Sitting here in Limbo
Waiting for the tide to turn.
Yeah, now, sitting here in Limbo,
So many things I’ve got to learn.
Meanwhile, they’re putting up a resistance,
But I know that my faith will lead me on.

– Jimmy Cliff

And then the harder they come, the harder they fall, one and all!

Whither the GSEs?  A year and a half into their conservatorship, nobody knows – and we could easily wait another whole year with no progress.  As reported in the Washington Post:

The federal government has spent the past half year seeking to roll back its emergency efforts at propping up the financial markets – with the notable exception of its involvement in mortgage giants Fannie Mae and Freddie Mac.

Taking over Fannie Mae and Freddie Mac wasn’t about propping up the financial markets, but rather keeping upright the housing markets.

Houses, not banks

As recently as December, the Obama administration said it expected to release a preliminary report on how to remake Fannie Mae and Freddie Mac around Feb. 1.

The best laid schemes of mice and Administrations gang aft agley.

But no plan was produced, and in response to questions from lawmakers, Treasury Secretary Timothy F. Geithner clarified last month that it would be another year before the government proposes how to restructure the firms.

That’s for me not to know and for you to speculate about, isn’t it?

Sixteen months after they were seized to prevent their collapse, the companies remain wards of the state –

Regarding the GSEs’ continued limbo, I’m of two minds:

1. Don’t risk open-heart surgery.  The GSEs are a lifeblood of the American housing finance system – and hence of the global capital markets.  Tinkering with them now risks a disruption we simply cannot afford.

Don’t tug on that … you never know what it might be attached to

2. Doing nothing is unacceptable too.  Because the GSEs are so important, they cannot be left with no hand at the strategic tiller.  The GSEs should be part of the solution, not simply a metronome ticking away on momentum.

Further, lack of management isn’t just bad strategy, it’s bad governance, and dangerous:

– running a tab that has now exceeded $125 billion in what has become the single costliest component of the federal bailout for the financial system.

Lack of transparency means lack of practical oversight … and we know how well opacity worked for them before, don’t we?

It looked really good until it failed miserably

Some members of Congress have complained that the huge public commitment is unsustainable.

It is – and without transparent reporting, we have no way of knowing whether the GSEs are rebuilding their balance sheets and net equity or continuing to run up losses not of their past executives’ making.

But the administration has been reluctant to start reforming Fannie Mae and Freddie Mac, officials and analysts say, because the firms in their current form play an essential role in supporting the housing market at a time when it is still under severe stress.

Absolutely, categorically true – we cannot allow the housing market’s financial heart to stop pumping liquidity.  Even if it’s artificial.

Don’t worry, your Federal government is at th econtrols

As other financial firms have exited the market and credit has seized up, Fannie and Freddie have been behind the vast majority of mortgages made since the start of the financial crisis. The companies now own or back more than half of all U.S. home loans.

With FHA right behind, and itself weakening.

Moreover, the companies are helping the administration pursue policies designed to make new homes more affordable, ease the burden on struggling borrowers and direct funding to parts of the country especially hard hit by the downturn.

Allow us to be crystal clear here – by continuing to supply liquidity, and to “ease the burden on struggling homeowners” [translation: forbear – Ed.], the Administration is almost certainly increasing Fannie Mae’s and Freddie Mac’s losses. 

A rising tide lifts all boats?

Their bet is simply that the gains to others (e.g. homeowners, other banks, securities holders) and the macroeconomic benefits (lower interest rates, support for employment) outweigh the costs. 

Any initiative to remake the firms could distract energy from these programs or, in some cases, put an end to them.

By their actions, Fannie and Freddie are taking a concentration of the pain that would otherwise be diffused throughout the economy. 

The companies have also been tapped by the Treasury Department to rewrite the terms of home loans for struggling borrowers facing foreclosure. But this program – carried out by Fannie, Freddie and other firms – has had less success. Although 1.3 million borrowers have been eligible, only about one-tenth have had permanent mortgage modifications.

Many of those eligible are under water in all scenarios; most of them should never have been homeowners in the first place.

And keeping the companies solvent has been costly. To cover their losses, the firms have both said they will need additional federal money beyond the more than $125 billion already committed.

As a taxpayer, I think and hope their strategy has been right for the country – I’m willing to pay more if it serves to strengthen the economy.  Were I a director of either institution, I’d want explicit exculpation from breach-of-fiduciary-duty claims.

Yes, something like that

Nor is the administration eager to foster a debate over Fannie Mae and Freddie Mac in an election year, according to analysts and lawmakers.

As a policy wonk, I had overlooked this.  Yes, raising the GSEs’ future now has to be a net loser for the Administration.  With all their current political tribulations and pitched battles on Capitol Hill, the Democrats can ill afford to open another political front.

The pair have long been lightning rods for criticism by many Republicans, who call them [1] an intrusion into the free market and [2] a Democratic patronage haven.

Yes on [1], probably No on [2].  Democrats and urbanists like housing subsidies more than Republicans do, so the leadership of Fannie and Freddie probably veers toward the liberal. 

Many Democrats, even as they faulted companies’ excesses, have defended the firms’ role in fostering homeownership.

Well, if the GSEs haven’t done that, why did we give them all those awfully big advantages?

