.5m last year by his bosses at Barclays Capital. That figure made Jenkins the highest-paid employee of any FTSE company and almost certainly the best-paid investment banker in the City that year. His package dwarfed the £3m paid in that year to Matt Barrett, former chief executive of Barclays, and was more than three times the total paid to the bank's five executive directors.

So what did Jenkins do to earn his fabulous salary? It is a question that Barclays Capital would prefer was not asked because, in its simplest form, Jenkins and colleagues Ian Abrahams and Mike Keeley spend their days working out clever ways to slash the tax bills of companies, including Barclays. His two colleagues are believed to have earned about £10 million each last year. Every bank in the City employs a structured finance division that performs the same role, but none is believed to be anywhere near as successful as either Barclays Capital or Jenkins.

Some competitors calculate that Jenkins' team generated more than 100% of Barclays Capital's profits in 2002 - suggesting that other key operations in the division operated at a loss - and probably produced more than half the surplus for 2003. Barclays Capital said these figures were 'gross exaggerations' and claimed Jenkins was in charge of four businesses, of which 'tax-efficient financing' was only one. These, said a spokesman, 'generate less than 20% of the bank's revenues'.

Not something you would want to share with the government.


A merger of sorts

In the new management team unveiled by Lloyds TSB as it takes over HBOS, just two out of the top 11 jobs in the new bank will
go to HBOS executives, with Lloyds TSB executives taking most of the top roles in a team headed by Eric Daniels, chief executive of Lloyds, and Sir Victor Blank, the bank's chairman.

Which reminds me of the "merger" between ING and Barings, as it was portrayed by some of the failed bank's staff who couldn't accept they were being taken over. They thought part of the UK bank's name was kept when the "merged" bank was named ING.

Wednesday, 29 October 2008

Boosting the economy

Gordon Brown could boost the economy by giving nearly every household £145 extra to spend every year simply by abolishing the TV License.

Tuesday, 28 October 2008

Crime of the week: Barclays' black diamond

Who knew about Barclays $1bn snafu last week?

On Friday, BARC's balance sheet underwent a little unwelcome expansion: a $970m position comprising corporate loans (including such choice credits as GM) CDO tranches and revolving credits surfaced on the books.Bidding opens today on the sale of the position, which the bank is naturally rather keen to (re)dispose of.

S&P LCD reports on a dispute between BARC and a fund managed by Black Diamond Capital Management:Black Diamond said last week that BDC terminated a derivative facility with Barclays because Barclays did not return excess collateral that was due on Oct. 7 and then failed to cure a default stemming from the bank's failure to return the collateral. BDC Finance on Oct. 17 sued Barclays in the New York State Supreme Court, alleging that Barclays failed to deliver to BDC no lessthan $302 million of posted collateral and interest, according to court filings.

The Black Diamond fund in question entered into a series of total return swaps (TRS) written on various assets on BARC's balance sheet. Those assets being the things BARC is now trying to sell.The existance of those swaps, of course, hitherto effectively wrote the assets out of regulatory existance on the balance sheet: BARC has not had to account for them before.The swaps naturally required collateral posting, which the Black Diamond fund had to put up with BARC. Alas, as spreads came down, collateral haircuts fell, and it seems BARC did not return the money to Black Diamond as you'd expect it was wont to do (the marks on the assets were recalculated on a daily basis - the dispute centres around Black Diamond's claim that the assets were worth more than Barc's marks said they were). Black Diamond consequently terminated the TRS, suddenly writing the $970m position back into regulatory existance at BARC.

This is bad for several reasons. BARC will have to take a writedown on the position. It is selling the assets into a collapsing market, so it will likely be an unpleasant affair.The bank has to sell the assets because the alternative - holding them - would incur too punitive a risk-weighted asset requirement under Basel II.Given that BARC's core capital is under particular strain, this is a no-no.

Then there are the broader implications. Barclays and many of its European peers have been big users of synthetic CDOs as a balance sheet arbitrage: creating off-balance sheet synthetic structures which net arrangement fees but which also, crucially, provide massive balance sheet relief.As with the Black Diamond fund, such structures typically enter into total-return swap agreements or CDS contracts with banks, securing an income stream and, supposedly, risk. But with corporate spreads now gapping out to unprecedented levels and the prices on loans cratering (see graph from Bank of America below), the synthetic CDO market might be a huge shoe to drop: banks may find themselves with, to repeat a phrase coined by Citi analysts at the start of this year, further massive "involuntary asset growth".

Not good when you need to rapidly delever.

The Barclay's/Black Diamond debacle might have been caused by an idiosyncratic dispute over collateral posting, but the broader issue - of risks thought conjured off balance sheet using synthetic technology coming back to haunt banks - is a developing theme.

Monday, 27 October 2008

Not only is the PM wrong, but also ...

From today's edition of Her Majesty’s Telegraph:

Gordon Brown backed Lord Mandelson and again called for an inquiry into the "illegal" approach by Mr Osborne.

The Prime Minister told BBC Scotland: "This was an issue where someone had tried to get a donation from a foreign citizen and that is unlawful. It is clearly unlawful. It's in the legislation of Parliament that it's unlawful to take, or solicit, or even to further the objective of acquiring foreign donations.

"That is the issue and that is what has got to be investigated and I know that the Electoral Commission has been asked to do it, the Parliamentary authorities. It's a matter for these authorities, it's not a matter for me."

Sorry, Gordon, there is no offence of soliciting an illegal donation, merely of accepting one. Equally, there is no offence of trying to “further the objective of acquiring foreign donations, although a "person commits an offence if he— (a) knowingly enters into, or (b) knowingly does any act in furtherance of, any arrangement which facilitates or is likely to facilitate, whether by means of any concealment or disguise or otherwise, the making of donations to a registered party by any person or body other than a permissible donor.”

It should be obvious that you can’t enter into or do any act in furtherance of such arrangements unless there actually is a donation. Furthermore, for their to be a donation, there has to be a willing donor, apparently not the case here.

But just to clarify a few points, foreigners are quite entitled to make donations, they just have to be registered to vote, which is how Lakshmi Mittal was able to donate £4,125,000 to the Labour Party. And not all UK nationals may make donations. They have to be registered to vote. They should be registered but not all of them are. If a political party asks a UK resident person to make a dontaion and he/she does so, but the party later discovers that the donor is not registered to vote and returns the donation, the party is not guilty of an offence.

So Gordon, you are wrong on many points and right on none. Some might say you are making political capital by accusing an opponent of an act which he denies, but the reality is that you have used your authority and media profile to accuse another person of a crime that does not exist.

That is not the behaviour of a gentleman, or even of a Prime Minister. But then as we have long known, you have no class.

Labour is bad for your wealth

An interesting graph showing the average return on the FTSE since 1984. This shows the cumulative annualised growth of the FTSE (ln(fn/f0)/n) where f0 is the value of the FTSE in April 2004 and fn is the value of the FTSE n (possibly fractional) years later. I omitted the first 3 years which showed very high returns, but cumulative growth averaged out at 10% throughout the Conservative government, but fell away so that total growth between 1994 and 2008 is now only an average of 5% per year.

Here is another view, showing a rolling 10 year growth of the FTSE:

Brown may think he is leading the UK out of recession

... but last week sterling suffered it's worst week against the dollar since 1982 (by a long, long way), in fact, 30% worse than the week of Norman Lamont's Black Wednesday in 1992.

