Let’s hope that Goldman and other financial firms that skirted the edge of the law (and beyond) get what they deserve – or at least some meaningful restrictions on their freedom to socialize their losses.

Goldman’s "Fabulous" Fab’s conflicted love letters

People walk past revolving doors of the Goldman Sachs headquarters in lower Manhattan, April 7, 2010.

Credit: Reuters/Brendan McDermid

NEW YORK/WASHINGTON (Reuters) – Fabrice Tourre and his girlfriend talked like a couple very much in love.

They emailed back and forth about how they wanted to curl up in each other’s arms and how they looked forward to tender moments together. Tourre, a Goldman Sachs bond trader, also wrote in the emails of the impending collapse of the subprime mortgage market and how he was masterminding ways at Goldman to make money from it.

Little did they know that three years later these very personal emails written through Tourre’s Goldman Sachs e-mail account would become part of one of the biggest investigations into the subsequent financial crisis.

In the email exchanges between Tourre and his girlfriend, Marine Serres, Tourre comes off as a young, hotshot trader who foresaw the subprime meltdown while still selling shoddy subprime-backed products so prolifically he could peddle them to "widows and orphans."

But Tourre — the only individual the Securities and Exchange Commission charged in its fraud case against the firm — also seems ethically conflicted.

"Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the U.S. consumer with more efficient ways to leverage and finance himself, so there is a humble, noble and ethical reason for my job amazing how good I am in convincing myself !!!" Tourre said in an e-mail to Serres in January 2007.

That portion of the e-mail reflecting Tourre’s conflicted views on his role in the subprime meltdown immediately followed another part of the e-mail that the SEC released in its complaint earlier this month.

The SEC’s complaint only included Tourre referring to himself as "fabulous Fab" and talking about "standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!"

The SEC left out Tourre’s ethical musings in its complaint.

Goldman Sachs released the Tourre emails over the weekend as it readies for its appearance before a Senate panel on Tuesday. Goldman Sachs Chief Executive Lloyd Blankfein and Tourre are scheduled to testify, along with other former and current executives.

The collection of e-mails also show that Tourre was not the only person at Goldman with confidence the subprime market was doomed.

Daniel Sparks, a former head of the mortgages department at Goldman, is also expected to testify on Tuesday before the Senate Permanent Subcommittee on Investigations.

"According to Sparks, that business is totally dead, and the poor little subprime borrowers will not last so long!!!" Tourre wrote in a March 7, 2007, email to his girlfriend.

Tourre — who refers to Serres at one point as a "super-smart French girl in London" — also tells her about selling to unwitting investors the type of synthetic collateralized debt obligation, or CDO, at the center of the SEC case.

The SEC charges that Tourre and Goldman fraudulently marketed an "Abacus" CDO by hiding vital information from investors, including the role that hedge fund Paulson & Co played in picking mortgage products tied to the CDO. Paulson & Co betted against the CDO.

"Just made it to the country of your favorite clients!!! I’m managed (sic) to sell a few abacus bonds to widow and orphans that I ran into at the airport, apparently these Belgians adore synthetic abs cdo2," Tourre wrote in June 2007.

Earlier in 2007, in an e-mail to a friend, Tourre shares his fears that the product he helped create is crumbling — and he has a sense of humor about it.

"It’s bizarre I have the sensation of coming each day to work and re-living the same agony – a little like a bad dream that repeats itself," Tourre writes. "In sum, I’m trading a product which a month ago was worth $100 and which today is only worth $93 and which on average is losing 25 cents a day …That doesn’t seem like a lot but when you take into account that we buy and sell these things that have nominal amounts that are worth billions, well it adds up to a lot of money."

He added, "When I think that I had some input into the creation of this product (which by the way is a product of pure intellectual masturbation, the type of thing which you invent telling yourself: "Well, what if we created a "thing", which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price?") it sickens the heart to see it shot down in mid-flight… It’s a little like Frankenstein turning against his own inventor "

Tourre, 28 when he wrote the emails, reflects on the strangeness of being so young, yet being in such a critical role with pressures from those above him at the firm to make money.

"… I am now considered a "dinosaur" in this business (at my firm the average longevity of an employee is about 2-3 years!!!) people ask me about career advice. I feel like I’m losing my mind and I’m only 28!!! OK, I’ve decided two more years of work and I’m retiring."

(Reporting by Steve Eder in New York and Karey Wutkowski in Washington; Editing by Bernard Orr)

Barry Ritholz:

The Daily Show just kills it in this piece on Corporate fraud.

