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Bernanke on Regulation – Analyst Blog

Dirk Van Dijk — Thu, 07 May 2009 17:43:56 +0000

Highlights include American International Group, Inc. (AIG), Citigroup, Inc. (C), JPMorgan Chase & Co. (JPM), Wells Fargo & Co. (WFC) and Bank of America Corp. (BAC).

This morning, Fed Chairman Ben Bernanke gave a speech on the topic of financial regulation and the lessons learned from the recent disaster. Here is a key section of the speech, with my thoughts interspersed:

"Looking forward, I believe a more macroprudential approach to supervision--one that supplements the supervision of individual institutions to address risks to the financial system as a whole--could help to enhance overall financial stability. Our regulatory system must include the capacity to monitor, assess, and, if necessary, address potential systemic risks within the financial system. Elements of a macroprudential agenda include:

"monitoring large or rapidly increasing exposures--such as to subprime mortgages--across firms and markets, rather than only at the level of individual firms or sectors;"

It is sort of surprising that this has not been done already.

"assessing the potential systemic risks implied by evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products;"

Yes, the Fed should not be sitting on its thumb when major financial players leverage themselves up to 30:1 or more (especially if all the off-balance sheet stuff is taken into consideration). Markets evolve and the regulators have to keep up.

"assessing the potential systemic risks implied by evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products;"

I'm looking at you, AIG (AIG). There will always be a high degree of interconnectedness between major financial firms. Someone has to be looking at the "what if" cases should one of them go down.

"ensuring that each systemically important firm receives oversight commensurate with the risks that its failure would pose to the financial system;"

The devil is in the details here. Given the size of the banking behemoths, each one of them should be treated as a nuclear warhead, and should receive the same level of oversight that we have in regard to our stockpiles of strategic weapons. The problem is that "oversight commensurate with the risks that its failure would pose" would require an incredible amount of micro management.

The solution to that is to make sure that no bank gets big enough to pose such a risk. It is time to break them up, both by function (i.e. reimpose a modern equivalent of Glass-Steagall) and perhaps by region. Ten mini Citigroups (C) would each would not pose an overall risk to the system if one of them were to fail.

Of course you would want to keep an eye on them, just as the military keeps an eye on its 1,000 lb conventional bombs. However, the consequences of one of those going missing is much less profound than a missing nuke warhead.

Unfortunately, in the largely ad-hoc response to the crisis, we have been moving in exactly the wrong direction. JP Morgan (JPM) swallows up Bear Stearns and Washington Mutual, Wells Fargo (WFC) takes over Wachovia, and Bank of America (BAC) now owns Countrywide and Merrill Lynch. All of them were too big to fail before this started, and now they are way too big to fail. Either we regulate them extremely closely -- to the point where they will be complaining that every credit card being issued has to be first cleared with the Federal Reserve Board of N.Y. (OK, I'm exaggerating for effect here) -- or we break them up.

"providing a resolution mechanism to safely wind down failing, systemically important institutions;"

This is very important, and is at the core of why all the money that has been poured into American International Group has by and large simply flowed out the backdoor to big foreign banks and Goldman Sachs (GS). If we put them into bankruptcy, it would have been a huge systemic hit to the system, especially coming at almost the same time as the Lehman Brothers collapse.

Without being in bankruptcy, we had to honor the CDS contracts at 100 cents on the dollar. The result was a huge backdoor handout to the banks (a much bigger scandal than the bonuses, IMHO). This would have provided an intermediate step where the new 80% owners of AIG (aka the taxpayers) could have just returned the premiums on the CDS's and rewritten the bonus contracts when we came in.

We can do this with smaller banks, but not with big bank holding companies or huge non-bank financial firms. We need this, and we need it right away.

"ensuring that the critical financial infrastructure, including the institutions that support trading, payments, clearing, and settlement, is robust;"

I agree that boring "financial plumbing" stuff is important and has to be maintained. If it backs up, you have one heck of a mess on your hands. This can easily be handled by a sort of boring "public utility" model of banking. Let's get back to the days when banking was a sleepy part of the economy. Low risk, low reward, and bankers were noted for their low golf handicaps. Keep the higher risk stuff (which the economy very much needs) in separate entities.