Week Ending




25 October 2008




19 September 1992




27 April 1985




03 August 1985




04 October 2008




Thursday, 23 October 2008

UK companies with foreign owners that have donated to Labour

So the Labour Party think it is illegal to accept a donation from a UK trading company which is owned by foreign shareholders. Here is a list of donations accepted by Labour from UK companies with foreign shareholders:

EDF Energy, company no: 2366852, 40 Grosvenor Square, Victoria, London, SW1X 7EN
27/10/2003, 6,000
19/09/2005, 6,000

BAA, company no: 1970855, Belgrave House, Buckingham Palace Road, London, SW1W 9TQ
09/03/2007, 2,000

E.ON UK PLC - Sponsorship, company no: 2366970, Westwood Way, Westwood Business Park, Coventry
08/10/2007, 10,000

English, Welsh & Scottish Railway Ltd, company no: 02938988, McBeath House, 310 Goswell Road, EC1V 7LW
31/01/2005, 6,200
20/07/2005, 9,000
05/10/2007, 15,000
19/10/2007, 3,000
07/03/2008, 6,500

Microsoft Ltd, company no: 01624297, Thames Valley Park, Reading, RG6 1WG
28/03/2006, 9,400

Bloomberg UK Ltd, company no: 03430322, 1 Angel Court, London, EC2R 7EP
31/08/2001, 17,625
29/01/2003, 14,100

Bloomberg UK Ltd, company no: 3651326, City Gate House, 29-45 Finsbury Square, London, EC2A 1PQ
17/10/2003, 19,388

Bloomberg Tradebrook Europe Ltd, company no: 3556095, City Gate House, 39-45 Finsbury Square, London, EC2A 1PQ
25/10/2004, 19,388
30/06/2005, 19,975
19/09/2006, 29,375
10/09/2007, 29,375

Novartis Pharmaceuticals Ltd, company no: 1170167, Frimley Business Park, Frimley, Camberley, GU16 7SR
15/09/2004, 11,750

Novartis Vaccines and Diagnostics Ltd, company no: 03970089, Florey House, Robert Robinson Avenue, Oxford Science Park, Oxford, OX4 4GA
12/09/2007, 3,000

EADS UK Ltd, company no: 2473840, 111 Strand, , London,WC2R 0AG
10/12/2007, 7,225

Vauxhall Motors Ltd, company no: 00135767, Griffin House, Luton, LU1 3YT
05/12/2001, 7,050
23/10/2006, 2,000

Total £ 249,851

Wednesday, 22 October 2008

Who pays the least tax?

Tax as a percentage of GDP by country in 2005 (courtesy of the OECD)


Tuesday, 21 October 2008

How does Gordon Brown keep the National debt at 37% of GDP

Easy enough ... he lies


The office of National Statistics is quite clear.  The National Debt is 43% of GDP.  The figure is only 37% if the Northern Rock liabilities are excluded.





More background on AIGFP

The Reckoning

Behind Insurer’s Crisis, Blind Eye to a Web of Risk

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

— Joseph J. Cassano, a former A.I.G. executive, August 2007

Two weeks ago, the nation’s most powerful regulators and bankers huddled in the Lower Manhattan fortress that is the Federal Reserve Bank of New York, desperately trying to stave off disaster.

As the group, led by Treasury Secretary Henry M. Paulson Jr., pondered the collapse of one of America’s oldest investment banks, Lehman Brothers, a more dangerous threat emerged: American International Group, the world’s largest insurer, was teetering. A.I.G. needed billions of dollars to right itself and had suddenly begged for help.

One of the Wall Street chief executives participating in the meeting was Lloyd C. Blankfein of Goldman Sachs, Mr. Paulson’s former firm. Mr. Blankfein had particular reason for concern.

Although it was not widely known, Goldman, a Wall Street stalwart that had seemed immune to its rivals’ woes, was A.I.G.’s largest trading partner, according to six people close to the insurer who requested anonymity because of confidentiality agreements. A collapse of the insurer threatened to leave a hole of as much as $20 billion in Goldman’s side, several of these people said.

Days later, federal officials, who had let Lehman die and initially balked at tossing a lifeline to A.I.G., ended up bailing out the insurer for $85 billion.

Their message was simple: Lehman was expendable. But if A.I.G. unspooled, so could some of the mightiest enterprises in the world.

A Goldman spokesman said in an interview that the firm was never imperiled by A.I.G.’s troubles and that Mr. Blankfein participated in the Fed discussions to safeguard the entire financial system, not his firm’s own interests.

Yet an exploration of A.I.G.’s demise and its relationships with firms like Goldman offers important insights into the mystifying, virally connected — and astonishingly fragile — financial world that began to implode in recent weeks.

Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.

Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.

In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.

“It is beyond shocking that this small operation could blow up the holding company,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn. “They found a quick way to make a fast buck on derivatives based on A.I.G.’s solid credit rating and strong balance sheet. But it all got out of control.”

The London Office

The insurance giant’s London unit was known as A.I.G. Financial Products, or A.I.G.F.P. It was run with almost complete autonomy, and with an iron hand, by Joseph J. Cassano, according to current and former A.I.G. employees.

A onetime executive with Drexel Burnham Lambert — the investment bank made famous in the 1980s by the junk bond king Michael R. Milken, who later pleaded guilty to six felony charges — Mr. Cassano helped start the London unit in 1987.

The unit became profitable enough that analysts considered Mr. Cassano a dark horse candidate to succeed Maurice R. Greenberg, the longtime chief executive who shaped A.I.G. in his own image until he was ousted amid an accounting scandal three years ago.

But last February, Mr. Cassano resigned after the London unit began bleeding money and auditors raised questions about how the unit valued its holdings. By Sept. 15, the unit’s troubles forced a major downgrade in A.I.G.’s debt rating, requiring the company to post roughly $15 billion in additional collateral — which then prompted the federal rescue.

Mr. Cassano, 53, lives in a handsome, three-story town house in the Knightsbridge neighborhood of London, just around the corner from Harrods department store on a quiet square with a private garden.

He did not respond to interview requests left at his home and with his lawyer. An A.I.G. spokesman also declined to comment.

At A.I.G., Mr. Cassano found himself ensconced in a behemoth that had a long and storied history of deftly juggling risks. It insured people and properties against natural disasters and death, offered sophisticated asset management services and did so reliably and with bravado on many continents. Even now, its insurance subsidiaries are financially strong.

When Mr. Cassano first waded into the derivatives market, his biggest business was selling so-called plain vanilla products like interest rate swaps. Such swaps allow participants to bet on the direction of interest rates and, in theory, insulate themselves from unforeseen financial events.

Ten years ago, a “watershed” moment changed the profile of the derivatives that Mr. Cassano traded, according to a transcript of comments he made at an industry event last year. Derivatives specialists from J. P. Morgan, a leading bank that had many dealings with Mr. Cassano’s unit, came calling with a novel idea.

Morgan proposed the following: A.I.G. should try writing insurance on packages of debt known as “collateralized debt obligations.” C.D.O.’s. were pools of loans sliced into tranches and sold to investors based on the credit quality of the underlying securities.

The proposal meant that the London unit was essentially agreeing to provide insurance to financial institutions holding C.D.O.’s and other debts in case they defaulted — in much the same way some homeowners are required to buy mortgage insurance to protect lenders in case the borrowers cannot pay back their loans.