And with Obama’s campaign to overhaul financial regulation facing resistance on Capitol Hill, administration officials don’t want to add another divisive issue to the mix.

Especially if the Administration is unsure what it wants to do.

“We’ve obviously had our hands full, as has the Congress,” said Michael Barr, assistant Treasury secretary for financial institutions. “We’re just beginning to see some positive signs in the housing market, but we’re not out of the woods yet and so we want to be careful to be sure that we had an appropriate, paced process.”

There’s a Barr in them financial woods

Barr said Treasury officials have been meeting informally with their counterparts at the White House and the Department of Housing and Urban Development and exchanging policy papers to develop principles for overhauling Fannie Mae and Freddie Mac.

All well and good – maybe it starts to coalesce a thought cloud – but a far cry from actual progress, particularly as the Republicans will weigh in strongly before anything happens.

These principles include, for instance, that the government ensure borrowers could still get mortgages even when the private market is no longer offering loans.

A laudable principle if the reason the private market isn’t lending relates to a credit crunch.  But if the private sector is sensibly pulling back from risk, and the GSEs zag when they should have zigged, we will be much worse off.

You are here …

But whatever replaces Fannie and Freddie, it should not be allowed to grow so large that its failure could threaten the financial system.

Oh, brilliant …

“And that’s how there’ll never be any financial crisis ever again.”

“Great, Jackie.”

“They weren’t planning to do much about it,” said Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, in an interview. “They’re busy, and it’s hard and it’s complicated and they’re trying to put it off.”

So the Administration, understandably, put GSE reform into the too-hard-revisit-later basket.

Where did I file it?

Frank said he is “forcing” the issue by scheduling a committee hearing later this month, summoning Geithner and other officials to discuss options for reforming the firms.

A hearing, useful though it may be, will not force the issue, but at least it will raise the issue.

Once among their strongest supporters, Frank has more recently called for their abolishment.

As independent entities, that is. 

“Independence may be overrated”

Future scenarios for reforming Fannie Mae and Freddie Mac range widely – from total privatization to total nationalization. But no consensus has emerged over the best fix.

Nor will it any time soon.  This is guaranteed to be divisive. 

Spokesmen for Fannie Mae and Freddie Mac said their current focus is on keeping funds flowing into the mortgage market and helping distressed borrowers remain in their homes.

As it should be.

The companies did not address the question of how they should be restructured.

In view of their obvious self-interest, nothing would be gained by the GSEs’ management vocalizing about their future.  They will be keeping their heads down.

When the Bush administration seized the firms, it said it would make $200 billion available to them. The Obama administration a year ago doubled that figure, then decided late last year to offer them unlimited financial assistance as a signal to investors that the companies’ solvency was guaranteed.

But critics warn this has given Fannie Mae and Freddie Mac a blank check.

That is the problem.  They do have a blank check.

Fill in the zeroes later

“This idea of having money laying around that they can spend on whatever they think politically makes sense is certainly consistent with what we’ve seen from this administration,” said Rep. Jim Jordan (R-Ohio), a member of the House Oversight and Government Reform Committee who has called for an investigation into the delay in planning for the companies’ future.  

True enough, but there are good reasons for caution.

“Any suggestion now about future changes could destabilize the market,” said Karen Shaw Petrou, managing director of analysis firm Federal Financial Analytics and a longtime observer of housing finance policy. “The U.S. mortgage market is so fragile that all Treasury needs to say is ‘boo’ and it could fall apart.”

But time could be tight. Under the firms’ agreement with the Treasury Department, they must shrink their mortgage portfolios every year, eroding their ability to support the market.

That is, unless the rules get changed … yet again.

I’m smiling outside, and crying inside

James Lockhart, a former top regulator of Fannie Mae and Freddie Mac, said the administration is erring by waiting another year to begin the reform process.

“The clock is ticking. We need to reinvigorate the private mortgage market and create something new and we know how long Congress takes,” Lockhart said. “It’s unhealthy to have as much government involvement in the mortgage market as we have in this country.”

He’s right, of course, but limbo is no state for us to be in.

Could be dangerous

Sitting here in Limbo

Waiting for the dice to roll.
Yeah, now, sitting here in Limbo,
Still got some time to search my soul.
Meanwhile, they’re putting up a resistance,
But I know that my faith will lead me on.

– Jimmy Cliff

I said forgive them, Lord, they know not what they done

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Proving that America has no monopoly on good ideas, the impending collapse of Greek finances is revealing, strand by strand, that whatever shenanigans and subterfuges might have been pioneered by the Enrons of this world, the sovereign nations of Europe will have perfected and taken to scale.  As reported in the Wall Street Journal (Arial):

Proving the capital markets know more than governments do: Greece has big default spreads

Concerns that Greece and other struggling European nations may not be able to repay their debts are focusing investor attention on another big worry: Economies across the Continent have used complex financial transactions—sometimes in secret—to hide the true size of their debts and deficits.

Actually, nearly always in secret, as we shall see.

Investors long turned a blind eye to European governments’ aggressive bookkeeping, aimed at meeting the euro zone’s fiscal ceilings. Countries using the euro currency have a rich history of exotic maneuvers aimed at meeting rules requiring members to cap debt levels at 60% of their gross domestic product and their annual budget deficits to no more than 3%.

