Links November 23: I said, SHUT IT DOWN!

Joe's terms for Wallis. Peter Martin
Fear and loathing of Joe. The Australian
Joe the idiot. Hewitt, Bartholomeusz
Ken Henry embraces Dutch Disease. Peter Martin
US austerity drive. Bloomberg, Krugman
US bank face $100 billion BaselIII shortfall. FT
US housing shadow inventory. Calculated Risk
How Ireland's bailout works. Reuters
Europe in real trouble now. Bloomberg
The greatest central banker of our time. RCM
The coming coal crash. John Garnaut
Versus this. NYT
Copper bubble farce. Businessweek
Versus the supply argument, which doesn't canvass speculation. Metal Miner
Gold ETFs bulging. Bloomberg
Deep T's attack on ratings. Delusional Economics

The Claytons Inquiry

It's the Wallis Inquiry you're having when you're not having a Wallis Inquiry.

And Stephen Bartholomeusz outlines it today:

Earlier today Suncorp’s chief executive, Patrick Snowball, made a considered contribution to the debate, noting that since the crisis all the banks had diversified their funding and reduced their dependence on offshore wholesale funding markets.

"This change in the funding mix is important for Australia and a step in the right direction. It does not change the facts that the costs of this funding mix are higher; international debt and equity markets remain stressed; local supplies are not unlimited and funding is the key structural issue for Australia’s financial system," he said.

"This funding issue cannot be addressed quickly or without a comprehensive and non-partisan review. Broadening the range of competitively priced funding options would be the most effective way for the government and regulators to increase bank competition."

Snowball said that funding reforms lacked the immediate political appeal of regulating rate rises and bank fees but were vital rather than optional and would improve competitiveness.

Snowball is right. The crisis exposed the vulnerability of our system to the closure of offshore wholesale markets and it shut down our securitised debt markets.

Responding to that revealed vulnerability ought to be the priority and the primary focus of policymaking – and the probable need for greater government intervention in domestic capital markets tends to suggest a formal inquiry is required.

Hockey’s suggested terms of reference are broader than they need to be, but it would also be worth asking an expert committee to consider the implications of the explicit government guarantees provided during the crisis and the implicit guarantees that continue.

There isn’t a need for another big Wallis-style inquiry into every aspect of the system including its regulatory architecture but a focused investigation of the funding risks for the majors and the lack of access to funding of their competitors and the distortive and potentially dangerous longer term effects of the guarantees might produce some valuable insights and reforms.

Whether it did or didn’t, it would produce the major benefit of shutting the populist politicians up and preventing them from continuing their dangerous meddling in affairs they generally know little about but whose functioning and stability – and profitability – is vital to the economy.

Any regular reader of this blog will know that it is in complete agreement with Bartho's focus. He's one of the only other analysts out there that has consistently given thought to liabilities.

However, one has to ask, how exactly can you isolate an expert examination of financial system funding issues without fundamentally addressing Australian financial services architecture?

The Wallis structure of securitisation-funded entities competing with deposit and wholesale funded entities is the fundamental design created by Wallis. A Claytons Inquiry is a great way to pretend to address the many funding issues like excessive offshore borrowing, unstable marketable securities, moral hazard etc. before just reshuffling government guarantees.

But if you really want to get to the bottom of the risk and give it back to the banks, then you may well need new architecture. You certainly don't want to rule out the possibility before you've started.

We need a full-flavoured, overproof Wallis Inquiry.

Come on, Gotti

This morning Robert Gottliebsen attempts something of a backflip with three million twists after his egregious defence of housing bubble interests late last week that was deconstructed nicely by Delusional Economics.

Gotti begins:

The Australian newspaper followed up by revealing that the manager of Treasury’s Macro Financial Linkages unit, Phil Garton, believes that if financial deregulation was “reversed significantly” there would be risks to the current level of high house prices. He does not isolate the Greens' proposal but I would suggest that’s exactly what Treasury is referring to. I don’t always agree with Treasury officials, but in this case it is good to have Garton on my side.