Under the terms of the insurance derivatives that the London unit underwrote, customers paid a premium to insure their debt for a period of time, usually four or five years, according to the company. Many European banks, for instance, paid A.I.G. to insure bonds that they held in their portfolios.

Because the underlying debt securities — mostly corporate issues and a smattering of mortgage securities — carried blue-chip ratings, A.I.G. Financial Products was happy to book income in exchange for providing insurance. After all, Mr. Cassano and his colleagues apparently assumed, they would never have to pay any claims.

Since A.I.G. itself was a highly rated company, it did not have to post collateral on the insurance it wrote, analysts said. That made the contracts all the more profitable.

These insurance products were known as “credit default swaps,” or C.D.S.’s in Wall Street argot, and the London unit used them to turn itself into a cash register.

The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999.

Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.

Mr. Cassano and his colleagues minted tidy fortunes during these high-cotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.

In fact, compensation expenses took a large percentage of the unit’s revenue. In lean years it was 33 percent; in fatter ones 46 percent. Over all, A.I.G. Financial Products paid its employees $3.56 billion during the last seven years.

The London unit’s reach was also vast. While clients and counterparties remain closely guarded secrets in the derivatives trade, Mr. Cassano talked publicly about how proud he was of his customer list.

At the 2007 conference he noted that his company worked with a “global swath” of top-notch entities that included “banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.”

Of course, as this intricate skein expanded over the years, it meant that the participants were linked to one another by contracts that existed for the most part inside the financial world’s version of a black box.

Goldman Sachs was a member of A.I.G.’s derivatives club, according to people familiar with the operation. It was a customer of A.I.G.’s credit insurance and also acted as an intermediary for trades between A.I.G. and its other clients.

Few knew of Goldman’s exposure to A.I.G. When the insurer’s flameout became public, David A. Viniar, Goldman’s chief financial officer, assured analysts on Sept. 16 that his firm’s exposure was “immaterial,” a view that the company reiterated in an interview.

Later that same day, the government announced its two-year, $85 billion loan to A.I.G., offering it a chance to sell its assets in an orderly fashion and theoretically repay taxpayers for their trouble. The plan saved the insurer’s trading partners but decimated its shareholders.

Lucas van Praag, a Goldman spokesman, declined to detail how badly hurt his firm might have been had A.I.G. collapsed two weeks ago. He disputed the calculation that Goldman had $20 billion worth of risk tied to A.I.G., saying the figure failed to account for collateral and hedges that Goldman deployed to reduce its risk.

Regarding Mr. Blankfein’s presence at the Fed during talks about an A.I.G. bailout, he said: “I think it would be a mistake to read into it that he was there because of our own interests. We were engaged because of the implications to the entire system.”

Mr. van Praag declined to comment on what communications, if any, took place between Mr. Blankfein and the Treasury secretary, Mr. Paulson, during the bailout discussions.

A Treasury spokeswoman declined to comment about the A.I.G. rescue and Goldman’s role. The government recently allowed Goldman to change its regulatory status to help bolster its finances amid the market turmoil.

An Executive’s Optimism

Regardless of Goldman’s exposure, by last year, A.I.G. Financial Products’ portfolio of credit default swaps stood at roughly $500 billion. It was generating as much as $250 million a year in income on insurance premiums, Mr. Cassano told investors.

Because it was not an insurance company, A.I.G. Financial Products did not have to report to state insurance regulators. But for the last four years, the London-based unit’s operations, whose trades were routed through Banque A.I.G., a French institution, were reviewed routinely by an American regulator, the Office of Thrift Supervision.

A handful of the agency’s officials were always on the scene at an A.I.G. Financial Products branch office in Connecticut, but it is unclear whether they raised any red flags. Their reports are not made public and a spokeswoman would not provide details.

For his part, Mr. Cassano apparently was not worried that his unit had taken on more than it could handle. In an August 2007 conference call with analysts, he described the credit default swaps as almost a sure thing.

“It is hard to get this message across, but these are very much handpicked,” he assured those on the phone.

Just a few months later, however, the credit crisis deepened. A.I.G. Financial Products began to choke on losses — though they were only on paper.

In the quarter that ended Sept. 30, 2007, A.I.G. recognized a $352 million unrealized loss on the credit default swap portfolio.

Because the London unit was set up as a bank and not an insurer, and because of the way its derivatives contracts were written, it had to put up collateral to its trading partners when the value of the underlying securities they had insured declined. Any obligations that the unit could not pay had to be met by its corporate parent.

So began A.I.G.’s downward spiral as it, its clients, its trading partners and other companies were swept into the drowning pool set in motion by the housing downturn.

Mortgage foreclosures set off questions about the quality of debts across the entire credit spectrum. When the value of other debts sagged, calls for collateral on the securities issued by the credit default swaps sideswiped A.I.G. Financial Products and its legendary, sprawling parent.

Yet throughout much of 2007, the unit maintained that its risk assessments were reliable and its portfolios conservative. Last fall, however, the methods that A.I.G. used to value its derivatives portfolio began to come under fire from trading partners.

In February, A.I.G.’s auditors identified problems in the firm’s swaps accounting. Then, three months ago, regulators and federal prosecutors said they were investigating the insurer’s accounting.

This was not the first time A.I.G. Financial Products had run afoul of authorities. In 2004, without admitting or denying accusations that it helped clients improperly burnish their financial statements, A.I.G. paid $126 million and entered into a deferred prosecution agreement to settle federal civil and criminal investigations.

The settlement was a black mark on A.I.G.’s reputation and, according to analysts, distressed Mr. Greenberg, who still ran the company at the time. Still, as Mr. Cassano later told investors, the case caused A.I.G. to improve its risk management and establish a committee to maintain quality control.

“That’s a committee that I sit on, along with many of the senior managers at A.I.G., and we look at a whole variety of transactions that come in to make sure that they are maintaining the quality that we need to,” Mr. Cassano told them. “And so I think the things that have been put in at our level and the things that have been put in at the parent level will ensure that there won’t be any of those kinds of mistakes again.”

At the end of A.I.G.’s most recent quarter, the London unit’s losses reached $25 billion.

As those losses mounted, and A.I.G.’s once formidable stock price plunged, it became harder for the insurer to survive — imperiling other companies that did business with it and leading it to stun the Federal Reserve gathering two weeks ago with a plea for help.

Mr. Greenberg, who has seen the value of his personal A.I.G. holdings decline by more than $5 billion this year, dumped five million shares late last week. A lawyer for Mr. Greenberg did not return a phone call seeking comment.

For his part, Mr. Cassano has departed from a company that is a far cry from what it was a year ago when he spoke confidently at the analyst conference.

“We’re sitting on a great balance sheet, a strong investment portfolio and a global trading platform where we can take advantage of the market in any variety of places,” he said then. “The question for us is, where in the capital markets can we gain the best opportunity, the best execution for the business acumen that sits in our shop?”