‘Meeting’ is a euphemism for ‘avoiding while giving lip service to.’

Blow in my phone and I’ll borrow you anywhere

Despite criticism, European leaders deemed many of these moves acceptable as they sought the long-planned currency union.

While efforts will now be made to blame Wall Street or City of London bankers for taking these bets, you can’t cheat an honest man:

As my dear old grandfather Litvak said (just before they swung the trap), he said:

You can’t cheat an honest man.

Never give a sucker an even break

Or smarten up a chump.

By Larsen E. Whipsnade

Nobody made Greece do these trades, the Greeks were trying to get away with skullduggery.  Whose fault is it that the money was lost – the bookie who took the bet, or the punter who wanted to put it down?

To try to meet the targets, which were aimed at building trust in the stability of the euro, governments over the years have:

Translation: To build trust, we had to bamboozle you.  Doing what we promised would have been too hard.

Sold state assets

Bundled expected future payments into securities to hawk

Even, in the case of Greece, insisted to the Eurostat statistics authority that large portions of its military spending were “confidential” and thus excluded from deficit calculations.

I can’t see you, therefore I’m invisible!

I’m invisible – see?

In 2000, Greece reported that it spent €828 million ($1.13 billion) on the military—about a fourth of the €3.17 billion it later said it spent.

“I lied.”

Greece admitted to underreporting military spending by €8.7 billion between 1997 and 2003.

A billion here, a billion there, soon you’re talking about real money.

A man who spent so many billions they’ve named a Senate office building for him: Dirksen

Portugal classified subsidies to the Lisbon subway and other state enterprises as equity purchases.

Hey, if I spend it on myself, isn’t an investment, isn’t it?

After learning that, Eurostat made Portugal redo its accounting in 2002.

If I have this right, Eurostat is a toothless CBO.  They can observe the truth – if people tell it to them – but they have no ability to compel anyone to accept the truth.

I’m from Eurostat and I’m here to enforce against you

The country revised its 2001 deficit from €2.76 billion, or 2.2% of GDP, to €5.09 billion, or 4.1%—well over the limit.

Ever go out to dinner with more than eight people?  Everybody orders dessert – because everybody realizes that for the incremental dessert they eat, their friends will pay seven-eighths.

The Euro was a club and all the kids wanted to join; so they all sucked in their belts, wriggled into their trusses, and here they are. 

I’ve dropped two deficit sizes already!

It’s a classic tragedy of the commons-currency, and the British must be thankful they are not in it.

France arranged a deal with the soon-to-be privatized France Telecom in 1997 under which the company paid the government a lump sum of more than €5 billion. In return, France agreed to assume pension liabilities for France Telecom workers. The billions from France Telecom helped narrow France’s budget gap to around €40 billion in 1997; it reported a deficit for that year of 3% of GDP—right on the target, and helping it to join the euro.

Totally cockamamie, of course – but in the context, I’d have looked the other way. 

Just bring the truck back undamaged, okay? – and I don’t know anything about any bananas.

One-offs are acceptable; structural gorging is not.

Adding to the difficulties, EU regulators have few tools for forcing euro-zone countries to adhere to fiscal requirements.

Few?  Try ‘none,’ particularly as the EU has never enforced any of its rules against any of its larger members, and rules you don’t enforce are worse than useless.

Last week, such worries exacerbated market jitters over Europe’s debt woes and could complicate Greece’s plan this week to sell more debt, bankers and investors say.

Gee, do you think the revelation of widespread cooking of the books will make it harder to sell more IOUs?

In recent weeks, countries’ use of currency swaps has drawn attention. In such transactions, often benign –

Translation: Not always corrupt and malignant.

– countries might borrow in a currency not their own, for example, and use a derivative to offset the risk of currency fluctuations.

Okay, Vice President of Common Sense – why would a nation borrow money in a currency not its own, and then hedge back to its own currency?  Why not just float bonds in your own currency?  Sounds awfully fishy to me.

It’s a trap!

Investors paid little attention to the often-opaque derivative deals until concern of a Greek default began to rattle markets.

Why should they?  After all, they had a sovereign guarantee.

Oh, wait …

The closer scrutiny also comes against the backdrop of exploding budget deficits in many European countries and fears about the stability of the euro.

The evidence is overwhelming – the Euro is teetering on the edge of kaput, because the European countries have been living beyond their means ever since the single currency was introduced.

About those pension liabilities …

Had America continued to produce above-inflationary returns, Europe’s yield starvation would have been assuaged.  We did not, and as our yields come back to reality, Europe’s pension liabilities crash.

Governments across Europe pumped hundreds of billions of euros into their economies to combat the financial crisis, sending national debt levels soaring.

There should be little consolation in the knowledge that however bad the American economy may be, Europe’s is worse.

The Portuguese finance ministry declined to comment on whether Portugal has used currency swaps such as those used by Greece, but said Portugal only uses financial instruments that comply with EU rules.

Mo-om, we only did what the Greeks did!

I warned you, young lady, no complex derivative trades until you’re at least eleven

And if the Greeks flung themselves into the seas, would you do it too?