Only problem is, The Australian makes clear the Garton comments were part of preparation of the Red Book for the incoming government, long before the current bank debate and the Greens' push for regulated interest rates:

Documents obtained by The Weekend Australian under Freedom of Information laws show the Treasury officials preparing the so-called Red Book of briefs for the incoming government were as divided as private sector economists about the strength of the property market.

Phil Garton, the manager of Treasury's Macro Financial Linkages Unit, sent colleagues a draft paper on the rise in household debt, prospects for further growth in the debt-to-income ratio and the potential implications of slower household debt growth.

Australia's crossroads

This blogger began reading Doug Noland during the 'dot bomb' bust ten years ago. During that bear market, Noland consistently analysed events through the prism of an underlying credit bubble that was the product of an unholy alliance between the US Fed, US securities markets and the government sponsored entities Fannie Mae and Freddie Mac.

Following the bust, he precisely described the reflation dynamics that were driving housing markets and predicted with near paranormal accuracy how the unholy trinity behind credit creation was going to come apart in the near future. It took seven years but turned Noland's analysis into prophecy.

In short, Doug Noland predicted and described the GFC earlier and with greater precision than anyone else, anywhere (including the laudable Steve Keen, who just happened to teach Doug Noland at UWS!)

Why this intro? Well, Noland writes weekly at Prudent Bear and his latest missive is a screamer:

Beginning back with early-nineties banking system impairment, the Greenspan Federal Reserve nurtured Wall Street financial engineering and the rapid expansion of non-bank marketable debt. The GSEs, securitization markets and derivatives were viewed as instrumental for fostering the needed Credit expansion in the face of severe banking and fiscal headwinds. The Fed unleashed a lion.

No longer was monetary policy focused on creating and extracting banking system reserves in an effort to influence bank lending (and through bank Credit, growth and inflation). The old rules for governing a largely contained financial system no longer applied. A New Era was born. The Fed now could manipulate short-term borrowing costs and immediately stimulate flows into the securities markets, speculator risk-taking and leveraging, asset inflation, mortgage refinancing and equity extraction, home price gains, additional household net worth, spending... It became The Age of the Maestro, The Masters of the Universe, the enterprising investment banker and opportunistic mortgage originator. Traditional measures of economic health – the Current Account, savings rates, sound investment, productive capacity, stable money and Credit, balanced financial flows – were discarded. What mattered now were the markets, market perceptions and how the Fed could be counted on to orchestrate and sustain a boom.

If there is one insight that you should take from this blog make it the above description of how US (and global) capital markets credit creation actually works. That is opposed to how they should work in theory.

To understand the difference, we can turn to a post made last week at this blog:

The global economy is a three-ringed circus. The inner ring is real commerce, production, consumption and trade. This is the layer at which fundamentals like supply and demand operate. The second ring is a layer of financial transactions - the shifting of savings and creation of credit, as well as currency exchanges that most of us think of as global capital movements. This is the level at which macro-economics operates. The third ring is the global meta-economy of derivative gambling that leverages off and arbitrages prices in the first two rings. In part this is Noland's global banking universe of marketable securities, as well as other derivatives.

The outer ring is the problem. Because of its leverage, opacity and magnitude, it massively amplifies any sudden movement in the underlying two rings.

So what you might ask? What does it matter to us if markets work this way?

Well, it matters all right, for the reason that our banks and regulators have spent the best part of two decades believing in and integrating with the outer ring of this system. Despite their reputation for prudence, Australian banks manage some $13-14 trillion in off-balance sheet derivatives that have enabled them to control the currency and interest rate risks in their portfolio of $500 billion in offshore marketable securities.

Before the GFC, the Australian RMBS market was also dependent upon the global marketable securities marketplace for over half of its' sales.