This article has been revised to reflect the following correction:

Correction: September 30, 2008
Because of an editing error, an article on Sunday about the financial problems of American International Group referred incorrectly to the timing and participants at meetings at the New York Federal Reserve between Saturday, Sept. 13, and Monday, Sept. 15. Although there were indeed meetings that weekend, there was also a separate meeting on Monday to discuss financial aid for A.I.G. Lloyd C. Blankfein, the chief executive of Goldman Sachs, was the only Wall Street chief executive who attended the Monday meeting, not the only chief executive who attended weekend meetings. Also, Henry M. Paulson Jr., the Treasury secretary, did not lead or attend the Monday meeting. (Both Mr. Blankfein and Mr. Paulson did attend the weekend meetings.)

Monday, 20 October 2008

Financial Crime of the week: AIG

AIG used credit default swaps to insure the high yielding, subprime mortgages that the banks invested in to get to their profits up. The Basel II rules determine how much capital a bank must have, based on the quality of the bank's loan book - the riskier the loans, the more capital and therefore the less gearing that can be employed.

AIG offered a way around this for a fee, and it was able to do so because its vehicle AIG FP in London was unregulated as an internal finance function (yeah right!), so that no capital at all was required on the swaps. AIG had a AAA credit rating, which was effectively bestowed on the subprime mortgages by the CDS insurance.

Banks were able to tell their regulators that high yielding subprime mortgages were actually AAA assets requiring minimal capital under Basel II, even though AIG was insuring them using no capital itself.

Better still, using mark-to-market accounting, AIG could book a one time profit from the fees on a five year CDS as soon as it was written, subtracting the expected losses from defaults from the up front fee. In other words, whatever a computer said AIG was likely to make on a contract, the accountants could book as immediate, actual profit, and the broker that sold the contract could be paid an immediate bonus.

The FBI is investigating AIG, Fannie Mae, Freddie Mac and Lehmans, and has 1,500 other mortgage-related investigations underway.

State agencies are also busy with mortgage fraud cases and the State of California is suing the mortgage originator, Countrywide Financial, for deception and "unfair competition".

This weekend the US President George W Bush concluded his radio address with these words: "America is the best place in the world to start and run a business, the most attractive destination for investors around the globe, and home to the most talented, enterprising, and creative workers in the world. We're a country where all people have the freedom to realise their potential and chase their dreams. This promise has defined our nation since its founding, this promise will guide us through the challenges we face today, and this promise will continue to define our nation for generations to come."

And some time soon some of the most talented, enterprising and creative workers will be behind bars.

Desperate stuff from the FSA

Watch Hector Sants of the FSA on the Andrew Marr Show, saying the FSA knew
all about the risks in the banks and after the problems arose they had done
a good job of working with the banks to sort out the mess.


Which sort of overlooks the point of bank regulation, which is to ensure
that that bank losses are minimised and banks are not reckless. A good
banker doesn't just lend money in the expectation that if it goes wrong they
can work things out. They lend on the basis that they are only taking
moderate risk and that they are adequately rewarded for the risk. The FSA
should have pulled them up short when they are not doing so.

Sunday, 19 October 2008

The curse of Broadgate?

Is there a curse on the banks and financial traders who used to occupy the Broadgate development in the City of London from 1990?

Consider the tenants:

Various Japanese Banks - long since disappeared.

Williams de Broe - part of BBL, bought by ING, but nearly incsolvent in 2005 and sold for virtually nil in 2006.

Bankers Trust - corporately convicted of fraud, unable to trade and bought by Deutsche bank.

Warburg - merged with UBS.

UBS - Lost $42 billion and currently being bailed out by the Swiss government.

Shearson Lehman - became Lehman Brothers and the rest is history.

Babcock & Brown - share price is 5% of last year's price.

AIG Financial Products - currently bringing down its AAA parent with losses on its unhedged 500 billion CDS book.

HBOS - failed miserably, forced to merge with LLoyds TSB.

RBS - failing miserably, 60% nationalised.

Maybe we should all wear togas

"The budget should be balanced, the Treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt. People must again learn to work, instead of living on public assistance".

Cicero, 55 BC

Saturday, 18 October 2008

Old Crime :RBS's Goodwin in line for £8m bonus

Remember this from 2004:

Fred Goodwin, chief executive of the Royal Bank of Scotland, could qualify for a bonus of up to nine times his salary - more than £8 million - according to Manifest - the proxy voting service.
Under the bank's medium-term bonus scheme, directors can be awarded shares worth up to 150 per cent of their salary plus bonus every year. While bonuses were capped at the basic salary, the 2003 annual report says directors are now eligible for up to twice their salaries 'for exceptional performance, as measured by the achievement of significant objectives'. These are not spelled out.

Manifest said that this means directors could be awarded shares equivalent to four-and-a-half times their basic salary every year. If the bank's performance is in the top 10 per cent of a group of 10 rivals over a three-year period, these awards could be doubled again, bringing the total to 900 per cent of annual salary.

So if they all went bust, but RBS was in the least bust 10%, Goodwin would have got 9 times his salary.

Thursday, 16 October 2008

Financial Crime of the week, and that is saying something these days

This one is from the Swiss National Bank, who have been taken for the biggest ride of all time by UBS, remember them the bank that has already lost I forget how much, was it $42billion? Anyway they are putting $6billion into an SPV and that central bank is funding the rest. Well no bank funds a vehicle with 10% equity unless they can avoid it, so the logical conclusion is that these securities are overvalued if they are transferred in at par and the $6billion is less than the likely losses. Still as the press release states (my italics below): However, it is SNB’s view that these assets are of real value.

My view is that any value is a real value, but some values are lower than others.

Steps to strengthen the Swiss financial system

Swiss National Bank finances transfer of illiquid assets of UBS to a special purpose vehicle

The major Swiss Banks UBS and CS Group today are announcing measures to strengthen their capital base. At the same time, the Swiss National Bank (SNB) establishes the possibility to transfer illiquid assets to a special purpose vehicle (SPV) for orderly liquidation. The SNB has reached agreement with UBS on a long-term financing and orderly liquidation of illiquid securities and other troubled assets in the amount of no more than USD 60 billion. CS Group refrains from making use of such a possibility.

The step taken by the SNB is part of measures of the Swiss Federal Government to strengthen the Swiss financial system. It is based on the SNB's statutory mandate to contribute to the stability of the financial system. The SNB is convinced that it will result in a sustainable reduction of strains in the Swiss financial system. The stabilization thus reached will be favorable for the development of the Swiss economy as a whole and is in the interest of the country.

According to the agreement with the SNB, UBS sells the securities to a special purpose vehicle and provides capital in the maximum amount of USD 6 billion, which will serve as a first protection against losses. The SNB finances the purchase of these assets by granting the SPV a secured long-term loan in an amount not exceeding USD 54 billion and obtains control over the SPV. After full repayment of the loan, the SNB participates in profits generated by the SPV with USD 1 billion up-front and with 50% of eventually remaining equity value. UBS can thus be relieved from all relevant remaining risks stemming from problem-ridden segments of credit markets. As part of these measures, UBS has agreed to strengthen its capital base and to comply with best practices for compensation schemes and policies as determined in consultation with the Federal Banking Commission.

The loan granted by the SNB in an amount not exceeding USD 54 billion will be secured by a security interest perfected in all of the SPV’s assets. The SPV pays interests at the one month USD-Libor-Rate plus 250 basis points. Payments streams from interest payments, repayment of principal, and the sale of assets will be used primarily to repay the SNB loan after coverage of operating expenses. The term of the credit will be 8 years but can be extended to a maximum of 12 years in order to permit an orderly liquidation of the assets. The SNB will have no recourse against UBS for this credit. The SNB's credit is in USD since the assets are primarily denominated in this currency. Initially, the SNB will provide for the necessary currency from the US Federal Reserve through a Dollar-Swiss-Franc swap. Thereafter, the SNB will turn to the market for refinancing. It does not intend to use its currency reserves.