If you haven’t seen it, its must viewing.

By giving the big banks every possible bailout with no concern for cost to taxpayers, Geithner, Summers, and Fed Chairman Bernanke, ignited a firestorm of popular anger – much of which got directed toward Obama – and rightfully so.

Volcker, who was initially appointed as Fed Chairman by President Carter but whose real influence came under Reagan, broke the back of the growing inflation of the 1960’s (that doubled prices in that decade) by raising short-term interest rates to unprecedented levels. This was the opposite of the zero-interest rate policy of Bernanke – and the effects on bank profits was opposite also. In the end, though, Volcker came to be regarded by the financial community as a hero.

Volcker has been a strong critic of letting banks get too big to fail and using that status to take risks that imperial financial stability of the world – with the banks reaping the upside and taxpayer and savers bearing all the downsides.

Let’s hope this is just the first round

Financial Regulation

Bank plan highlight’s Volcker’s new clout

Fri Jan 22, 2010 3:35pm EST

Related News

* Volcker had been outspoken on "too big to fail" concern

* Ex-Fed chief consulting about bank plan with lawmakers

By Caren Bohan

WASHINGTON, Jan 22 (Reuters) – When President Barack Obama launched a fight with Wall Street by announcing a new U.S. plan to limit banks’ size, the man standing at his side was former Federal Reserve Chairman Paul Volcker.

Volcker’s new clout on the White House economic team was on full display as the 6-foot-7-inch longtime adviser took the choice spot next to Obama, who named his proposal to restrict bank trading activities "the Volcker Rule."

The 6-foot-1 Obama referred to Volcker as "this tall guy behind me."

U.S. Treasury Secretary Timothy Geithner and senior economic adviser Lawrence Summers — who attended the announcement but at a greater distance from the president — still wield a tremendous amount of power.

Volcker, who commands respect on Wall Street and among both Democrats and Republicans, is seeing a resurgence of his influence after venting frustrations to friends that he had been left out in the cold when it came to economic decision-making at the White House.

The 82-year-old Volcker was one of Obama’s most influential advisers during his 2008 presidential campaign and now chairs a panel of outside economic advisers to the White House.

He had rarely been seen in Washington since the start of the Obama administration and made no secret of a difference in opinion with the White House over how to deal with the problem of "too big to fail" financial firms.

Volcker’s fear, shared by some other economists, is that newly consolidated U.S. banks might engage in reckless behavior on the belief that the government would never allow them to fail because of their sheer size. Such risky activity could put the financial system at risk of another crisis, these economists say.

CLOUT

Asked by the New York Times in October about reports he was losing influence with the Obama White House, Volcker retorted that he "did not have influence to start with."

That made Volcker’s presence at the announcement all the more significant to underscoring Obama’s commitment to push the new regulatory approach that Wall Street appears set to fiercely oppose.

"Volcker being there was huge," said Simon Johnson, a professor at the Massachusetts Institute for Technology and a former chief economist at the International Monetary Fund.

The bank announcement elated many of Obama’s liberal supporters, who have welcomed his tougher rhetoric in recent weeks toward the banking executives he referred to in December as "fat cats."

Geithner and Summers, who worked together at Treasury during the Clinton administration, have been criticized by some liberal supporters of Obama and view them as too cozy with Wall Street.

Legislation in 1999 tearing down the Depression-era Glass-Steagall law separating commercial and investment banking passed under their watch. Obama’s new bank rules would not bring back Glass-Steagall but would revive its spirit.

Volcker, who has been consulting on Capitol Hill about Obama’s bank proposal, could be an asset to the administration in selling the proposal, said Johnson, who shared Volcker’s frustrations that the administration had not moved earlier to limit the size of banks, which get an implicit subsidy in the form of federal deposit insurance.

"Volcker carries a cache that is unparalleled," said Johnson, noting the former central banker’s role in breaking the back of double-digit inflation in the early 1980s — a victory that came despite a huge popular backlash against the economic pain brought on by his interest-rate increases.

RIFT WITH GEITHNER?

In an indication of a possible rift, financial industry sources told Reuters on Thursday of some reservations Geithner had expressed behind the scenes about the new bank plan, which was not included in the original plan on financial regulatory reform that the administration unveiled last June.

Administration officials, while noting the importance of Volcker’s role, insisted the decision to go forward with the plan was unanimous.

Geithner and Summers worked closely with Volcker late last year on it and had largely finalized it by late December. They put the finishing touches on it on Jan. 13.