Regulators ignored this historic process of debt-accumulation under the rubric of the Pitchford Thesis - that Current Account Deficits no longer mattered in an era of floating currencies, so long as the debt was in the private sector - a near perfect fit with Noland's description of the abandonment in the US of traditional measures of economic health.

The inevitable result was that when global liquidity was interrupted - as sooner or later it always is, and sooner rather than later in this system - the only way to backstop the liquidity that is now the lifeblood of the Australian banking system was fiscal guarantees to the big banks that pretty much are the local financial system.

Now, as the bank debate rages, we face a choice: Confront the regulatory error that allowed banks' to become dependent upon the unstable outer ring of global marketable securities, or, expand the guarantees that backstop the integration in the name of greater competition, and throw traditional measures of economic health to the wind.

To understand what it is we are choosing, let's return to Noland:

I’ve argued for years now that the Fed had adopted a radical approach to monetary management - and it was disturbingly apparent that our central bank had become enamored with history’s most powerful monetary policy mechanism. And with dynamic marketable debt increasingly supplanting the boring old bank loans as the main driver of system Credit expansion (especially as the nineties progressed), the Federal Reserve had to take an increasingly aggressive and activist approach to ensuring ample marketplace liquidity and unwavering market confidence. The ’94 bursting of the bond/MBS Bubble, SE Asia, LTCM, the tech bust… The Fed nurtured a historic Credit Bubble and the larger the Bubble inflated the greater role monetary policy had to play to ward against a devastating crisis of confidence. Policy was conspicuously radicalized in the aftermath of the 2008 collapse of the mortgage/Wall Street finance Bubble.

But the chickens are bound to come home to roost. Especially after the past two years’ unprecedented global expansion of government debt, marketable debt securities that now absolutely dominate the world. The specter of market illiquidity reemerged with this spring’s Greek contagion crisis, and it was sufficiently scary. The ECB intervened to support struggling debt issuers and a vulnerable banking system. The Fed, fearing a more systemic crisis, played its QE2 trump card. The markets perceived this move as an unending commitment from the Fed to provide a liquidity backstop. Risk markets have inflated across the globe.

It is my view that a world financial apparatus dominated by marketable debt instruments is inherently unstable. Implement a monetary policy regime to manage marketplace liquidity and asset prices at your own peril. Be prepared for market dependency and ever-increasing liquidity injection requirements. Such a regime will reward the savviest speculators and ensure acute systemic vulnerability.

Australian monetary policy has already been compromised by this liquidity-driven system in the tearing up of the RBA's rules for repo transactions and shadow game they and APRA are deploying in Invisopower!, the hiding of who owes what where. But for the time being at least, our major choice is different in that it is a fiscal backstop that is needed to stabilise the system under duress.

The corollary of this fiscal liquidity guarantee is that whoever controls the health of the Budget, controls the health of the banking system. It doesn't take Einstein to conclude that that equals an unhealthy dependence upon China.

Yet a vociferous band of economists, journalists and analysts are calling for us to do just that.

Do we really want to go further down this track of unstable, securities-based credit creation? It has already created one of the greatest housing bubbles in history and skewed our financial system and economy toward mortgages and offshore debt.

It's now threatening to undermine our strategic commitment to the United States through a doubling down on the China-dependent Budget liquidity backstop.

Not to mention running the risk that if the great China experiment catches a cold, we'll cough once then drop dead on the spot.

Shouldn't we rather ask ourselves how do we stabilise what we've already got without throwing away our system?

Links November 22: The global grinder

Arbitrage capitalism. Doug Noland
Ireland bailed. Calculated Risk
Stop the bailout blackmail. Jeremy Warner
Week ahead for DOW. Calculated Risk
Copper bubble explosion. WSJ
Rothschild backs Indonesian coal. FT
Swan doesn't mention securitisation guarantees. SMH
World steel output up. Steel Orbis
The Joye of the RBA. The Australian (h/t The Lorax)

Australia pwned

If you want to understand just how deluded Australia is strategically then take a look at the above extraordinary chart. Business Insider ran this under the heading "Why China interest rate tightening matters" (h/t The Lorax).