The assets to be purchased by the SPV include mainly debt instruments backed by US- residential and commercial mortgages. Markets for most of these securities have been frozen or are illiquid since the beginning of the financial crisis. However, it is SNB’s view that these assets are of real value. By establishing the SPV, it will be possible to sell them in the medium term or hold them until maturity. The portfolio also includes other US asset backed and auction rate securities as well as European and Asian Bonds. The purchase price will be determined based on the actual book value as well as an opinion of an independent valuation agent with the SPV paying the lower of the two prices per 30 September 2008. SNB will oversee the transfer of the assets to the SPV and their management and liquidation. UBS will serve as an asset manager, but the SNB has the right to appoint a replacement manager at any time.

School Leaving: Qualifications

Michael Gove: To ask the Secretary of State for Children, Schools and Families how many letters he has received from members of the public on the 14 to 19 diplomas in the last three months; and what percentage of those letters have supported the programme. [224564]

Sarah McCarthy-Fry: Over last three months we have received a total of 113 pieces of correspondence in regard to diplomas. Of which four (4.52 per cent.) were specifically in support of the introduction of diplomas. The remaining 109 pieces of correspondence were general inquiries.

Its all this new-fangled mathematics.  In my day 4/113 was less than 4% not greater.

Tuesday, 14 October 2008

That bail-out

I am still mystified by this bank “rescue”.  RBS’s interims (Jun 30) showed they had zillions in book net worth, way above their market value.  The FSA have told the banks that they must have 9% Tier 1 capital – 4% used to be enough with another 4% Tier II generally being acceptable.  Barclays say that with their rights issue they will be over 11%.  That sounds like a lot even before a recession. So what is going on?  Why is there a need for a bail out?  Does the market know that their are undisclosed losses in their banking book (which is not required to be marked to market like their trading book)?  Were they stitched up by the government or is there more bad news on the way?


Monday, 13 October 2008

RBS and the missing £45 billion

So NatWest is now owned by the government. How does a bank with shareholders equity of £61 billion come to have a market cap of only £16 billion? How many unsettleable trades are there?

What about Basel II, VaR etc? As their interim report (June 2008) says:

• Historical data may not provide the best estimate of the joint distribution of risk factor changes in the future and may fail to capture the risk of possible extreme adverse market movements which have not occurred in the historical window used in the calculations.

• VaR using a one-day time horizon does not fully capture the market risk of positions that cannot be liquidated or hedged within one day.

• VaR using a 95% confidence level does not reflect the extent of potential losses beyond that percentile.

I couldn’t have put it better myself.

Friday, 10 October 2008

That Japanese banking crisis in full

Following the problems in the sub-prime lending market in America and the run on banks in the UK, uncertainty has now hit Japan.

In the last week Origami Bank has folded, Sumo Bank has gone belly up and Bonsai Bank announced plans to cut some of its branches. Karaoke Bank has been put up for sale and is likely to go for a song, while in early trading today shares in Kamikaze Bank nose-dived.

Samurai Bank is soldiering on following sharp cutbacks, Ninja Bank is reported to have taken a hit, but remains in the black. In further news, 500 staff have been chopped at Karate Bank and there are reports of something fishy going on at Sushi Bank where unions fear that staff may get a raw deal.

New Financial Terms

BEAR MARKET -- A 6 to 18 month period when the kids get no allowance, the wife gets no jewellery, and the husband gets no sex.

BLUE CHIP – A frozen uncooked vegetable you find at the back of the freezer, your standard fare for the next 12 months.

BROKER -- What my broker has made me.

BULL MARKET -- A random market movement causing an investor to mistake himself for a financial genius.

CASH FLOW -- The movement your money makes as it disappears down the toilet.

CEO -- Chief Embezzlement Officer.

CFO -- Corporate Fraud Officer.

DERIVATIVE – A biscuit often made with a chocolate coating on one side only.

EBIT -- Earnings before irregularities and tampering.

EBITDA -- Earnings before I tricked the dumb auditor.

EQUITY -- A chance to be treated unfairly by bigger shareholders.

ESOP – A collection of fables.

EX DIVIDEND -- Last year's cheque.

EXCEPTIONAL ITEMS – Last year’s accounting magic slightly reworked for this years accounts.

FINANCIAL PLANNER -- A guy whose phone has been disconnected.

GAAP -- The difference between accounting book value and reality.

GEARING -– What you need when you get on your bike to look for your next career move.

HEDGING -- Your next career move.

IFRS -– International Fantasy Reporting Standards.

INSTITUTIONAL INVESTOR -- Past year investor who's now locked up in a nuthouse.

MARK TO MARKET -– Throw away.

MARKET CORRECTION -- The day after you buy stocks.

MOODY -- A Financial Planner who is about to be come an Institutional Investor.

NAV -- Normalized Andersen Valuation

P/E RATIO -- The percentage of investors wetting their pants as the market keeps crashing.

PROFIT -- An archaic word no longer in use.

RIGHTS ISSUE -- The right to buy more of a share that you were trying to sell.

SSAP – Accounting rules for ssuckers.

STANDARD & POOR -- Your life in a nutshell.

STOCK ANALYST -- Idiot who just downgraded your stock.

STOCK SPLIT -- When your ex-wife and her lawyer split your assets equally between themselves.

VALUE INVESTING -- The art of buying low and selling lower.

VAR – Value and run.

WINDFARMS – A collective investment scheme powered by warm air.

WINDOWS -- What you jump out of when you're the sucker who bought Yahoo @ $240 per share.

WINDOWS VISTA -- What you see before you jump.

YAHOO -- What you yell after selling it to some poor sucker for $240 per share.

YIELD – Give up and go home.

It's all Prescott's fault - allegedly


Thursday, 9 October 2008

Follow the Money

The following is a paper published earlier this week by former Sempra Metals economist John Kemp looking in detail at the Fed’s emergency money market operations and its ultimate reliance on Chinese support:

In an underground car park in Washington DC, FBI Deputy Director Mark Felt told the young Washington Post investigative reporter Bob Woodward to “follow the money” in the hunt for the source of the Watergate break-in. The advice remains good today. Tracking the flow of funds through the financial system and across the balance sheets of the Federal Reserve and other banks provides the best way to understand what his happening below the surface.

Even before Congress passed the Emergency Economic Stabilisation Act and approved spending up to $700 billion to purchase mortgage-backed securities from the market in the Troubled Assets Relief Programme (TARP), the Federal Reserve and the United States Treasury were intervening in the market to prop up the banking system in a way that has no precedent in modern history.

By the close of business on Fri Oct 3, the Federal Reserve had already extended various emergency loans to domestic borrowers and foreign central banks totalling more than $600 billion, and the United States Treasury had gone out into the money market to borrow $400 billion and deposit it with the Fed to replenish the central bank’s exhausted balance sheet.

Details of the rescue operation are available in near real-time in two documents published on the internet: The Daily Treasury Statement of Cash and Debt Operations of the United States Treasury published by the US Financial Management Service (FMS), and the tabulation of Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks published weekly by the Federal Reserve System.