Aides said Obama personally felt strongly about moving ahead on curbs on the banks, in part because of concerns about risk-taking by banks after they returned to profitability in the wake of the 2008-2009 financial meltdown.

White House officials played down any talk of Geithner and Summers losing influence.

A trademark of Obama’s management style, which was apparent during the deliberations over his Afghanistan strategy, is to encourage the airing of dissenting views and then to work with his advisers to arrive at a consensus.

"He is concerned to make sure that he’s exposed to all points of view," Summers told a small group of reporters in a briefing last week when asked to describe Obama’s decision-making process. "So he wants to hear disagreement with things that he has said or advisers who have different perspectives to share those differing perspectives."

Also emerging as a bigger player in shaping economic policy is Vice President Joseph Biden, who devoted much of his time last year to helping to oversee the $787 billion stimulus program that Obama signed into law last February.

Biden feels "passionately about the same set of problems" of firms becoming too big to fail and helped to shape the proposal on banks, said one White House official.

(Editing by Howard Goller)

There is absolutely no one in the inner circle of Obama’s economic advisors who doesn’t believe fully in that the current financial/corporate, free market economy. There is no one within the administration to tell Obama of the pressing need for fundamental changes in the management and operation of our economy and in the political economy of power. Even Paul Volcker, who is no radical thinker, has apparently been pushed to the sidelines.

When you add to Bernanke to Summers and Geithner, you have a trio seemingly hell-bent on transferring whatever the required amount of wealth from savers and taxpayers to the financial institutions to reinflate them to the bloated size they were before the meltdown. The biggest banks are being made whole while the rest of us are living with our wealth reduced by one-third to one-half, or more for many unlucky enough to buy and mortgage houses at the top of the bubble.

When I read a number of news items last week, my sense of discouragement grew. The biggest investment banks, led by Goldman Sachs, the biggest, baddest, and most successful, are upping bonuses, ramping up speculation, and using all of their political clout (which is massive) to water down the gentle regulatory reforms proposed by Obama.

As a hopeful investor, I was particularly struck by news that Goldman Sachs and Credit Suisse had both mightily expanded their “program trading” activities. Program trading is minute by minute trading in massive quantities, using computers and sophisticated programs to profit from discrepancies in the pricing of securities – and also to profit from inside information and from their abilities to move the market. The numbers are staggering. In the week ended June 19, 2009, 40 percent of all trades on the NY Stock Exchange were program trades. This was an increase from 30 percent the prior week. As Zero Hedge said in reporting these numbers:

Virtually every broker saw their Principal PT operations double week over week: seems like everyone is brokering those ETF trades now. Poor SPY and IWM [popular ETFs] are being mangled 10 ways from Sunday nowadays.

The absolute numbers are equally staggering. Goldman Sachs’ program trades were almost a billion shares in the week, and Credit Suisse’s were half a billion.

With this amount of domination in the market by the investment banks, it makes me wonder what are the odds against me in the market?

The resurgence of the investment banks is not just in the US, but in Europe, too – where governments are equally dedicated to bailing them out. Reuter columnist Paul Taylor wrote on June 24, 2009:

No sooner has the financial system begun to stabilize than Big Finance is reverting to its old ways — aggressive hiring, remuneration on steroids, wriggling out of regulation or threatening to decamp to evade tougher supervision.

These are is not the rantings of some crypto-Marxist City-basher, but the considered view of one of Europe’s most thoughtful financial regulators.

Today’s Der Spiegel has a lengthy article, “A Real Free Lunch” detailing the extent of the transfer of wealth to investment banks in Germany, and their use of the low-interest loans from the central bank to make safe, profitable investments and speculations, rather than to loan to businesses – the ostensible, public justification for the bank bailouts.

The extent to which speculation appears to be driving the markets is indicated by how closely all asset classes –stocks, currencies, and commodities – have been moving together. I’ve noted that there is an almost perfect correlation between the price of the Australian dollar and the S&P 500! This seem completely bizarre.

In the chart below, the blue line is the S&P 500 index. The weekly ups and downs tracked very closely, though the change in the Australian dollar was generally more muted.

The close correlation in prices has been widely noted, and taken by some as a warning sign. A recent article in Bloomberg spelled out:

Cash Best as Record Correlation Hints Herd Collapse (Update3)

By Eric Martin and Michael Tsang

June 29 (Bloomberg) — Investors are moving in lockstep like never before, driving up stocks, commodities and emerging markets and risking a replay of last year, when they all plunged the most since World War II.