European officials said last week that EU regulators didn’t know about a particularly controversial “off-market” currency swap structured in 2001 by Goldman Sachs for Greece. Officials say they believe the problem isn’t widespread –  

How would they collectively know, since it’s evident they individually went to considerable lengths to hide what they were severally doing?

– but a number of prominent European politicians, including German Chancellor Angela Merkel, have called on authorities to have a closer look at the transactions and whether banks helped governments distort their books.

A 2008 Eurostat report, however, says questions about how to account for off-market swaps like the one used in Greece were raised as early as 2007. The report said it provided detailed guidance about how to handle some forms of them. Eurostat didn’t respond to a request for comment.

You just stay small and inconspicuous, okay?

At the moment, Eurostat’s in an impossible position – having provided the clearest advice, having seen it ignored, with having the consequences now surfacing.

We warned the Greeks, and what did it get us?

Eurostat tried for years to change the rules on use of swaps.

As we saw in 3% altruistic, if governments inadvertently create a program liable to extreme misuse, not only will it expand rapidly, it will also be fiercely defended and hence prove enormously hard to kill.

“Feed me!  Feed me!”

European finance ministries in 2000 overruled Eurostat, arguing that they needed as much flexibility as possible to manage debt loads.

Should one blame the pharmacist if the junkies broke into the dispensary?

In 2001, Goldman and Greece came up with a now-controversial solution: a new off-market swap. It agreed in the future to convert yen and dollars into euros at an artificially favorable rate.

In other words, the parties agreed to a future transaction with a built-in bargain for Greece: a “pay me later” that offered many years of vaporware – the ability to book a transaction on a false basis:

Greece could use that [Artificially favorable – Ed.] rate when it recorded its debt in the European accounts—pushing down the country’s reported debt load by more than €2 billion, according to people familiar with the matter.

Everything’s exactly as it seems

In exchange for the good deal on rates, Greece had to pay Goldman. The amount wasn’t revealed.

A payment would count against Greece’s deficit, so Goldman and Greece came up with another twist. Goldman effectively loaned Greece the money for the payment, and Greece repaid that loan over time.

But the two sides structured the loan as another kind of swap. Treated as a swap, the deal didn’t add to Greece’s debt under EU rules.

So they created an artificial trade, then hid the fee, then hid the loan that hid the fee, then hid the swap that hid the loan that hid the fee.

Gikas Hardevoulis, a former advisor to the then-prime minister of Greece, said the trade should not have been done. “It was done to dress up the debt figures by some smart idiot in the finance ministry” he said.

Lenin called them “useful idiots.”

He also expected capitalists to sell Communists the guns to overthrow them …

… and look what it got him!

It wasn’t until 2008—a decade after the deals became popular—that Eurostat was able to revise its rules to push countries to include swaps in their debt and deficit calculations.

Transparency is always the first step to reform.

Greece’s remaining exposure to the complicated arrangement remains unclear.

The more the veils unravel, the worse will be what we see.

Europe is headed for a very ugly landing.

Financial drugs make you financially ugly

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Shouldn’t have let us have anything valuable

Otter : Flounder, you can’t spend your whole life worrying about your mistakes! You effed up – you trusted us! Hey, make the best of it! Maybe we can help.
Flounder : [crying] That’s easy for you to say!

Last week, at his company’s annual meeting, JPMorgan Chase CEO Jamie Dimon let loose with a scalding critique of the Federal government.  As reported in American Banker:

I believed I would be fairly treated by my government

JPMorgan Chase & Co. chief executive Jamie Dimon said during his company’s annual investor day Thursday that he has been turned off by the “capricious, arbitrary and punitive behavior” of regulators since his company accepted $25 billion in aid as part of the bailout of the financial industry in 2008.

Ever since the global capital crunch, we have seen periodic outbreaks of irrational populism.  It’s understandable, of course – finance is abstruse, bankers make money and therefore are easy targets, and elected or appointed officials sometimes find it convenient to flog a helpless whipping boy, such as the absurd spectacle of Congress seeking to overturn AIG executive bonuses payable to the people who would be disarming the latent financial bombs left over from the crunch.  Meanwhile, in a classic case of “do as I say, not as I did”, the government was promulgating executive pay rules that it proposed to apply to anyone whom it did not need, and to exempt from anyone it did. 

“We think to this of this, gentlemen, as a line-up“

Even the President has occasionally lapsed into illogical populist language, justifying a proposed new tax with the specious sound bite ‘we want our money back’ … at a time when the government had already been repaid.  Indeed, the government has generally reaped net profits from the TARP repayments, via not only the dividends but also the buyback of the mandatory share options.

Even more bothersome to Mr. Dimon was the implied libel on his bank for having taken TARP in the first place:

While the company has since returned that aid with interest, JPMorgan Chase has been lumped in with all of the troubled institutions that may have acted irresponsibly in the run-up to the financial crisis, Dimon said. It is also facing a slew of new accounting rules, federal fees and other regulatory changes that could sap its bottom line.

As I’ve posted before, government and capital have asymmetric doomsday devices. 

Ze are zo many zings a goffernment can do

Government has the sovereign power, which inherently cannot be bound, so that government can if it chooses abrogate contracts with relative impunity, or repudiate its debts via sovereign bankruptcy, or more subtly, it can devalue its currency through inflation, the young’s revenge on the old for their previous profligacy.