And sure, it does. But that's not what this blogger sees.

In 2004 our exports to the US were on a par with China. By 2008, China was at 3 x US. But since the GFC, with US demand in retrenchment and China stimulating their fixed investment boom, our Chinese export earnings are now 6 x US.

Has there ever been a more dramatic shift in the power relations of a single nation?

We may not yet know it yet, but China owns us: economically, politically, strategically...

Hope is kindled...

This is music to this bloggers ears, or at least, eyes. From The Australian (h/t the Lorax):

A senior Treasury official has sounded the alarm over Australia's property market.

He has warned that the prospect of a sudden and dramatic drop in prices is "the elephant in the room" and should not be ignored by the federal government.

While the government and Reserve Bank insist Australia does not have a housing bubble - as some economists and the International Monetary Fund suggest - it remains such a worrying concept that Treasury has privately sought reassurance from its analysts that prices are not artificially high and that Australia does not face the kind of house price collapse that has hit Britain and the US.

Documents obtained by The Weekend Australian under Freedom of Information laws show the Treasury officials preparing the so-called Red Book of briefs for the incoming government were as divided as private sector economists about the strength of the property market.

Phil Garton, the manager of Treasury's Macro Financial Linkages Unit, sent colleagues a draft paper on the rise in household debt, prospects for further growth in the debt-to-income ratio and the potential implications of slower household debt growth.

His email prompted an exchange with Steve Morling, currently the general manager of the Domestic Economy Division, who argued the paper should "make a bit more about the risks".

"The elephant in the room is house prices or more specifically the risk of a precipitous drop in them, perhaps from an external shock or perhaps from their own internal dynamics when affordability constraints or capacity debt levels see prices and expectations of house prices start to move in the opposite direction," Mr Morling wrote on June 15.

"(I) know there are very supportive fundamentals, but prices rose by 50-60 per cent in three to four years in the early part of this decade, with largely unchanged fundamentals, so they can have a life of their own.

"And given what's happened elsewhere I'm far less sanguine about this - and the interplay with debt - than in the past."

Mr Garton agreed that there would be risks if the fundamentals of low interest rates, unemployment, and financial deregulation "reversed significantly". But he maintained the price growth in the early 2000s was based on a "lagged response" to improvements in the fundamentals, and questioned how Australia could have maintained a bubble for more than six years.

Mr Morling said other bubbles had lasted that long, and the fundamentals were often used to justify price rises - including in Britain where a debate over lack of supply drove property prices higher "before the British property bubble burst".

"(I) think price expectations can take over from the fundamental drivers that you have identified for extended periods, including generating house price falls," he wrote.

Well, more power to Mr Morling!

We already know that Treasury is aware of the clear and present danger in the banks reliance on short-term financing to fund the the bubble. And we know that Mr Morley's concerns made it through to the Red Book itself, making clear that his views are shared at the most senior levels. Several months ago the SMH revealed that:

Auastralian banks' reliance on overseas funding and the high level of household debt loom large as a ''significant'' economic risks, Treasury has told the government in a normally secret briefing.

The nation's top economic advisers yesterday released the incoming government brief known as the Red Book after a flurry of freedom-of-information requests. While the document painted a bullish picture in which the resources boom drives a return to full capacity, the frank commentary also said debt was a vulnerability.

''A key risk for the Australian economy is our reliance on short-term external debt, largely intermediated through the banking system,'' the brief said.

''Among Australian financial institutions there has been some shift away from short-term funding since the crisis, but exposure to financing risk remains significant.''

The following paragraph was blacked out, but later on the Red Book also highlighted the dangers of the property-led surge in household debt.