These two sources reveal a massive support operation in which the assets and liabilities of the US banking system have been largely merged onto the balance sheet of the Federal Reserve, and the US Treasury has pledged the full faith and credit of the United States to support the central bank. By the end of Oct, the US authorities will have provided more than $1 trillion in support – on top of the $700 billion which Congress has authorised the Treasury to spend buying up impaired mortgage-backed securities.

But even $1 trillion is unlikely to be enough to stabilise the system and end the crisis. The scale of the rescue operation will strain the Fed’s and the Treasury’s resources to the limit, and beyond. Nationalising the debt problem will not make it go away. The United States needs access to a fresh source of funding in order to restore confidence. The only country with sufficient free resources to recapitalise the US banking system is China, with its mountain of foreign exchange reserves.

China’s support is crucial. It could take many forms, and it remains to be seen whether support will be pledged openly (in the form of a loan to the US government, or an operation swapping some of China’s mountain of US Treasury paper for impaired securities) or tacitly (in the form of exchange-rate support, or continued buying of US government bills as the Treasury struggles to roll over its growing debt). But one way or another only China has the resources to stabilise the financial system.

The scale of the Fed’s lending operations is revealed in the weekly Condition Statement, which is similar to the balance sheet of a private firm. In Jul 2007, before the onset of the crisis, the Federal Reserve Bank’s had assets of about $902 billion, mostly held in the form of a huge pile of US Treasury bills and bonds ($790 billion) with a few short-term repo loans to the banking system ($19 billion), some other longer-term loans ($41 billion), gold ($11 billion) and currency ($38 billion) making up the remainder. The Fed’s liabilities consisted of $812 worth of notes and coins in circulation, deposits from its member banks ($18 billion) and one or two other minor items. But the two largest items on the Fed’s balance sheet were the pile of US Treasury bills and notes it owned ($790 billion) and the currency in circulation which it had issued ($812 billion). Lending operations were marginal.

The main reason for owning a large stock of Treasuries was to back the currency issue and provide the Fed with resources to alleviate temporary liquidity shortages arising from lumpiness in tax payments and seasonal swings in credit demand by providing short-term funds through repo operations. More rarely the Fed would undertake reverse repo operations to drain excess funds from the system.

But as the crisis worsened in the autumn and spring, the Fed found itself as almost the only source of liquidity. Officials stepped up the provision of liquidity by vastly increasing the scale of repo operations, by which the Fed credited cash to the borrower’s accounts with the central bank, in return for receiving US Treasury bills to the same amount, and with a pledge that the borrower would buy the securities back within a specified time period, reversing the operation. The volume of funds provided through these temporary repo operations had ballooned from $39 billion in Sep 2007 to $99 billion by Apr 2008.

Temporary repo operations do not have any impact on the Fed’s own stock of Treasury paper. Although the Fed buys Treasuries from the market, the extra paper is not added to its own stock, because there is a legal agreement to sell them back within a specified period of time. The central bank merely holds them as a form of a collateral.

But officials worried the massive volume of funds being provided by these temporary repos would begin to expand the money supply and add to the upward pressure on already-high inflation. So the Fed tried to sterilise the impact of its temporary repos on the money supply by undertaking other offsetting measures to shrink the amount of money in circulation.

While it was borrowing Treasuries from the rest of the banking system through temporary repos designed to add liquidity to the cash markets, the Fed began to sell Treasuries from its own stock back to the banking system on a permanent basis to withdraw a similar amount of liquidity. The aim was to add short-term temporary liquidity but withdraw longer-term permanent liquidity in a similar amount and leave the overall money supply unchanged. The purpose was to insulate the Fed’s provision of liquidity to the banking system in its role as lender of last resort from the Fed’s need to maintain an unchanged federal funds rate at 2.00% and control money supply growth in its monetary policy role.

Between Mar and May 2008, the Fed sold $143 billion worth of Treasuries back to the banking system through permanent open market operations. The result of these and other operations was that the Fed’s own stock of Treasury notes fell -32% from $713 billion in Mar to $482 billion in May. As a result, there was little change in the size of the Fed’s overall balance sheet (with temporary repos and permanent reverse repos offsetting one another) but a marked change in its balance sheet, with a huge drawdown in the volume of Treasury notes owned outright and a big increase in temporary advances to the banks.

But as the crisis worsened and proved more prolonged than expected, temporary repo lending was inadequate. The Fed introduced a raft of new facilities designed to improve the functioning of the market. The Term Auction Facility, introduced in Dec 2007, and repeatedly expanded, provided as much as $150 billion in longer term repo credits with a maturity of 1-3 months. The Fed allowed commercial banks to borrow as much as $40 billion in loans from its Discount Window facility to ease funding shortages, and granted similar access to investment banks and other broker-dealers, lending as much as another $40 billion. It also provided about $29 billion worth of funding to JPMorganChase to support the acquisition of BearStearns.

But the overall impact of the facilities was marginal. Between Aug 2007 and Aug 2008, the size of the Fed’s balance sheet increased marginally from $903 billion to $936 billion. The main effect was to cut the pile of Treasuries which the central bank owned outright from $790 billion to $480 billion and replace them with a variety of other assets in the form of loans and advances.

In a fateful decision in Mar 2008, the Fed announced a new Term Securities Lending Facility (TSLF) through which it would swap Treasuries from its own stock for mortgage-backed and other securities held by the banks. The Fed has always lent out Treasuries from its portfolio to help alleviate shortages of particular maturities in the market, but normally only overnight. The TSLF enabled borrowers to swap Treasuries in much larger volumes and for much longer periods. By Aug 2008, the Fed had $480 billion of Treasuries in its own stock, but it had lent about $120 billion of them to the banks in exchange for lower quality and less liquid credits, leaving only $360 billion actually available.

But as the banking system descended into crisis from mid Sep onwards, the Fed’s lending surged. Discount Window loans for commercial banks soared from an average of $20 in the week ending Sep 10 to $44 billion by the week ending Oct 1. Credits to investment banks and other broker-dealers went from zero to $148 billion. The Fed also announced a new facility to support money market mutual funds unable to roll over asset-backed commercial paper which went from zero to $122 billion in the space of a fortnight. It extended another $53 billion of other loans, and swap arrangements with other central banks had already drawn down an extra $30 billion, with much more to come.

Worse, the volume of Treasury securities lent out via the TSLF and other facilities surged from $118 billion to $256 billion, cutting the volume of Treasuries left in the Fed’s possession and unpledged from $354 billion to just $232 billion, with the balance falling fast.

From the middle of Sep, the Fed dropped its previous insistence on sterilising credit extensions and began to allow its balance to grow significantly. Officials made no attempt to offset the new credits to money market mutual funds, banks, broker-dealers and other central banks. The Fed’s balance sheet, which had been steady at $905-935 billion for a year surged to an average of $983 billion on the week ending Sep 17, $1.189 trillion on the week ending Sep 24, and $1.441 trillion on the week ending Oct 1, and was still growing rapidly. The Fed’s balance sheet has now increased +53% in the space of three weeks.

Some of the new lending is backed by increased deposits from the banking system itself, as banks conserve cash and raise their balances with the Fed itself. Bank deposits with the Fed have soared from an average of $8 billion in the week ending Sep 10 to $167 billion in the week ending Oct 1. But with the Fed’s balance sheet looking increasingly stretched, the US Treasury has been forced to step in and strengthen the central bank by depositing huge volumes of excess funds.