Capital can flee, faster than government can grab it.

This is how much we’ll put at risk on your integrity

Economies work – and therefore nations work – when capital and government each see the other as a reliable counterparty operating according to consistent rules of long standing and with a shared interest in maximizing the common wealth.  It’s quite clear Mr. Dimon doubts the government’s integrity:

If he could do things again, Dimon said: “I don’t know if I would” accept aid. “But then again, when you are in that situation, and your country calls, it’s hard to say no.”

It wouldn’t be hard for him to say No now; in fact, his stockholders would probably demand it as a matte of his fiduciary duty.

At the least, he said, he would have tried to find some way to avoid the “vilification” that came from accepting federal aid. 

Good luck, Mr. Dimon; the sovereign cannot be bound.

So I discovered

When Dimon speaks, though, the Administration ought to listen:

Dimon has assumed the role of the country’s most credible banker and outspoken banker since JPMorgan Chase has emerged from the recession as perhaps the healthiest and most powerful commercial bank in the U.S.

“I didn’t have to be here, you know”

For that matter, the world ought to listen, as Mr. Dimon’s additional remarks echoed AHI’s concerns:

“We want to see employment go up consistently for several months,” Dimon said. “If we’re lucky, it will happen some time this year.”

Unfortunately, the global recession will linger like a bad cold.  The stimulus legislation hasn’t stimulated; if anything, it’s impeded economic recovery.

The company doesn’t expect to lose a lot of money should interest rates rise, as it has been focusing on reducing its rate exposure. 

In other words, Mr. Dimon is taking out insurance against Ben Bernanke raising rates – which of course he must and he will – and against inflation coming back.

A 100 basis point increase would translate into a $500 million loss, which he described as “mostly noise in our company.” 

He’s also hedged JPMorgan’s sovereign exposure elsewhere:

JPMorgan Chase also doesn’t have a lot of exposure to the debt woes plaguing Europe. “Greece itself wouldn’t be an issue for this company. Neither would any other country, in my opinion,” Dimon said. 

If anything, Greece’s troubles – and those right behind it of Spain and Italy, much larger economies – will sink the Euro, not the dollar.  Which is why the Euro’s suddenly in free fall.

No worries, Europe

He said JPMorgan Chase is actually more concerned about California’s deficit troubles, which could actually pose a higher default risk than the sovereigns in Europe.

Of course – because not only is JPMorgan all over California, California’s part of America, so that if California collapses – a bleak prospect looking more likely with each passing day of inaction – then the American economy will have another infection to fight off.

Mr. Dimon, therefore, is keeping huge capital reserves:

Dimon said the company also has no timeline for winding down its $40 billion in loan-loss reserves, which some industry watchers say could deliver a jolt to earnings in coming years.

I like being protected from a very rainy decade

In other words, the analysts believe that JPMorgan has over-reserved against loan losses, meaning that at some future point, JPMorgan could boost its earnings by deciding that it had previously been too conservative.  Such moves verge on ‘earnings management,’ if they are used to manipulate results and game bonus formulas rather than as exercises in disinterested judgment.

He said the bank’s reserves should be considered some $10 billion to $20 billion of excess capital that it will have at its disposal when things improve. “We’re going to keep them as high as we can keep them,” he said. “We think it protects the company.”

There’s another way to view those reserves – as a cushion against government unreliability.  That’s a lot of capital to sit on the sidelines because government has proven itself unreliable.

And let there be no mistake: having once been burned – as the bank sees it – by trusting government, it is fully ready not to trust again:

Regulatory pressure is another issue, [Investment banking division head Jes Staley] said, although the company is confident it can thrive in the face of any regulatory changes as long as they impact the industry equally.

Staley will play on any field that’s level

Hear the fear?  With the government not just regulating markets but owning large chunks of industries, it is easy to see government self-interested motivation behind its actions.

JPMorgan will also pass onto customers higher funding costs that may result as tighter regulation.  “We’re going to reset the price of credit globally, and in a dramatic way, if the regulators go beyond the bounds that they should,” Staley said.

That, my friends, is an unmistakable threat – and should be heard as such. 

You really want to take us on?

Altogether this is a totally damning report card on the state of governmental integrity:

Flounder : Will that work?
Otter : Hey, it’s gotta work better than the truth.
Bluto : [thrusting six-pack into Flounder's hands] My advice to you is to start drinking heavily.
Otter : Better listen to him, Flounder, he’s in pre-med.
D-Day : [firing up blow-torch] There you go now, just leave everything to me.

Why am I not confident?

They’ve lied and used me every time … maybe this will be different!

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Am I allowed to gloat?

Not gloating, just celebrating

Back in early December, I posted about Dubai World’s default announcement, calling it ‘a shock of the first magnitude, with consequences that will reverberate for years if not decades.’  In the days that followed the financial press was fully of it-ain’t-that-bad stories as various observers whistled past various potential economic graveyards.  The Gulf financial markets were unimpressed – they tanked.  Then the government of Dubai poured some oil on the turbid waters, and the markets calmed.