''Highly indebted households, together with high dwelling prices, further heighten the vulnerability of the economy to shocks. While household finances are in good shape overall, and arrears rates and other financial stress measures remain much lower than in the early 1990s, households are more exposed than previously to adverse shocks.''

None of this, of course, means that the government won't attempt to kick the can down the road with policies designed to reflate the dirigible. And The Australian's story continued to recount how "... the Treasurer retained the view that Australia did not have a property bubble".

However, it is no small thing that senior Treasury ranks have broken with the Pitchford (Ponzi) Thesis - that we can accumulate debt forever so long as it's private sector. Once minds have broken the group think, new possibilities are possible.

Weekend reading

Treasury acknowledges housing bubble. (h/t The Lorax) The Australian
Bernanke translated. WSJ
US bank stress. Alphaville
US so captured. Rortybomb
US manufacturing. Calculated Risk
The rape of Ireland. Bloomberg
Portugal and Spain to follow. BusinessWeek
China's inflation opportunity. Reuters
China's coming bust. Alphaville
The harmonious society. Silence!Reuters
Sensible Koeans. JAD
Soros on gold. Precisely.
And now for shadow banking. Gillian Tett
China/US price divergence. Gavyn Davies
More MRRT bluster exposed. FT
Give actors hard hats. SMH
Gittins. Barf
St George as Northern Rock. Michael West
India upholds ore export ban. Reuters
Nikel drag. Seeking Alpha
Gottliebsen pwned. Delusional Economics
The baby-boomer bust for houses. The Uncoventional Economist

RBA confirms death of housing

In a speech this week, RBA Deputy Governor Rick Battelino offered southern Queensland property investors a few crocodile tears before driving this spike home:

While there are differences between sectors and between regions, the Australian economy overall is doing well. We expect that the economy will continue to grow at a solid pace over the next couple of years, with growth picking up to an above-trend rate towards the end of this period. This will be accompanied by further increases in jobs and falls in unemployment.

With the economy now having grown more or less without interruption for about 20 years, it is understandable that spare capacity is limited. This means that the economy cannot grow much above its potential rate without causing a rise in inflation. With a large amount of money continuing to flow into the country over the next couple of years as a result of the resources boom, the challenge will be to manage the economy in a way that keeps economic growth on a sustainable path, with inflation contained. This is what the Bank is trying to do.

As this blogger has argued before, good news on the economy is now bad news for housing. The endless China boom meme now equals rate rises in a falling housing market.

Whether this means an immediate bust is still up for grabs, but as observed previously, this is largely irrelevant anyway. Whether its a bust or the slow decay of inflation, Australia's mortgage led growth era is finished.

Reviving the dodo

Yesterday Ian Harper, one of the minds behind our failed Wallis Inquiry financial services architecture, wrote in the AFR that "More needs to be done to redress the current imbalance between stability and competition in the Australian banking system. Effective stability has returned, however competition has not revived, in part due to the lingering side effects of measures taken during the global financial crisis to secure stability".

This follows on from recent comments by Nicholas Gruen in a similar vein.

Let's get one thing straight. Securitisation is not some innocent victim of the GFC. It was the GFC.

Securitisation - the bundling of loans and shifting of risk - was the single greatest cause and defining feature of the crisis.

The other causes, global imbalances, greed, asset manias are old stories of capitalism.

But never before have we had a global swath of derivatives of sufficient magnitude to wipe out private competition permanently.

To help understand this, we need a brief history of securitisation in Australia. Some of it is drawn from The Great Crash of 2008, this blogger's co-authored book with Ross Garnaut.

It took government intervention to get the non-bank lenders into business. In 1987, the New South Wales Government sponsored the formation of the First Australian National Mortgage Acceptance Corporation. At the same time, the Victorian Government established the National Mortgage Market Corporation. Both operations were subject to 26 per cent government ownership, with the remainder spread among a range of shadow bank players, including investment banks, building societies and unit trust managers. Not to be outdone, the Queensland Government legislated the Secondary Mortgage Market Act to support a program for ‘originators’ in that state. One private provider was also founded to compete with the new government lending shops: MGICA Securities, a subsidiary of AMP Ltd.