"working to mitigate procyclical features of capital regulation and other rules and standards;"

This is a good point. As things stand now, in good times the value of assets goes up, so the capital ratios look better. In bad times the value off assets goes down and banks become undercapitalized. However, rather than pretending the values of assets don't change (i.e. suspending mark-to-market accounting rules), it would be far better to require financial institutions to build up large cushions in the good times, and allow some more latitude on the capital requirements in bad times.

However, somehow I suspect that as soon as good times come back, the banks will flex all their political influence (they have a lot, as Sen. Durbin (D-Il) said of the bankers and the Senate, "they own this place") so the cushion is never built up in the good times. After all requiring more equity will result in a lower ROE, and that might result in bonuses that are only in the seven figures rather than in the eight figures. The horror, the horror!

"and identifying possible regulatory gaps, including gaps in the protection of consumers and investors, that pose risks for the system as a whole."

Yes, although I think referring to them as simply "gaps" is being too generous. We allowed these big institutions to go around and pick who would regulate them. How else would the primary regulator for the world's biggest insurance company end up being the Office of Thrift Supervision (OTS)?

The OTS actively went looking for more institutions to fall under its supervision, and its key marketing policy was that it would be the most toothless and ineffective of regulators. It was the most gung-ho on deregulation, and many of the biggest failures were firms that it was the primary regulator for, including Washington Mutual, Indymac and of course AIG.

We have to find ways to stop shopping around for your regulator and regulatory capture. The Fed would be a very good place to start. It is not comforting that the head of the New York Fed comes from Goldman, and still holds over ten figures worth of Goldman stock when he is now the primary regulator of the firm. That is more than just an appearance of a conflict of interest.

The board of directors of each of the regional Federal Reserve Banks are all made up of bankers. That is because the Federal Reserve is not owned by the government, rather it is owned (literally, not just figuratively) by the banks. Perhaps it is time we reconsider that arrangement.

The speech is a good start, but it does not go far enough. We need to return to the principals that were behind the financial regulatory reforms of the 1930's. The three-legged stool of good solid accurate information, including of potential conflicts of interest (the SEC), making it safe to keep your money in the bank (the FDIC) and making sure the bank does not take your money and use it to play the tables in Vegas (Glass-Steagall). The precise form will be different than the old regulations, but the new order should embody the same spirit.

Read the full analyst report on "WFC"
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Silver: Nice setup, Ted Butler

Alex Stanczyk — Sun, 19 Apr 2009 06:24:36 +0000

By Ted Butler A number of different factors have converged, creating what could be a lift-off point for the price of silver (and gold). This confluence of readily verifiable factors shows the silver market to be in a low risk and high reward situation. The factors involve both the paper and physical silver markets. The only [...]

And Then There’s This…Tuesday, April 14th, 2009

Contrarian Profits — Tue, 14 Apr 2009 21:20:22 +0000

pBoth gold and silver rose in Sunday evening trading on the Globex [counterparty...Western Pacific Ocean]. The peak prices in Far East trading occurred around lunchtime in Hong Kong. From there, both metals drifted slightly lower#8230;and remained there all through European trading until the Comex open in New York#8230;then away they both went./p pGold managed a $10 rally before some not-for-profit seller showed up at 9:15 a.m. Eastern time. Once the London p.m. gold fix was in, gold rallied again#8230;making it a hair above $900 for a few seconds#8230;before some other [probably the same] not-for-profit seller showed up. From there it got sold off into the close./p pSilver#8217;s 8:00 a.m. rally on the Comex was like a moon shot#8230;and heaven only knows how#8230;/p

Roubini Global Economics: Re-emergence of global protectionism

Prieur du Plessis — Sat, 07 Mar 2009 08:13:58 +0000

This post features Nouriel Roubini's team discussing the re-emergence of global protection, saying: "As governments around the world fight rising unemployment, falling exports and bank credit crunch, and several central banks are facing liquidity traps...