For about six weeks, though, when the inevitable happened, as Abu Dhabi made crystal clear that it has no intention of covering the debt fully.  As reported in The Wall Street Journal:

Dubai’s Aid Estimate Is Halved

DUBAI—A $10 billion bailout for Dubai from oil-rich Abu Dhabi, announced in December, is actually half that size, a Dubai government spokeswoman said Monday [Mid-January – Ed.], raising questions about the United Arab Emirates’ plans for paying down Dubai’s mountain of debt.

As we’ll see, Abu Dhabi’s done a fine job of letting out the bad news drip by drip, running out the clock until April. When the next bond payment is due, and gradually lowering creditors’ expectations, in a process that for two decades I have called ‘a bowling ball falling slowly downstairs,’ one heavy thud at a time, followed by a few moments’ peace, then another loud thud.

You don’t want to be on the receiving end

It is unclear how the reduction in funding will affect Dubai’s finances or its plans to restructure debt.

Hint: It’s going to be worse!

Dubai and its advisers are discussing a proposed debt standstill and restructuring agreement with lenders, who are holding some $22 billion of debt issued by Dubai World, the emirate’s corporate flagship.

Dubai is engaging in classical borrower-leverage negotiations.  The creditors, you see, think they have the whip hand, but the reality is that Dubai World’s assets have negligible recovery value.  Consisting of immovable real estate properties, purpose-built to focus on industries – leisure and travel – that depend on a healthy and expanding global economy, the Dubai World portfolio has value only if it continues running.  This being the case, Dubai’s creditors have basically no choice but to negotiate with Dubai World to keep operating and maximizing revenue.  In other words, the creditors have to grit their teeth and realize that their only hope of recovering some of the money they lost by listening to smooth-talking developers and bankers is … those same smooth-talking developers and bankers who lost them the money in the first place.

Just give me more money, you’ll feel better

Dubai has been criticized for a lack of transparency around the debt restructuring.

Treat ‘em like mushrooms, goes the saying, keep ‘em in the dark and keep ‘em crap.  That motto doesn’t work when there is a huge power imbalance – that is, individual borrowers who are small compared with a major institution should adopt a strategy of transparency, honesty, and diligence.

When the power dynamics are more nearly equal – as they are here, whether Dubai World’s creditors like it or not – the first step is bringing mutuality to perceptions.  In plain language, demonstrate their downside, a mantra I preach when representing delinquent but honorable borrowers against implacable but unthinking creditors.  Show them what they have to lose.  One such approach – crude, but effective – is to choke off information flow, leaving the creditors gradually to realize that if they threaten the managers, then the managers will go silent, and then you’ll really be up the creek.

What you’re going to lose is for me to know and you to find out

In response, it announced earlier this month a new media office to coordinate the emirate’s communications strategy.

Dubai World doesn’t need a media office, it needs to deal with its creditors.  This is just another shuck and jive.

Ahmed Al Shaikh, director of the new office, wasn’t reachable for comment Monday.

Way to go, media office!

I say nothing, nothing I say!

A spokesman for the federal government in Abu Dhabi was unable to comment on the matter.

How’s that new media strategy thingy working out for you?

On Monday, a spokeswoman for the Dubai Department of Finance said the $10 billion funding—described in December as coming directly from the government of Abu Dhabi—includes $5 billion in funds separately announced in November by two Abu Dhabi-controlled banks.

Double counting money – already you’re learning from the Westerners J.

Abu Dhabi and Dubai are two of seven semi-independent emirates that make up the UAE

As I pointed out before, this is a bit like being semi-cross-collateralized and semi-pregnant:

To tell the truth, I’m more than semi-pregnant

Dubai, struggling under total debt estimated as high as $80 billion, announced in February last year that the UAE federal government would buy $10 billion of bonds issued by Dubai. The proceeds would go to pay down debt and unpaid bills.

Obviously they saw the trouble a year ago, and I missed it.

Then, in late November, Dubai announced the two Abu Dhabi banks would subscribe to another $5 billion worth of bonds. Hours later, however, Dubai shocked global investors by announcing its corporate flagship, Dubai World, would request a debt standstill from lenders.

Classic good copy/ bad cop routine.  Let the credulous continue to believe, even as you dribble out the facts necessary to be able to say later, Hey, stop complaining, we told you long ago.

Mixing signals is very effective for paralyzing your creditors — at least in the short term – but really bad in that it also paralyzes the markets.

I ain’t gonna invest ’til you tell me some facts, son

Investors, suddenly worried that Abu Dhabi wasn’t willing to step in and rescue its indebted neighbor, sold off Dubai-related bonds. Investors also bid up the price of insuring against other highly indebted governments, from Greece to Russia.

A market panics quicker if it’s already pre-panicked.   And we know that Greece’s problems are structural, unresolved, and heading for serious unpleasantness.

Even cash-rich governments in the region, such as Saudi Arabia and Abu Dhabi, saw sharp rises in the prices of insuring against a default of their sovereign debt, making it more difficult and expensive for them to borrow on international markets.

Sovereign risk came to Islamic finance.  Islamic finance is now required to invent the jurisprudence of a sharia-compliant international bankruptcy.  This will be difficult.

In December, Dubai announced that Abu Dhabi had agreed to extend another $10 billion to help shore up finances, easing investor worry. Dubai said $4.1 billion of that would go to pay off a bond maturing that same day –

Just press ‘do not pay’ and see what happens

It sounded good – and kept Dubai World out of immediate monetary default.