These early initiatives came to grief in the bond market meltdown in the lead up to the recession of 1990–91. The government operations in particular were hit hard because they had exposed themselves to a huge refinancing risk. The NSW and Victorian operations were ultimately sold to the private sector; the Queensland market was stillborn. The shadow banking phoenix rose from these ashes in 1992 when John Symond founded Aussie Home Loans with the backing of Macquarie Bank, and John Kinghorn launched RAMS with the support of Citibank.

As with non-bank lenders in the United States, Aussie Home Loans and RAMS relied on investment banks to manage the securitisation process. From the mid 1990s they generated securities similar to the Wall Street MBS, called residential mortgage-backed securities (RMBS). The securities were generally bought by a mix of local and foreign investors. They were extraordinarily successful, seizing 7 per cent of the outstanding mortgage market by 2006.

The non-bank lenders had no regulator and no rules outside of regular trade practices and corporate law. And with investors globally becoming more accustomed to shadow banking, the standards that determined which Australians were creditworthy began to erode. The shadow bank lenders first introduced low-documentation or ‘low-doc’ loans in 1997, then ‘no-doc’ loans by 1999. Subprime or ‘non-conforming’ loans, given to people with bad or impaired credit histories, also proliferated in the late 1990s. Subprime specialist non-bank lenders like Liberty Financial and Bluestone grew swiftly and issued subprime RMBS. These securities first appeared in 2000 and by the end of 2006 some A$6.8 billion had been sold. The market was growing at 150 per cent per annum and looked set to burgeon.

The growing network of mortgage brokers held no deposits, had no reputational risk and was paid by fees for mortgage volume. Amidst the rising arrears rates for Australian RMBS, the highest levels of default were apparent within broker-originated loans. Endemic malpractices included getting clients to sign blank declarations of affordability (and income if relevant) and then working back to how much the client needed to earn to afford the loan.

When the market was in its mania, there was little subtlety in this practice. Audits of the files would readily demonstrate differences in handwriting. Some remarkable outcomes eventuated. Elderly applicants, either retired or in blue-collar occupations, were claiming to have extraordinarily high incomes. GE Money introduced what it called a ‘sanity test’ to forestall these types of occurrences in 2005. Another trick in the fraudster’s handbook was to put up the application as an investment loan (therefore getting the benefit of the potential rental income to augment serviceability) when it was clear that the application was actually for owner occupation. This went hand in hand with the practice of ‘necking kids’; that is, not declaring dependents to increase the applicants’ available income.

In 2007, the Federal Court ordered one mortgage broker to pay a former client A$32 000 in compensation after the broker falsified documents to ensure a A$365000 mortgage for the 20-year-old, unemployed, dyslexic and homeless man. The same broker was in court for similar abuses in 2009.

And the above is not even the worst of it. The mortgage frenzy created by the non-banks drew in the banks, who borrowed enormous sums of money offshore to compete and laid waste to their own credit standards. This is the core of the Great Australian Housing Bubble.

What we need now is an inquiry and new regulation for those banks that mitigates the risk in the offshore borrowing. Authorities should allow mortgage securitisation to die, as the market clearly wants it to. If we want more competition, then create new banks and deposit incentives. At least that way we also get more business lending.

Ian Harper concluded yesterday's treatise by arguing that "A clear signal must be sent that the banks are not he only game in town and that government will support securities markets to a measured extent as well."

It is astounding that some of our economic leaders want to just do it all again, this time risking the national Budget.