The Standard & Poor’s 500 Index, whose increase in the past three months was the steepest in seven decades, is rallying in tandem with benchmark measures for raw materials, developing- country equities and hedge funds. The so-called correlation coefficient that measures how closely markets rise and fall together has reached the highest levels ever, according to data compiled by Bloomberg.

…

The gains [in all markets’ pushed correlations between the indexes to 0.74 this month, based on percentage changes over the past 60 days. That’s the highest in at least five decades, data compiled by Bloomberg show. A reading of 1 means two assets move in tandem, while zero means no relationship.

The correlation never rose above 0.66 before this month.

Gains in U.S. stocks have mirrored those in crude oil as never before, with correlations above 0.7 this month, according to data compiled by Bloomberg.

Full Article

David Rosenberg, of Gluskin Schiff, a Canadian economist whose insights I respect, pointed out the correlation and warned of its implications:

June 4, 2009
Everyone is back in the same trade

• Buy stocks (massive multiple expansion – S&P 500 priced for $75 operating EPS)
• Buy commodities (still long-term bullish but a pullback is definitely overdue)
• Buy non-Treasury bonds (same story as commodities – long-term bullish on corporates, but supply is now coming in droves and being gobbled up – this is NOT the contrarian trade of six-months ago)
• Buy gold (again, in a secular bull phase, but the dollar is not going to zero and being bearish on the greenback has become far too fashionable – especially in the wake of Bill Gross’s latest missive; the Euro is saddled with problems at least as deep as the USD, if not deeper)
• And of course, sell Treasuries (that was a good trade coming off the 2% lows on the 10-year note, but what we just saw crammed into six months, which took 48 months to accomplish in the last bear market in govie bonds, was yields soaring 175bps from the low). Sentiment on government bonds is exceedingly bearish and inflation views have become too extreme for my liking. I believe there is a lack of appreciation from what history tells us about the aftershocks that occur after a cycle that was dominated by a credit collapse and asset deflation, as opposed to a garden-variety inventory-led recession. In five words: economic fragility, lingering deflation pressure.

  Full Report (requires free registration)

What we are seeing is the re-creation of a finance-dominated economy, with the hedge funds and investment banks using easy money to play with our futures. This is not a pretty picture, and it is not one that seems likely to get any better. The central banks, which are creatures of the banks, are calling the tune around the world. Most politicians, even if not in the pay of the banks, appear to see no alternative for “saving the economy” to pumping up credit through the banking system.

I have more reasons for being discouraged, but I’ll save those for another day.

It shows that this is a very unusual downturn, unique in some important respects, but generally not on the same scale as the Great Depression. Still, there are enough unusual aspects to this downturn to make for much greater uncertainty than usual about the future course of the global economy.

Quarterly Update: The Recession in Historical Context

June 5, 2009
Paul Swartz
Analyst, International Economics
pswartz@cfr.org

How does the current economic and financial downturn match up to past contractions? This chart book provides a series of answers, plotting current indicators (in red) against the average of all post–World War II recessions (blue). To facilitate comparison, the data are centered on the beginning of the recession (marked by “0”). The dotted lines represent the most severe and the mildest experiences in past cycles. Because the current downturn is frequently compared to the Great Depression, the appendix plots the current recession against the 1930s.
Leo Tolstoy famously said, “Happy families are all alike. Every unhappy family is unhappy in its own way.” So it is with downturns. Unlike most postwar recessions, this one stemmed from an asset market correction that destroyed savings and froze the credit system. The result has been more severe than a typical recession, as these charts show.
Four things to look for in this update:
•
Financial markets have dramatically improved, but from an extremely low base. Rather than pricing in disaster, they anticipate tough times ahead. For example, the charts on the spread for AAA and BAA bonds show the credit market moving from unprecedented panic to a level of fear that is merely in keeping with the worst experiences since 1945.
•
Real economy indicators show signs of stabilization. See in particular the charts on manufacturing sentiment, nonfarm payrolls, oil prices, and car sales. Nonetheless, many of these indicators remain worse than anything hitherto experienced in the postwar period.
•
The collapse in the federal government’s finances is unprecedented, raising questions about how the government deficit will be brought under control.
•
By most measures, the current recession is far milder than the Great Depression. But the appendix shows that house prices have recently fallen much more sharply than in the 1930s.

The following post from his blog today is on a timely subject, gives a flavor of his book, and cogently identifies a fundamental problem in corporate America today – but unfortunately with no sense of how this problem is going to be addressed. The current administration does not appear to have a clue or a will to tackle the fundamental failures of corporate America that are at the heart of our country’s decline. We are in dark days in America.