Are Austria’s Banks More At Risk Than Their Italian Counterparts?

Edward Hugh — Fri, 06 Mar 2009 20:08:00 +0000

by Edward Hugh: Barcelonabr /br /“For Austria, the actual crisis is yet to come. The decline of the eastern European economy will hit Austria in 2009".br /Peter Eigner, Professor of economic history at the University of Vienna”br /br /br /The yield difference, or spread, between 10-year Austrian securities and benchmark German bunds has been rising substantially of late, and hit 137 points on Feb. 18, the widest yet recorded (see chart below). At the same time Austria now has a higher default risk than those Mediterranean "laggards" Italy, Portugal and Spain, at least according to credit-default swap prices as quoted by CMA Datavision. Austrian swaps were trading at 253.3 basis points on March 3, compared with 17.5 points 12 months ago. That means it costs 253,300 euros a year to protect 10 million euros from default for five years. br /br /br /a href="http://1.bp.blogspot.com/_ngczZkrw340/SbFfRtpHzcI/AAAAAAAAM9E/eiB4kvwG70A/s1600-h/austria+bund.png"img id="BLOGGER_PHOTO_ID_5310130193561013698" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 400px; CURSOR: hand; HEIGHT: 255px; TEXT-ALIGN: center" alt="" src="http://1.bp.blogspot.com/_ngczZkrw340/SbFfRtpHzcI/AAAAAAAAM9E/eiB4kvwG70A/s400/austria+bund.png" border="0" //a!--more--br /div/divbr /br /The reason for this sharp spike in spreads is, of course, the heavy exposure the Austrian banking system has to the risk of defaults in the East. Austria’s banks have about 201 billion euros ($254 billion) oustanding in loans in Eastern Europe, equal to about 71 percent of gross domestic product, according to data from the Bank for International Settlements. Shares of Austria’s Erste Group Bank, which made more than two-thirds of its profit from emerging European economies in 2008, and Raiffeisen International Bank-Holding AG, which operates only in the region, have both dropped more than 85 percent from their peaks. br /br /To put this in perspective, Austria’s banks could withstand losses of up to 31 billion euros on their outstanding loans, according to stress testing carried out last month by Austria’s central bank. But what if the defualt figure rises beyond this?br /br /br /Now all these numbers have been causing some controversy of late (see a href="http://ftalphaville.ft.com/blog/2009/03/04/53194/cees-stand-against-spectre-lators/"Izabella Kaminska's piece in FT Alphaville/a ) and Erik Berglof, Chief Economist at the European Bank for Regional Development has taken issue with some of those who have expressed concern about the situation, specifically referring to the widely quoted BIS figure of $1,700bn, (cited among others Morgan Stanley's Stephen Jen, a href="http://fistfulofeuros.net/afoe/economics-and-demography/let-the-east-into-the-eurozone-now/"Yours Truly here on Afoe/a, and The Anthropologist's Grandson Ambrose Evans Pritchard in the Daily Telegraph). In particular, Berglof asks the following question:br /br /blockquoteThe $1,700bn, which is taken from Bank for International Settlements statistics, represents the total claims of foreign banks and their affiliates on eastern Europe. Western banks own some 80 per cent of the region’s banking sector. The BIS figure therefore simply reports the region’s bank balance sheets. At $18,000bn the equivalent figure for western Europe is more than 10 times higher — should we be concerned?/blockquotebr /br /My answer is, yes, we should be concerned, and more importantly, Austria's citizen's should. Let's look at what Berglof says next:br /br /blockquoteA much better measure of refinancing need is short-term external debt owed by the region’s banking sectors to foreign creditors. According to central bank data, this is about $200bn for all of central and eastern europe. /blockquotebr /br /Thinking about his argument, a lot of things make sense to me, in a sort of sudden flash of lightening. You see, we are talking about two different things here, one is the level of exposure to default on the loans, not sovereign default, but default by households and companies as the economies contract, and as the currencies slide (or, in the case of the Baltics and Bulgaria, internal deflation is carried out), and the other is the issue of speculative attacks on currencies and reserves due to the gap in the current account deficits. But this would be the