Links November 19: It's all good

Risk Oooooaaaawwwn. Metals, Grains
ForeclosureGate to roll on. NYT
The Irish boondoggle. NYT
More capital for US banks. WSJ
US leading indicators up. Econompic
US retail sales. A trend beckons. Tim Duy
Slow China. Michael Pettis, FT
Boom. SMH
Tax cuts madness. The Age
Why don't we have whingers like this in exports? John Durie
Ore to become buyers market. Minmetals
But not yet. Baosteel

The three-ringed circus

There's a great piece today by former IMF chief economist, Simon Jonson, in which he argues that:

Greece’s EU/IMF program heaps more public debt onto a nation that is already insolvent, and Ireland is now on the same track. Despite massive fiscal cuts and several years of deep recession Greece and Ireland will accumulate 150% of GNP in debt by 2014. A new road is necessary: The burden of financial failure should be shared with the culprits and not only born by the victims.

The fundamental flaw in these programs is the morally dubious decision to bail out the bank creditors while foisting the burden of adjustment on taxpayers. Especially the Irish government has, for no good reason, nationalized the debts of its failing private banks, passing on the burden to its increasingly poor citizens. On the donor side, German and French taxpayers are angry at the thought of having to pay for the bonanza of Irish banks and their irresponsible creditors.

Such lopsided burden-sharing is rightly angering both donors and recipients. Rising public resentment is testing German and French willingness to promise more taxpayer funds. German Chancellor Angela Merkel’s hasty and ill thought out plan to demand private sector burden sharing, but only “after mid-2013”, marks a first response to these popular demands. We should expect more.

Financial crises are actually not rare, and the rules for their resolution are clear. The fundamental insight is that huge amounts of financial losses, of seemingly real value, need to be distributed across creditors, debtors, equity holders and taxpayers. The first step is to bring the current budget deficit under control to achieve a primary balance, which both Greece and Ireland are now attempting. The second is to attract sufficient emergency funding, which the IMF and the EU essentially have done. But in neither Greece nor Ireland is that sufficient. They still have unaffordable debt burdens. Therefore, one more measure is needed, namely a reduction of the public debt.

The public debt can be contained in two ways. The first and preferable option is that the state never nationalizes private bank debt as Ireland has done. For Ireland, this opportunity has probably passed, but other countries should be warned not to make the same mistake. Kazakhstan’s refusal last year to bail out its major banks, despite strong demands from the senior creditors of these banks, has proved a far more successful path. Banks can and should go under if they have failed. The state should only defend small and medium-sized depositors.

If the state has taken on too large debt, sovereign default is the natural outcome.

...Sovereign defaults are always contentious, but they don’t need to end in catastrophic financial collapse ... Troubled nations, as part of their rescue plans, can and should introduce legislation that permits a qualified majority of creditors to change terms on outstanding sovereign and bank debt, while protecting bank deposits. Such rules could, for example, require 2/3 of non-protected creditors agree to a restructuring plan. This reduces the risk that holdouts can prevent a deal from being reached, but still gives creditors clear powers to negotiate terms.

Well-planned debt restructuring will not cause a systemic financial collapse. It is misleading to draw parallels from the chaotic liquidation of Lehman Brothers for the outcome of debt relief in Europe. The direct impact of debt relief for Greece, Ireland and others is easily measured and managed. The debtors and creditors are well known."

This blogger could not agree more with the principles described here but as it has illustrated before, it does not share the sanguine view of the outcome.

The global economy is a three-ringed circus. The inner ring is real commerce, production, consumption and trade. This is the layer at which fundamentals like supply and demand operate. The second ring is a layer of financial transactions, currencies and debts that most of us think of as global capital movements. This is the level at which macro-economics operates. The third ring is the global meta-economy of derivative gambling that leverages off and arbitrages prices in the first two rings.

The outer ring is the problem. Because of its leverage, opacity and magnitude, it massively amplifies any sudden movement in the underlying two rings.

Simon Jonson may be right when he says that the creditors who will take losses are well known. What is a total mystery, however, is to which counterparty they are hedged and, to which counterparty that counterparty is hedged, ad infinitum.