Compensation Is the Symptom, Not the Problem

 By Barry Ritholtz – June 11th, 2009, 10:55AM

Over the past few days, the compensation issue of senior execs art big finance firms has been front page news. The Obama administration is even appointing a “Comp Tzar.”

I find it amazing that at this late stage of the bailouts, how so few people — still — see the full picture. A perfect example of that is the focus (even obsession) on compensation. This is focusing on the symptom of an unhealthy6 corporate system, and not the underlying disease.

The true problem underlying the comp issue is corporate governance, and the way the Boards of Directors fail to represent the interests of shareholders. The way they systemically engage in the worst form of crony capitalism, transferring wealth from shareholders they are charged with representing to the senior management they are cronies with.

Yet another excerpt from Bailout Nation:

“We’ve come a long way from the days when the man atop the organizational chart made 40 times what the person on the lowest rung earned. Over the past few decades, executive compensation
has exploded, with some CEOs taking 200, 300, even 400 times the base pay at the company.

With so much of this compensation made via options-based incentives, the bosses had every reason to swing for the fences. The upside was all theirs, and the downside was the shareholders’—and taxpayers’.

But don’t for a moment think their terrible track record had a negative impact on their compensation. Despite their performance, these CEOs were paid as if they were enormous successes. The compensation figures that follow are enormous; that they were paid for such abject failure is a national embarrassment.

It is also an indictment of three major corporate governance issues that have not been discussed widely enough. The first is the crony capitalism that was rife in boardrooms across the United States. The cronyism of major corporate boards, especially those in the finance area, has become legendary. Rubber-stamp directors who rarely buck the chairman or challenge the CEO are unfortunately all too common. These boards did not serve either their companies or their shareholders well.

Also enabling this festival of greed are the large institutions that held the companies’ stock, most especially the big mutual funds that have been AWOL when it comes to policing the senior management. They have the time, expertise, and incentives to do so; it is beyond the capability of individual shareholders. Besides, it makes no economic sense for someone who owns 100 or 1,000 shares of stock to act as overseer and scold to corporate boards. But it was squarely in the interest of owners of 10 million shares and up to do so. Why the mutual fund complexes failed to protect their shareholders is hard to fathom. Perhaps when it comes to the finance sector, they feared missing out on syndicate deals and hot IPOs if they asked too many questions.

Then there are the so-called compensation consultants. They did a horrific disservice to the shareholders as well as the companies. The role of these primarily ethicless weasels was to give cover for these ridiculous compensation packages. I would love to see a review of the packages as written back then. If the compensation experts were members of an actual profession with standards and ethics, they would be drummed out of that profession. Instead, these people were merely tools used by the C-level execs to transfer vast sums of wealth from the shareholders to themselves.

What is Going On?

I’ve been expecting the end of the stock market rally for quite a while, but nothing has been capable of changing the upward trend. Technical signals that it is “overbought” (meaning it has gone up too far, too fast compared to historical norms) and fundamental analysis showing it is “overvalued” relative to historical norms seem to have no effect on the market. Marc Faber has been calling for a correction for several months and says he has “taken some money off the table” and shorted the S&P to hedge his long positions in Asian stocks. Still the market keeps going up. What is going on?

My own view is that the desperate efforts of the central banks around the world to counteract the financial implosion have pushed so much money into the financial system that they’ve recreated another liquidity bubble – too much cash and credit looking for a home. Just as the previous credit bubble caused massive inflation in values of real assets such as houses, commodities, land, and stocks, the current money inflation by the Federal Reserve and other central banks has been”successful” in restoring the conditions for asset-inflation. The market seems to be being driven by the same dynamic that caused the peak in stock prices and commodities in 2007 – but this time absent the underlying expansion of the real economy that provided some plausible rationale for the inflating prices. This time, we seem to be in a pure speculation binge.

I confess that I have been unable to resist following some of the crowd into investments in commodities and betting against the dollar by buying foreign currencies. These have been profitable at a rate that makes no sense, and so I am more fearful than ever of a sharp reversal – and am poised to run.

David Rosenberg, Chief Economist for Gluskin Sheff and Associates summarizes the situation succinctly. His point is that when everyone climbs into the same trades, at some point there is no one left outside to keep them moving upward. When they begin to fall and people begin to jump ship, the dynamic can quickly swing the other way. What is keeping it afloat now seems to be the excessive liquidity pumped into the system and the now conventional idea that inflation will be the big next economic event. I have emphasized his caution about this view.