point, we are not dealing here with a 1960s type balance of payments crisis (although you wouldn't know that from looking at the loan measures the EU has been taking, or from the language it is using which constantly refers to them as balance of payments loans). br /br /What we actually have on our hands, however, is not a simple balance of payments crisis, but rather a regional deleveraging process, as economies which have expanded well beyond their short term capacity level of output now contract sharply, in many cases with a boom bust dynamic. This is inevitably going to produce a steady stream of defaults over the next two to three years. One extaimate has been in the (worst case scenario) context of Ukraine that defaults may rise as high as 60%, but lets just imagine they rise above 20% - that would be around a 40 billion bill for Austria, and a 350 billion euro bill for Western Banks in the Context of Eastern Europe as a whole. And if we get a worst case scenario of 40% default, then you just double those numbers. br /br /Erste Bank have also today joined the fray, with analysts Juraj Kotian and Rainer Singer a href="http://www.bloomberg.com/apps/news?pid=20601095sid=aPSBYYF2yFC4refer=east_europe"publishing a new research report today/a. br /br /blockquoteErste said that statistics from the Bank for International Settlements had been misinterpreted. The analysts cited the “alarming news” that eastern Europe has borrowed $1.7 trillion abroad and has to roll-over or repay $400 billion this year. They compared that with Germany’s foreign borrowings of $2.3 trillion, Britain’s figure of $4.5 trillion and Belgium’s need to repay or roll-over $375 billion this year. /blockquotebr /br /The point about the UK is of course, very well made (although it doesn't make East Europe's position any better to know that things in the UK are bad), however Germany is a current account surplus country, so it is hard to see what exactly the relevance of the point they are making as regards Germany is. Unless, of course, they are suggesting that those banks who have leant to German customers are running a stronger default risk than those who have leant to Poland. They should, of course, have mentioned Spain or Greece, where the current account deficits have been massive, and foreign exposure is large, although since the risks of what has been happening in Spain and Greece are already well-known, it would hardly have helped their case. The difference is, of course, that Spain and Greece are in the Eurozone, which is where I am arguing the Eastern countries should now be, and I find it hard to see that these Erste analysts are even serving their own interests by serving up the kind of argument they have been serving up. What we need to see is stress testing on possible default rates for the Eastern loans, and on various scenarios, over the next 5 years.br /br /They also add this which seems to me to be extraordinarily spurious:br / blockquoteAustrian banks have granted loans of $318 billion, or 73 percent of the Alpine nation’s gross domestic product to eastern Europe, the report said. They have also borrowed $143 billion, or 33 percent of GDP, from the region, it added. That makes the banks’ net debt equivalent to 40 percent of GDP./blockquotebr /br /I mean, are they suggesting that the default risk inside Austria is the same as the default risk externally, if they are this is the first time I have heard such a suggestion. The problem in Austria is not likely to be the debt which Austrians have to pay externally (a href="http://bonoboathome.blogspot.com/2007/06/swiss-carry-trade.html"all those strange Swiss Franc mortagages/a, which have to have been a mistake, but still), but the none repayment of debts elsewhere which result in a ballooning of Austrian government debt which currently equals 62.3 percent of its GDP. Also Austria has a current-account surplus of almost 9 billion euros.br /br /Returning to the main theme, of course no one at this point has any accurate idea of the real level of default we are going to see in the East, or of the posterior recovery rate on the assets, but it doesn't help restore confidence if leading authorities essentially address the secondary issue and not the primary one. That presumeably is why Austrian spreads have risen and continue to rise. It is also why Eastern Europe needs a collective solution to its problems, and it needs one now.