Is it any wonder then that policy-makers feel they must bailout and that markets themselves enter total panic at the prospect of no public support. The three-ringed circus dispensed with the fundamentals of market discipline long ago. Now, it's all bets are on, then all bets are off.

Jonson is right that Ireland is not Lehman. It's a debtor default this time we're looking at, not the collapse of a key counterparty in the outer ring daisy chain. But there are three senses in which he is wrong that an Irish default would be low-impact. First, after decades of regulators ignoring the growing inherent instability of global finance, markets are now well accustomed to their own power. If Ireland goes for haircuts, as clearly, in theory, it should, it will be a huge shock. Second, there'll be a run on all other PIGS' debt (h/t Anon). Third, it will cause chaos in the euro as it's future is cast into doubt and bets are reversed. That, in turn, will reverse the global reflation trade as all and sundry bolt for the $US, global liquidity dries up and commodities correct.

If you think Ireland is going to default (sooner or later someone is going to, and why not the Irish?) then panic now.

Links November 18: European resolution

How to resolve Europe. Simon Jonson
Versus the growing anger at Germany. FT
Versus Europe's doom. Ambrose Evans-Pritchard
US, UK houses falling again. Independent, Calculated Risk
US construction down and out. Steel Orbis
The way out. Martin Wolf
China to buy gold. Zero Hedge
Even as it buys more Treasurys. WSJ
Unleash QEIII-X. Econompic
More bank irrelevance. SMH
Quarterly contracts here to stay. Baosteel
Chanos reiterates massive short on Australia:



Longer piece here.
Chinese divorcing to buy more property. American in China (h/t The Lorax)

Bloggers rule

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The Federal Bond Insurance Corporation (FBIC)

Whilst just about every man and his dog in the bank debate remains focussed on the irrelevance of interest rate margins, this blog has been thinking about how to address the underlying cause, the banks' dependence on foreign funds and how to manage it.

It's come up with the following: The Federal Bond Insurance Corporation (FBIC).

The FBIC is a government corporation, much like Australia Post or Export Finance & Investment Corporation. It's role is to monitor and manage offshore bank borrowing.

It does this through charging the banks fees for wrapping their foreign bond issues in a AAA rating.

The fees are pooled in the corporation and act as the collateral that supports the bonds. The corporation can issue its own debt to leverage this capability but should be kept to very conservative gearing ratios.

This has the following benefits:

- it shifts the current implied Budget guarantee for the banks' wholesale debt into an open an transparent relationship with a separate entity which is funded by the banks
- over time, the pool also grows through its own investments and profitability
- thus, it removes the burden of guarantee from the Budget, as well as mitigating much of the moral hazard currently at work for the major banks
- because of the AAA rating, the additional cost of the insurance is offset by the reduced cost of funds for the big banks in foreign markets, the banks therefore have no excuse to make unilateral interest rate rises at home
- the transparency bought to wholesale funding also helps in this regard. But more importantly, it frees our regulators from the current shadow game of hiding the problem, what this blogger calls Invisopower!
- the corporation could be situated somewhere between APRA and the RBA and also be given some kind of macro-prudential charter governed through a board that includes representatives from both. This should include containment of offshore bank borrowing within certain pre-ordained constraints that ensure the country does not over-leverage itself
- it might also be guided by a pro-competition agenda in which big bank fees are used to actively subsidise the fees charged to smaller banks. This will build competition for the big four in a new generation of medium-sized banks, instead of the current ludicrous suggestions of returning to the failed experiment of non-bank lenders
- obviously, and most importantly, the FBIC frees the nation from the risk of a major run by foreign creditors and the calamitous fallout if the Budget guarantee is not as effective as everyone currently thinks (for instance, in the event of a Budget crushing event in China)

In short, an FBIC would enable a transition to a lower risk, higher competition financial system without bringing current players to their knees.

This blogger is quite certain it's missing all sorts of downsides and unintended consequences with this suggestion. It invites you to improve it in comments and to pass on the post.