Market & Data Musings
Brunch with Dave

Read full article (PDF, 315KB) [requires free registration]

June 4, 2009
Everyone is back in the same trade

• Buy stocks (massive multiple expansion – S&P 500 priced for $75 operating EPS)
• Buy commodities (still long-term bullish but a pullback is definitely overdue)
• Buy non-Treasury bonds (same story as commodities – long-term bullish on corporates, but supply is now coming in droves and being gobbled up – this is NOT the contrarian trade of six-months ago)
• Buy gold (again, in a secular bull phase, but the dollar is not going to zero and being bearish on the greenback has become far too fashionable – especially in the wake of Bill Gross’s latest missive; the Euro is saddled with problems at least as deep as the USD, if not deeper)
• And of course, sell Treasuries (that was a good trade coming off the 2% lows on the 10-year note, but what we just saw crammed into six months, which took 48 months to accomplish in the last bear market in govie bonds, was yields soaring 175bps from the low). Sentiment on government bonds is exceedingly bearish and inflation views have become too extreme for my liking. I believe there is a lack of appreciation from what history tells us about the aftershocks that occur after a cycle that was dominated by a credit collapse and asset deflation, as opposed to a garden-variety inventory-led recession. In five words: economic fragility, lingering deflation pressure.

You may access the full text of the Research Report by clicking on the link above.

The focus on US deficits was given a big boost by the news that Moodys downgraded the debt of England. Who would have thought that England, once the financial center of the world and still one of the largest financial centers, would have come to this state? Even more surprising to many is the increasing perception of the possibility that US government debt will be downgraded from the world’s most secure to a lesser status. The news of Britain’s downgrade also caused a sharp fall in the price of US treasuries, because people judged that what happened in England could happen here. Bill Gross of PIMCO (the largest bond company in the world) said that this is not unthinkable (which means it is thinkable).

I recently posted an article on the negative for Britain of the dominance of the financial sector there, arguing that the parallels with the US are all too great. One of the parallels is the massive deficit that both countries are incurring in trying to keep their financial sectors and the economy afloat in a world that imploded as a consequence of financial excesses.

John Mauldin has an insightful, very detailed review of the magnitudes of coming US deficits, their likely consequence for interest rates and bond prices, and of his own gloomy thoughts on the implications for the future non-prosperity in the US. Below are some selected quotes with a link to the full article.

John Mauldin at frontlinethoughts.com, 5/23/2009

A Trillion Dollars as Far as the Eye Can See

As of this week, total US debt is $11.3 trillion and rising rapidly. The Obama Administration projects that to rise another $1.85 trillion in 2009 (13% of GDP) and yet another $1.4 trillion in 2010. The Congressional Budget Office projects almost $10 trillion in additional debt from 2010 through 2019. Just last January the 2009 deficit was estimated at "only" $1.2 trillion. Things have gone downhill fast. …

The Global Recession Gets Worse

Let’s take a quick trip around the world. In the first quarter, the German economy fell by 14%, Japan by 15%, Mexico by 21%, and England was down almost 8%.

Global trade is simply collapsing. The chart below is the ugliest it has ever been. Chinese exports are down 41%, Japanese exports down 38%, Germany’s down by 32%, and so on. (chart courtesy of www.variantperception.com )

…

European banks are in far worse shape than their US counterparts. That is because they utilize far more leverage, on an average about 30 times leverage. How can that be, in what is supposed to be a conservative industry?

"European banks were only restricted on the basis of risk-weighted assets, unlike the US where it is the total leverage ratio that matters, so most European banks bought assets that were rated by Moody’s and S&P, who couldn’t rate their way out of a paper bag, and for anything that wasn’t highly rated, they bought credit default swaps or guarantees from AIG and MBIA. Because of that European banks were able to lever up a lot more than their US counterparties. Given the much higher leverage levels and general worsening of collateral values, we think that all the shoes in Europe have not dropped."

European banks have assets of about 330% of their GDP, compared to US banking assets, which are about 50%. They have over $700 billion in loans to Asian businesses (which are watching their exports collapse) and $1.3 trillion in loans to Eastern Europe, which is in a very serious recession, and so many of those loans are simply not going to be worth anything. Simply put, there is going to be a need for massive amounts of money to bail out European banks, or we’ll watch their economies simply implode. …

Governments around the world are responding to the global recession by running massive deficits. In addition to the US, the UK, Japan, Russia, Spain, and Ireland are all running deficits of over 10%.