– and the rest to provide interest expenses and working capital for the company through April 2010.

In other words, Abu Dhabi paid $10 billion to buy itself six months.

The disclosure Monday cuts by 20% the funds that analysts had assumed Abu Dhabi, the capital of the UAE and its financial powerhouse, had committed to Dubai over the course of last year. While both governments have disclosed little about the series of bailouts, analysts had widely interpreted the total funding commitment from Abu Dhabi and the federal government to Dubai at $25 billion. Dubai’s disclosure Monday reduces that to $20 billion.

One should never gloat about the misfortunes of others, and so I am not doing so.  But I am allowed to say I told you so.

You think you can say that?

My December sovereign-bankruptcy post said that a deep restructuring was required:

Dubai World, the real estate development arm of the Government of Dubai, unilaterally suspended payments on its debts.  As reported in the New York Times:

LONDON — The government of Dubai, in a blunt acknowledgment of the severity of its financial position, said on Wednesday [November 26, 2009 – Ed.] that it had asked its banks for a six-month stay on its schedule of debt repayments.

Though it is not yet being reported as such, this is a shock of the first magnitude, with consequences that will reverberate for years if not decades. 

1. It will bring us directly into the realm of sovereign bankruptcies, a fiscal plague that we have avoided for just under thirty-five years.

Back when we were trying to Whip Inflation Now

2. It will write new laws concerning the efficacy of Islamic finance, and in the process, hold a global financial referendum on whether Islamic finance moves forward, bringing with it the economies of the Islamic world, or collapses, with economic and political fallout none of us can know.

Last week [February 16 – Ed.] the bowling ball fell another step with this bitter announcement, also reported in The Wall Street Journal:

Dubai Debt Talks Hit Markets

Don’t, you’ll rattle him!

DUBAI—Dubai stocks fell again, though only slightly, and the price of insuring against a default in the city-state rose on Monday, on the second day of market upheaval following news that flagship corporation Dubai World may offer creditors just 60% of the money they are owed as part of a deal to reschedule $22 billion in debt.

People familiar with the matter told Zawya Dow Jones that one potential offer being considered in debt-restructuring talks was a repayment offer of 60 cents on the dollar, paid back after seven years, and backed up by government guarantees

Sounds very much like the recapitalization that happened 225 years ago in England, when Parliament settled the Prince of Wales’s debts:

I’m a man of words and deeds

The free-spending prince was not merely a trial to his parents, he was a positive burden to the state, running up mountainous debts:

The problem of the Prince of Wales’s debts, which amounted to the extraordinary sum of £630,000 in 1795, was solved (at least temporarily) by Parliament. 

From 1787 onward, there was a dalliance of convenience between the Prince of Wales and the Whigs, with political support by the former traded for economic support by the latter, and in a move worthy of Silvio Berlusconi or Jacques Chirac he used his position of power for crass personal advantage.

Charles James Fox: what are a few IOUs if I can form the government?

Being unwilling to make an outright grant to relieve these debts, it provided him an additional sum of £65,000 per annum.   

In effect, Parliament converted the Prince’s obligations into a long-term bond, thus on the one hand backing him in full but on the other making creditors wait years for repayment.  What with the inflation that always attends upon a war, Parliament was economically settling the Prince’s debts for some number of pence in the pound. 

I finished [December 8, 2009 – Ed.]:

One can easily imagine a similar solution being imposed on Dubai World’s creditors by a combination of blandishments and a little additional capital from Abu Dhabi.

Is it too soon for a victory lap?

A – H – I!  A – H – I!

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[Continued from yesterday's Part 1.]

Yesterday, examining the New York Times‘ reporting of Ben Bernanke’s reconfirmation as Federal Reserve Chairman, we saw that the Times focused on what happened – a 70-30 final vote – rather than the mountainously glaring things that didn’t happen:

“But the Senate did nothing at the hearings.”

“That was the curious incident.”

Nowhere does the Times article mention any single:

* Controversial Bernanke statement, gaffe, or concession about his or the Fed’s record.

* Pledge or promise he committed himself to.

* Statement of limitations on the Fed’s powers and authorities that might be imposed as a condition of his reconfirmation.

* Announcement of legislation being introduced to curtail the Fed’s independence.

And you were there!

As the Wall Street Journal put it some days later:

Despite last month’s bruising confirmation battle, Federal Reserve Chairman Ben Bernanke and the central bank’s independence came out relatively unscathed, according to economists in the latest Wall Street Journal forecasting survey.

“Bernanke will do what he thinks is correct for the long run success of the U.S. economy,” said Paul Kasriel of The Northern Trust.

Kasriel bills himself an econtrarian

That’s the real story – faced with a unique opportunity to hamstring the Fed chairman, at a time when President Obama had minimal political capital and no fallback plan, the Senate did nothing.

Without a doubt, the Senate could have tried such a tactic. 

In 1688, when Parliament invited William of Orange to become king, it imposed limitations on his authority as a condition of the tender: the King In Parliament.  That phraseology – and the particulars that undergirded it – limited William’s prerogatives and within a hundred years had led to the leaching of virtually all political power out of the sovereign and into the chamber. 