Russian Debt And The Euro

Edward Hugh — Tue, 10 Feb 2009 09:43:00 +0000

by Edward Hugh: Barcelonabr /br /blockquoteKeynes’s genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge.br /Martin Wolf, a href="http://www.ft.com/cms/s/0/be2dbf2c-d113-11dd-8cc3-000077b07658.html"Financial Times/a/blockquotebr /br /The euro fell again yesterday, by 1.1 percent against the dollar (to $1.2860) and by 1.2 percent against the yen (to 117.52 yen). The change, even if quite large in a short space of time, is hardly dramatic, but what is of more interest is the why. Russian companies announced yesterday that they were thinking of opening negotiations to "restructure" their debt. a href="http://www.bloomberg.com/apps/news?pid=20601101sid=aq5iyuLURj1srefer=japan"Bloomberg/a:br /br /blockquoteThe euro fell after a Russian bank official said the nation’s lenders asked the government to help moderate talks with foreign lenders on $400 billion of loans, adding to speculation financial turmoil in Europe is worsening. br /br /The euro fell versus 13 of the 16 most-active currencies after Anatoly Aksakov, president of the Russian Association of Regional Banks, said in an interview with Bloomberg News that the group has written to the government after talking with foreign banks. He said $135 billion of the loans are due this year and the remainder of the $400 billion within four years. br /br /The “report of rescheduling debt is driving the euro lower because European financial institutions have a bigger exposure to Russia than their counterparts in other countries,” said Takashi Kudo, Tokyo-based director of foreign-exchange sales at NTT SmartTrade Inc., a unit of Nippon Telegraph Telephone Corp., Japan’s largest fixed-line phone company. /blockquotebr /br /And then there is a href="http://leopolis.blogspot.com/2009/02/dude-wheres-my-tenge.html"Kazakhstan to think about/a:br /br /blockquoteKazakhstan’s banks may have their ratings cut as the devaluation of the nation’s currency makes it harder for them to repay foreign debt and “substantially increases” credit risk, Moody’s Investors Service said yesterday./blockquotebr /br /And Mr Euro, like me, is getting worried:br /br /blockquoteThe widening spreads between the interest rates that different euro-area nations must pay bond investors are “worrying developments,” according to a “speaking note” prepared for Luxembourg Finance Minister Jean-Claude Juncker and obtained by Bloomberg News. /blockquotebr /br /In fact, while there is a growing feeling that the worst phase of the financial-system meltdown may be over in the U.S, unease is mounting that here in Europe the worst may be yet to come. The reason? Europe's commercial banks have more exposure to distressed emerging markets than their U.S. counterparts. By one estimate, European banks provided three-quarters of the $4.7 trillion in cross-border loans to the Baltic countries, Eastern Europe, Latin America and emerging Asia. Thus it is quite likely that the emerging-markets exposure of European banks exceeds even that of U.S. lenders to Alt-A and subprime loans.br /br /blockquote“People expect that part of these debts were from the European banking system,” said Sebastien Barbe, a strategist at Calyon in Hong Kong, the investment banking unit of France’s Credit Agricole SA. “You already have a very weak banking system in Europe. If you have these Russian issues, the next step would be questions about whether similar problems will come out of other Eastern European countries.” /blockquotebr /br /Dory Wiley, president of Commerce Street Capital, a money-management firm that invests in banking stocks argues that "most of the big banks in Europe are insolvent........That is what made them great - but unpredictable - shorts. They represent major components in those country funds everyone buys." The big danger now is that European governments, since they are the prime backstops for their commercial banks, will see their debt liabilities balloon and steadily be forced, in a domino like contagion process onto the slippery path towards downgrade, rising yield spreads and default.br /strongbr /Unicredit Saved Again By Libya/strongbr /br /I think it should now go without saying that Unicredit is deeply involved in many of the most problematic countries from this point of view - Russia, Ukraine and Kazakhstan to name but three. So while, as reported here yesterday, the Italian bank seems to have scraped its way over the latest hurdle a href="http://www.reuters.com/article/rbssBanks/idUSL916310020090209"thanks largely to the timely intervention of the Libyan central bank/a, this hardly seems to be a stable situation (links to the posts which give some background on all of this a href="http://italyeconomicinfo.blogspot.com/2008/12/unicredit-shares-fall-again-merrill.html"can be found here/a).br /br /blockquoteLibya's central bank will fill half of a 500 million euro ($645.5 million) gap in bank UniCredit SpA's 3 billion euro capital raising measures, newspapers reported on Monday. Shareholders Fondazione Cassa di Risparmio di Torino (CRT) and Carimonte Holding will also take up about 230 million euros of the shortfall, Il Messaggero newspaper said...........La Stampa said Libya's central bank would hold about 7 percent in UniCredit after the capital increase and become the biggest single shareholder./blockquotebr /br /strongMaking The Punishment Fit The Crime, Or the Crime Fit The Punishment?