And, as in the case of the US, these are not going to be one-time deficits. The IMF predicts that England will shrink again next year and the recovery in the US will be modest at best. The US economy is expected to grow by 0.2% (far from the optimistic projections of various US government agencies), the 16-nation eurozone will eke out a modest gain of 0.1%, and the Group of Seven (G7) leading industrial economies will, as a whole, only grow by 0.2 percent. They project that Japan’s economy will stagnate next year.

Where Will the Money Come From?

And now let’s look at what is bumping in my worry closet. The world is going to have to fund multiple trillions in debt over the next several years. Pick a number. I think $5 trillion sounds about right. $3 trillion is in the cards for the US alone, if current projections are right.

Just exactly where is that money going to come from? The US trade deficit is now down to under $350 billion a year. The Fed can monetize a trillion. Maybe. Look at the yield curve on US government debt below (Bloomberg). US savings are going to go up, but where is the incentive to buy ten-year debt at 3.5%? Four-year debt under 2% doesn’t do much for your savings growth. Even with monetization and the Chinese buying our debt with the dollars we send them, that still leaves the bond market about $1.5 trillion short, give or take $100 billion.

The world is deleveraging. Debt is being drawn down. Securitization of various types of debt has seriously slowed. Banks are cutting back on lending. Home prices are dropping all over the world. Commercial real estate is rolling over, and banks all over the world are exposed. "Recession turns malls into ghost towns" is the headline in today’s Wall Street Journal. Personal savings are rising and retail sales are flat to down. Unemployment is rising.

All this should be massively deflationary. Interest rates should be falling or at least not rising. But a funny thing is happening. In the past two months, the yield on the ten-year bond has risen by 1%. It has moved 0.38% or almost "4 big handles" in just two weeks. Look at the chart below. What is happening?

According to Merrill Lynch, the size of the world bond market is estimated to be approximately $67 trillion, with the shares of US, Euroland, and Japanese securities each representing less than 50 percent of this total. (PIMCO)

England has been put on negative watch for its debt rating. Bill Gross said yesterday that it is not unthinkable that the US could lose its AAA rating. I think the bond market is looking at the mountain of debt that will have to be somehow sold and wondering where such a colossal sum will come from. Where do you find $10 trillion in the next ten years for US debt?

And that is just for US government debt. $5 trillion for new global debt in the next two years? In a deleveraged world? How much will the other countries need? What about money needed for businesses and mortgages and credit cards and so on?

If you add $10 trillion to the current $11.3 trillion (including Social Security trust funds, etc.), that totals $21 trillion in 2019. Let’s be generous and suggest that interest rates will only be an average of 5%. That would be an interest-rate expense of over $1 trillion. That is 25% of projected revenues and 20% of expected expenses. And that assumes you have nominal growth of over 4% for the next ten years. If growth is less, tax revenues will be less. It also assumes massive tax increases from carbon credits.

…

Long before we get to 2015, let alone 2019, I think the bond markets will have called a halt to $1 trillion deficits. There will be a real crisis. The deficits will not be funded at anywhere close to an interest rate that will not break the budget. Taxes will get raised beyond what they were in the Clinton years. And Obama’s budget makes some very optimistic judgments about how much will be saved in medical costs, as if no one has tried to rein in medical costs before. The crisis may come much sooner if his universal health-care bill is passed as proposed without offsetting cuts somewhere else.

Watch the bond market. Rates should be going down, not up. The bond market is telling us the deficit simply can’t be financed down the road. Now, maybe a few cool heads in the Democratic Party will prevail in the US Senate and the deficits will be brought under control. (The Republicans have so far seemed as clueless as they are impotent.) We could (theoretically) run $400 billion deficits for a very long time, as GDP would be growing somewhat faster.

It would be best to run budget surpluses, but the game does not end if there are reasonable deficits. It ends with deficits that cannot be funded except by monetization. And that will tank the dollar, except against all the other countries that are monetizing their debt.

I am increasingly inclined to think that as the world comes out of its current malaise – and it will – US investors should think more globally with their investment portfolios. That is something we will explore over the coming year. But that’s enough for today.

Full Article

In a wide-ranging interview recorded by Bloomberg Television, Mr. Faber touched on a wide variety of subjects. Below is a link to the audio. Note that although the headline emphasizes the downside of his remarks, it is out of context. In context, he says the correction would be a prelude to a further rally.

Play audio

This is a major shift in outlook from a person who has an admirable track record.

Martin Wolf, a columnist for the Financial Times, writes about the costs to Britain of its politically dominant financial sector. All that he says is applicable to our country. Read it and weep.