We’ll let you be king, subject to some … preconditions

Not there (the Journal again):

Just one economist of the 50 who answered the question thought that the Fed’s independence from political interference was significantly undermined by the confirmation fight in the Senate. Bernanke was eventually backed by a bipartisan vote of 70-30, the lowest ever number of ayes for a Fed chairman. Twenty-nine economists said independence was slightly undermined by the fight.

Actually, nothing’s changed … yet.  There is the potential to erode the Fed’s independence.

While an arm-twisting campaign by the administration limited the opposition, the outcry against the Fed –

“Father forgive them, for they have no bloody clue.”

Give me a break.  How many people do you know who could say what the Federal Reserve is, let alone make even a partially coherent case why the Fed should be curtailed?  That’s just short-term political scapegoating at work.

– will most likely continue rippling through economic policy generally, and Mr. Bernanke’s leadership of the Fed in particular.

The effects could be felt first in the debate over how to reform financial regulations. The Obama administration has proposed consolidating risk regulation under the Fed, while some in Congress want to strip away its oversight authority.

Note well the distinction – the Administration wants to give the Fed more authority, not less.  Because of

Jefferson’s curse, regulation of financial institutions is thoroughly balkanized, which leads, as I explained in Cutting Turf, leading to interstices – gaps in the observation platform as one might put it – through which flowed most of the highly volatile financial instruments whose unwinding has created out current undoing.

Oversight must be consolidated, and it must be standardized.  These are fundamental post-catastrophe financial reforms yet to come.

There is thus a risk that consolidation will center somewhere other than the Fed.  The only other logical candidate is Treasury – FDIC covers only depository institutions, for whom additional oversight is appropriate, and the OCC’s remit is limited. 

“The institutional prestige of the Fed, even apart from this vote, had taken a hit, and it started back around the disaster of September 2008,” said Stephen H. Axilrod, who worked at the Fed for 34 years [1952 to 1986, that is, 24 years ago – Ed.] and wrote a history of its monetary policies. “I don’t think it has recovered. This is a low point in the Fed’s recent history, that’s for sure.”

Probably true, but so what?  Prestige grows back naturally.  Power lost doesn’t.

The vote also made clear Congress’s insistence on transparency from a historically secretive institution that has made extraordinary interventions in the market since 2008.

“The Fed is going to have to work hard, for a long period, to regain the public confidence of the sort it enjoyed during the halcyon days when everything was going so swimmingly,” said Barry Eichengreen, professor of economics and political science at the University of California, Berkeley.

When the food is bad, blame the waiter.

You serve lousy monetary policy in this joint, sir

The last time any nominee for chairman faced such opposition was 1983, when the Senate confirmed Paul A. Volcker to a second term on an 84-to-16 vote.

That was a more civilized era, when Senators showed more deference to Presidential nominees.

Mr. Volcker, too, had served under presidents of opposing parties and had navigated the Fed through a difficult recession.

But while Mr. Volcker sharply raised interest rates to tame runaway inflation — actions that were initially unpopular –

That’s a polite phrase.  I remember people wanting to crucify Volcker.

Did I look like I cared?

– but were later praised, Mr. Bernanke faces a different challenge.

And he’s already said that he will raise interest rates.  Indeed, six months ago, he wrote an editorial so promising:

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period [written July, 2009, just before Mr. Bernanke's renomination – Ed.].

We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

A model of clarity: Chairman Bernanke will push interest rates up and up as fast as he can without stalling the fragile economic recovery.

The Fed has held short-term interest rates near zero since December 2008, a policy reaffirmed on Wednesday. And while analysts expect rates to start rising later this year, the scale and timing of that rise will be a challenge.

Just you wait, Ben Bernanke, just you wait

There’ll be time enough for you to raise the rate

So, too, will be the unwinding of the Fed’s emergency lending programs and its purchase of $1.25 trillion in mortgage-backed securities.

When one pulls $1.25 trillion – for viewers playing at home, that’s $1,250,000,000,000 – out of the money supply, it’s going to be a shock.

Many politicians will not want the Fed to put the brakes on recovery by raising rates.

Many politicians will have lost their opportunity to do anything about the Fed raising rates.

Missed by that much

Indeed, the Senate majority leader, Harry Reid of Nevada, offered only a lukewarm endorsement last week after telling Mr. Bernanke that the Fed must do more to ease lending to households and small businesses. While the Fed says Mr. Bernanke gave Mr. Reid no specific commitments, the central bank will continue to face close scrutiny.

Scrutinize away

To recapitulate:

1. He got reconfirmed while promising nothing.

2. He lost none of the Fed’s autonomy.

What then was all the fuss and bother?  As Isaac Asimov put it in his Foundation story, The Encyclopedists:

When, after two days’ steady work, he succeeded in eliminating meaningless statements, vague gibberish, useless qualifications – in short, all the goo and dribble – he found  he had nothing left.  Everything canceled out.  Lord Dorwin, in five days of discussion, didn’t say one damned thing, and said it so you never noticed. 

I swear to answer your questions, not to tell you the questions to ask

As so often happens, the newspaper got the story wrong.  The Times headlined it:

Senate, Weakly, Backs New Term for Bernanke

When the real story was:

Senate, True To Form, Talks and Does Not Act

All is unfolding as I have foreseen

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