/strongbr /br /Many readers are, unsurprisingly, outraged by the idea that the EU should create bonds to help a distressed Italian (or Austrian, or Irish) banking sector. Typical of many responses is this from an Italian:br /br /blockquoteI'd favour a liberal approach, but it's only my humble opinion, anyway I think bad banks should have to pay for bad policies, households should have to pay for their reckless borrowing, governments should have to pay for communicating the sunstainability of currency pegs and expantion policies. I'd like to see these kind of attitude, negotiating a volunteer currency convesion and a longer repayment time for forex loans, sharing the losses and extra costs among banks borrowers and government. otherwise the ones who acted properly will not see any advantage in acting the right way./blockquotebr /br /I think this view is being advanced in a very well meaning way, in the sense that the person voicing it simply wants to see some sort of justice, some sort of sense of responsibility. But as I pointed out in my reply to him, the issues here are systemic ones, and the majority of Germany's citizens are hardly responsible for the bad decisions made by representatives of the Russian subsidiaries of their banks. What I am trying to say is there is no effective mechanism as far as I can see whereby those who took the decisions (many of whom are already bankrupt, and others soon to become so) can be made to pay up and put things right. Meantime innocent parties get trampled on. Being intentionally emotive for a second, think about the one million people who lost their jobs in India in December, and all those millions of other people in poor countries across the globe, what responsibility did they have for the irresponsible lending practices of a limited group of Unicredit managers and employees who caused the financial shock waves they are now receiving?br /br /Take the Latvian case. Looking through the IMF standby loan document, I was amazed to find that as a result of this bailout national debt to GDP will rise from 8% in 2008 to 50% in 2010. The thing is the only "crime" of those Latvian citizens caught up in the Parex problem were those who happened to have their money on deposit there. Now such were the covenants on the syndicated loans contracted by the banks that those who provided them (they certainly knew what they were doing) seem to have first call on any funds the government puts into the bank over and above the needs of the hard pressed depositors. Given the rapid population ageing Latvia now has coming and the serious economic growth problem they face as a result of the boom bust my feeling is that they will be unable to fully recover from the blow and will more than likely have to do some sort of sovereign default at some stage - unless, of course, they are admitted to the eurozone, the debt is "restructured" and some kind of EU institutional support offered. I personally consider the current "sit back and watch" approach to be grossly unfair, especially given that the root of their problem really lies in making it a condition of their EU membership that they join the eurozone, and then withdrawing the possibility when the financial destabilising effects of the original condition send their economy sprialing out of control. br /br /Bad decisions were certainly taken by Latvian politicians, but I have no doubt that the fundamental structural cause of their current problems was the one I have just mentioned. So sending a whole country into bankruptcy because of the decisions and speculation of a few people in a bad bank does not seem to be like using our emotional intelligence, and this is why I think the EU have to help them. We simply cannot continue to perpetuate this kind of injustice in our midst.br /br /I can't help feeling that inflicting significant economic pain on large numbers of innocent people is not a fitting process of retribution. It is more akin to the unfortunate campaign of intensive bombing carried out by the Allied Powers against Dresden, simply to make the German people "pay" for the crimes of Adolf Hitler. It is amazing to me that we are still having the same kinds of argument 60 odd years later.br /br /We live in an imperfect world and the reality principle suggests we accept it as such. When you get hit by a tragedy in your life the best advice, I think, is that you do a bit of psychological counselling, put the issue behind you, and get on with your life. Don't go off on a "fatal attraction" kind of obsessive vendetta to try to make the guilty parties pay. Just do what has to be done, stop Europe's financial system melting down, change the regulations for the future, and let's all go to work and get on with things. A first step in this direction would be - a href="http://fistfulofeuros.net/afoe/economics-and-demography/italy-needs-eu-bonds-and-it-needs-them-now/"as I argued on Sunday/a - for the EU Commission to negotiate a substantial EU Bonds issue with the Swedish, Italian and Austrian governments, and stopping the rot on this whole problem before things get further out of hand.