Why Britain has to curb finance

By Martin Wolf

Published: May 21 2009 19:44 | Last updated: May 21 2009 19:44

The UK has a strategic nightmare: it has a strong comparative advantage in the world’s most irresponsible industry. So now, in the wake of the biggest financial crisis since the 1930s, the UK must ask itself a painful question: how should the country manage the cuckoo sitting in its nest?

The question is inescapable. London is one of the world’s two most important centres of global finance. Its regulators have, as a result, an influence on the world economy out of proportion to the country’s size. In the years leading up to the crisis, that influence was surely malign: the “light touch” approach led the way in a regulatory race to the bottom.

EDITOR’S CHOICE

Martin Wolf: This crisis is a moment, but may not be a defining one – May-19

Martin Wolf: Why Obama’s conservatism may not prove good enough – May-12

The fiscal costs of this crisis will be comparable to those of a big war. Thursday’s threatened downgrade by Standard & Poor’s is a reminder of those costs. Loss of jobs and incomes will also scar the lives of hundreds of millions of people around the world.

All this occurred, in part, because institutions replete with highly qualified and highly rewarded people were unable or unwilling to manage risk responsibly. The UK, as a country, the City of London and the broader financial industry bear much responsibility for this calamity. This is a time for self-examination.

A recent report on the future of UK international financial services, produced by a group co-chaired by Sir Win Bischoff, former chairman of Citigroup, and Alistair Darling, chancellor of the exchequer, fails to provide such self-examination. This is partly because the committee consisted of the industry’s “great and good”. It is far more because Mr Darling had already decided that “financial services are critical to the UK’s future”. Thus, the report’s remit was “to examine the competitiveness of financial services globally and to develop a framework on which to base policy and initiatives to keep UK financial services competitive”.

If you ask the wrong question, you will get the wrong answer. The right question is, instead, this: what framework is needed to ensure that the operation of the financial sector is compatible with the long-run health of the UK and world economies?

Quite simply, the sector imposes massive negative externalities (or costs) on bystanders. Thus, the recommendation “that the financial sector be allowed to recalibrate its activities according to the sentiments and demands of the market” is wrong. A market works well if, and only if, decision-makers confront the consequences of their decisions. This is not – and probably cannot be – the case in finance: certainly, people now sit on fortunes earned in activities that have led to unprecedented rescues and the worst recession since the 1930s. Given this, the industry has become too big. If implicit and explicit guarantees and externalities, including volatility, were fully charged, the sector would surely shrink.

So how should one manage a sector that produces such “bads”? The answer is: in the same way as any polluting activity. One taxes it. At this point, the authors of the report will surely ask: “How can you suggest taxing a sector so vital to the UK economy?” The answer is: easily. Financial services generate only 8 per cent of gross domestic product. They are more important for taxation and the balance of payments. But this tax revenue turns out to be perilously volatile. True, in 2007, the last year before the crisis, the UK ran a trade surplus of £37bn in financial services, partially offsetting an £89bn deficit in goods. But smaller net earnings from financial services would have generated a lower real exchange rate and more earnings elsewhere. Given the costs imposed by the financial sector, a more diversified economy would have been healthier. Such sacrilegious ideas are, of course, not to be found in the Bischoff report.

How then should the UK approach policy towards the sector? I would suggest the following guiding ideas.

First, the UK needs to make global regulation work. It should discourage regulatory arbitrage even if it expects to gain in the short run.

Second, it must, in particular, help ensure that owners and managers of financial institutions internalise most of the costs of their actions.

Third, it must reject egregious special pleading from the industry. The sector argues that moving derivatives trading on to exchanges might damage innovation. So what? Maximising innovation is a crazy objective. As in pharmaceuticals, a trade-off exists between innovation and safety. If institutions threaten to take trading activities offshore, banking licenses should be revoked.

Fourth, while trying to create a stable and favourable environment for business activities, the UK should try to diversify the economy away from finance, not reinforce its overly strong comparative advantage within it.

Fifth, UK authorities need to ensure that the risks run by institutions they guarantee fall within the financial and regulatory capacity of the British state. They should not let the country be exposed to the risks created by inadequately supported and under-regulated foreign institutions. At the very least, they should not undermine other governments’ efforts to regulate their own institutions.

The “old normal” was simply unsustainable. The “new normal” must be very different. It is far from clear that the industry and government recognise this grim truth.

Write to martin.wolf@ft.com
More columns at www.ft.com/martinwolf

Copyright The Financial Times Limited 2009