The Treasury normally issues small volumes of “cash management bills” to meet temporary shortfalls in its accounts when demand is unexpectedly heavy or tax receipts are slower than anticipated. The volume of bills issued is not usually more than $70 billion in any one month, and the bills are usually rolled over rapidly into regular bills and notes at the next funding auction. But in the second half of Sep, the Treasury sold an unprecedented $320 billion worth of cash management bills and deposited all the resulting funds into a special “supplementary financing program account” with the Fed. Another $140 billion were issued in the first three days of Oct, taking the total in the supplementary account to $399 billion.

In effect, the Treasury has taken advantage of the panic-driven flight to quality to issue a mountain of very short-dated cash management bills, and deposited the proceeds with the Fed, which has enabled the Fed to grow its own balance sheet and expand its own lending to the banking system. The Treasury is pledging the full faith and credit of the United States to raise funds in the money market on behalf of the banks who cannot, substituting its own AAA-rating for the impaired creditworthiness of the major financial institutions. Because of the sheer volume of “safe haven” flows, the Treasury has been able to issue most of this paper at annual interest rates of just tenths of a percentage point. The Fed has taken a substantial portion of the banking system effectively onto its balance sheet, while the Treasury is now borrowing in the market to support the central bank.

One consequence of this is that it is too simplistic to assume the massive growth in the Fed’s balance will be inflationary (contrary to the views of some commentators). While the has increased the various loans and advances it makes to the market sharply in the last three weeks, this is counterbalanced by the $400-460 billion of over-borrowing undertaken by the US Treasury from the public, which has removed a broadly similar amount of liquidity from the system. So the bailout is not (yet) a clearly inflationary signal (though to the extent it reduces the risks of a severe recession, it reduces the risk of a DE-flationary spiral).

The volume of support from the Fed and the US Treasury is unprecedented. Once the TARP ($700 billion) and the various lending facilities already announced ($1.0-1.5 trillion) are fully implemented, the Fed and the Treasury will be extending credits and other support equivalent to around 15-20% of US GDP (though the actual cost to the taxpayer should be much smaller as most credits and at least some of the securities acquired under TARP should be repaid for what the authorities bought them for).

But the scale of the operations also highlights the limited usefulness of this type of intervention and has fuelled market doubts about its eventual effectiveness, as was evident in yesterday’s renewed plunge in US equity markets.

The Fed itself has basically run out of money. While the Treasury can continue borrowing to support the central bank, the government is already getting close to the debt ceiling. Before the passage of the Emergency Economic Stabilisation Act, Congress had authorised the Treasury to borrow up to $10.615 billion. By the end of last week, the Treasury had already borrowed $10.120 billion, and had just $494 billion worth of unused borrowing authority left. The Stabilisation Act raised the statutory debt limit by a further $700 billion to $11.315 trillion. But that was done to allow the Treasury to raise money to buy up to $700 billion worth of troubled assets under the TARP; it has no effect on the amount of borrowing authority the Treasury has for other programmes.

So the Treasury still has around $494 billion of unused borrowing authority left. That gives it some scope to raise more funding through the sale of cash management bills, but it cannot keep up the current pace of borrowing very much longer. More seriously, it will be using up borrowing authority that it needs for the coming year.

The respected non-partisan Congressional Budget Office (CBO) is already projecting a budget deficit of more than $400 billion in fiscal 2009, and the tax breaks included in the Stabilisation Act to secure its passage second time around by the House of Representatives will increase the deficit further. At the very least, the US Treasury will have to come back to Congress within the next few months and ask for a further substantial rise in the statutory debt limit. Borrowing to support the financial system looks set to crowd out the government’s ability to borrow in order to fund tax cuts and domestic spending programmes, sharpening the budget dilemmas for the incoming administration and Congress next January.

But all this borrowing threatens eventually to undermine the market’s confidence in the financial position of the United States. Of the $10.120 billion of US government debt outstanding at the end of Oct 3, $4.272 trillion had actually been sold to other government entities such as the Social Security and Medicare Trust funds, and was largely an internal accounting transfer. Only $5.914 trillion had actually been placed with the public. The amount of debt placed with the public has already surged +9.5% from $5.401 trillion at the start of Aug and +17.0% from $5.057 trillion at the start of fiscal 2008 in Oct 2007. The $700 billion for the TARP will add even further to the rapidly growing mountain of public debt that has to be sold to the public.

For the time being, the market’s demand for ultra-safe instruments is so huge that the Treasury is having no difficulty placing all the paper it wants at little or no interest. But the cash management bills are all very short term, and the Treasury will soon start having to roll them continuously, or fund them by issuing longer-dated securities, and the longer-dated securities will be much more expensive in terms of interest costs. Funding could become much more difficult once the immediate crisis, and the associated safe-haven flows has passed.

More worryingly, all this borrowing by the US Treasury threatens to crowd out borrowing by the banks and the private sector. I have never really believed in the strict versions of the “crowding out” theory, and the problem is somewhat theoretical at the moment, since the banks and most corporations cannot really borrow from the market at the moment in any event, so the Treasury borrowing is not really crowding them out in any meaningful sense. In fact the Treasury is borrowing into what would otherwise be the vacuum created precisely because others cannot borrow.

But sooner or later, the private sector will need to restore its access to the capital market, and the Treasury’s massively increased public borrowing requirements, up by more than 25% in a year, could start to create problems. Either households and corporations in the United States must be persuaded to save more, and buy more of both government securities and private notes, or foreign investors must be persuaded to increase their holdings of US government paper.

In either event, borrowing costs for both the government and the private sector look set to rise in the medium run, at least in real inflation-adjusted terms. It is notable that the cost of long-term government borrowing through US Treasury bonds has only declined to 3.45% despite the near-collapse of the rest of the financial system, not lower than during some of the troughs of the last recession, when economic conditions were difficult by the financial system was still functioning normally. So for term borrowing, rather than overnight cash, the government’s funding cost is cheap, but not that cheap. Borrowing costs for the private sector have continued to rise even for the highest grade credits. Some of this is due to immense uncertainty about the repayment capability of even high-rated corporations at the moment, and should eventually unwind when the crisis abates. But corporate borrowing costs look set to re-rate upwards in the medium term.

This brings us to the last part of the puzzle: the behaviour of the exchange rate and international capital flows. The current crisis is remarkable because the currency of the country at the centre of the crisis (the US dollar) has strengthened substantially against the currencies of almost all its major trading partners. The dollar’s strengthening is counter-intuitive. It is as if the inhabitants of the building were running towards the seat of the fire rather than away from it after the fire alarm sounded.

The obvious answer is that the currency is benefiting from safe-haven flows, as investors flock to the safety of the US government bond market, and perhaps calculate that the US government’s aggressive stabilisation efforts contrast favourably with the slower and more piecemeal moves in Europe and elsewhere. But while it is easy to see how investors in the United States itself might flock to the apparent safety of the US government bond market, it is less clear why investors in overseas markets would rush to increase their exposure to the country at the very heart of the crisis. The point about running towards the seat of the fire after the alarm has gone off applies.

But at least two factors appear to be supporting the US dollar. US banks and corporations are almost certainly liquidating some of the assets they own overseas and bringing funds home to strengthen their balance sheets and reduce the amount they need to borrow in the short-term. US corporations hold substantial assets overseas, some of them long-term, others short-term funding held in offshore vehicles to minimise tax liabilities.

On Fri Oct 3, the Internal Revenue Service (IRS) relaxed the rules governing how much of these funds corporations can bring back on a temporary basis without having to pay 35% corporate income tax on them. Normally IRS allows corporations to bring funds back from overseas subsidiaries for up to 30 days twice each year. Following Friday’s extension, corporations can bring funds back for up to 60 days, three times per year. The IRS move was explicitly designed to provide some help to corporations experiencing severe funding pressures.

But it is likely corporations were already bringing some funds back, and were liquidating longer-term assets to strengthen the parent company’s financial position, even before the IRS move. Liquidation of overseas portfolios, or borrowing from overseas subsidiaries with surplus cash, is a one-time source of support for the currency, however, and will dry up when the liquidation is completed, or even go into reverse when the borrowing from subsidiaries has to be repaid. So this source of dollar strength could prove to be strictly temporary.

The other source of dollar strength is probably from quiet intervention in the foreign exchange markets by one or more central banks. The final interesting item on the Fed’s Condition Statement is a memorandum item at the bottom of the table which shows the volume of US Treasury securities which the Fed holds as custodian for foreign governments and central banks. The Fed doesn’t own these securities, and it cannot lend them out without authorisation, but it provides a convenient repository for other central banks to hold their US paper, including the People’s Bank of China.

The volume of Treasury securities held in custody by the Federal Reserve Banks for foreign account holders has soared from $732 billion at the end of 2001 to $1.061 trillion at the end of 2003, $1.519 trillion at the end of 2005 and $2.056 trillion at the end of 2007. When foreign central banks buy dollars to prevent their own currencies from appreciating, the proceeds are usually converted into US Treasury bonds, and many of them are held in the Fed’s custody. The Fed’s custody account therefore provides a useful indicator of the volume of foreign exchange intervention, and the surge in custody holdings over recent years is a useful yardstick of the extent to which China, as well as some other countries in Asia and the Middle East running large balance of payments surpluses, have intervened to support the dollar and keep their own currencies from rising too much.

Throughout this year, the level of foreign exchange intervention has been modest. The Fed’s custody holdings have grown by perhaps $10-20 billion per week. But in the most recent week, ending Oct 1, the Fed’s custody holdings surged by almost $44 billion, suggesting heavy intervention by one or more overseas central banks has been supporting the dollar.

The Fed’s custody holdings amount to a staggering $2.466 trillion – of which $1.495 trillion is invested in Treasury securities and another $970 billion is in agency bonds. To put this in perspective, of the $5.850 trillion worth of US Treasury debt which is actually held by the public rather than as an accounting entry in the Social Security and other trust funds, foreign governments hold about 25% of the total in their Fed custody accounts.

Two points follow.

The first is that if the US Treasury is going to issue another $700-1,000 billion of new debt to cover TARP and other credit extensions, finding domestic buyers for all of it may prove difficult, and it will probably need to persuade foreign governments to absorb at least a proportion of the new total. For several years, US legislators have complained vigorously about the volume of foreign exchange intervention by foreign central banks. They have argued that it has kept emerging markets’ exchange rates unusually low and granted an unfair advantage to their exporters, without realising that it has also helped support US government borrowing and kept yields and the whole spectrum of US interest rates lower than they would been otherwise. The recycling of balance of payments from the Middle East and Asia into the US bond market helped finance much of the 2002-2007 expansion, as well as the subprime crisis that ended it. But in the medium term, continued foreign government support for the US bond market will become more important than ever before as the US Treasury tries to borrow its way out of the crisis by replacing impaired bank and mortgage debts with paper newly issued by Uncle Sam.

The second point is that the $2.4 worth of Treasury and agency securities held in custody, including $1.5 trillion worth of Treasury securities, is now very large indeed, especially relative to the Fed’s own rather meagre pool of unlent securities. The Fed has no authority to lend them out without permission of the owning governments and central banks. But it is possible to envisage circumstances in which the Fed could obtain permission to swap those Treasury securities for mortgage-backed and other private securities, while taking on the credit risk itself and guaranteeing the ultimate owners of the foreign reserves against the risk of default. The Fed, and ultimately the US Treasury, would still be liable for the cost of any defaults. But they would not need to issue so many new Treasury bonds to finance the swap programme, and could circumvent the statutory debt ceiling more easily.

The Fed does not divulge the exact owners of the securities in its custody. But by far the world’s largest accumulator of reserves has been China, and the country is widely assumed to own a very large share of the total. China has already expressed some anxiety about its concentration of reserve holdings in dollar-denominated assets and the resulting exchange rate risk. Senior policymakers have repeatedly indicated that they would like to diversify the country’s reserves into other currencies, but the attempt has been frustrated because as the largest holder of dollar reserves China stands to lose the most from any loss of confidence in the currency and consequent devaluation. So while China probably does not want to add to its holdings of dollar assets and its exposure to the United States, the size of its existing holdings, and its need to protect their value, may leave it no choice.

China has other reasons to support the United States. North America and Europe are by far the most important markets for China’s export-dependent economy. China will not avoid a sharp slowdown, and the risk of social instability, in the event of a deep recession in the United States that spreads to Western Europe and Japan. So China’s government has strong reasons of self interest to support the Fed’s and the Treasury’s efforts to stabilise the financial system. Finally, by supporting the United States, China would be playing the role of international lender of last resort, and confirm its emergence as one of the top-tier participants in the world economy and financial system, taking its place alongside the United States, Japan and the eurozone. The gain in prestige would be enormous and it would prove impossible to deny China the right to participate alongside the G7 countries in shaping the future of the financial system.

China’s support for the stabilisation package will be crucial, though what form it will take is unclear. Explicit support via a loan to the US Treasury or swap arrangements using its huge stock of US Treasury securities would probably represent too much of a humiliation for the US authorities. But support could be offered more tacitly in the form of foreign exchange intervention to support the value of the US dollar, especially as the impact of repatriation flows unwinds, and continued support for the government debt market in the form of further purchases of newly issued US Treasury securities is probably essential. Explicitly or tacitly, China’s support is a necessary condition for stabilisation to be a success.

During the 1920s and 1930s, the United States, acting through the Federal Reserve, repeatedly had to support the Bank of England and the Bank of France when periods of tight credit and the outflow of funds threatened to overwhelm their modest balance sheets. The Fed acted, albeit inconsistently, reluctantly and not always reliably, as a sort of international lender of last resort, because it alone had the free reserves, in this case the free gold, to support the other central banks when their own balance sheets came under pressure. Now that China, and to some extent the major oil exporters of the Middle East, have amassed a huge stockpile of US Treasury paper, they alone have the resources to take up the role of international lender of last resort. In one form or another, whether explicitly or tacitly, they will have to support this stabilisation if it is to succeed. They have powerful reasons of self interest to do so, and China’s stock of Treasury bond holdings is so large it has little choice. But as the phrase goes, he who pays the piper names the tune. Just as the Fed’s lending in the 1920s and 1930s bolstered its position in the international financial system relative to London and the centres of Continental Europe, so support for the bailout from China and the rest of Asia will mark a further shift in the financial system’s centre of gravity towards the east.