Russia Heading Towards The Abyss?

Manuel Alvarez-Rivera — Mon, 09 Feb 2009 13:07:00 +0000

blockquote“A significant amount, if not all, of the speculative attacks on the ruble are funded by the central bank itself,” said Vladimir Osakovsky, Moscow-based economist for UniCredit/blockquotepThe underlying dynamics of the current ruble devaluation are provoking more than a little consternation in Russia at the moment. In the forefront of the debate are data from Bank Rossii (the central bank) which show they lent 7.7 trillion rubles ($214 billion) in overnight and seven-day loans (secured with bonds or other collateral) in just 16 trading days last month - this was about double the 4.8 trillion rubles provided via so-called repurchase auctions in December. Over the same period the ruble lost 18 percent against the dollar. The question is, is there a connection here?/ppRussia's banking authorities now certainly seem to think there is and Kommersant reported (Friday) that policy makers planned to reduce bank loans in an attempt to limit bets on the ongoing ruble devaluation. As a result the ruble remained safely within the target band all day Friday, and there was no need for any kind of intervention./pp/ppThe decision follows several days of severe criticism over the way in which Russian banks appeared to be using the loans being made available to them. Oleg Vyugin, former deputy central banker and currently chairman of MDM Bank has suggested that Russia's banks have now accumulated about $40bn in hard currency deposited for their clients on accounts with the central bank and another $40bn on accounts held with foreign banks. /pblockquotePolicy makers lifted the rate on overnight and seven-day loans obtained through the auctions by 1 percentage point to 11 percent this week, the highest since at least November 2007. Banks used “almost all” the money from loan auctions to bet against the ruble, Natalia Orlova chief economist at Alfa, Russia’s largest non-government bank, said. Policy makers “have basically fueled the speculation on the ruble themselves.....The market is intent on testing the central bank’s ability to spend reserves and they’re going to really have to tighten liquidity, or something, if they want to have a hope against that.” /blockquote!--more--br /br /blockquote“If they really wanted to stop speculation, they have to raise the rates significantly, say to 20 or 30 percent, for a short period of time,” said Evgeny Gavrilenkov, chief economist at Moscow-based brokerage Troika Dialog. “One day they have to say: Give me my money back, no more repo is available.” “They have to raise interest rates if they want to stop speculation.....But there is still a lot of concern among the authorities that the banking sector might collapse.”/blockquotebr /br /According a href="http://www.bloomberg.com/apps/news?pid=20601095amp;sid=aqpJfhFF6fZ0amp;refer=east_europe"to Bloomberg/a, Russia's banks bid for 505 billion rubles in repo auctions on Thursday, more than the 402 billion rubles actually lent. Banks also requested 139 billion rubles in an auction of unsecured loans on 3 February, about six times the 23.5 billion rubles provided. The possibility of obtaining such loans was opened up to over 100 Russian banks in November as part of a plan to boost liquidity amid the seizure in global credit markets. The extra funding has helped lower the average interest rate banks charge each other for overnight loans, known as the MosPrime rate, to 10.83 percent on Wednesday from a record 25.17 percent on Jan. 27.br /blockquoteBank Rossii may send representatives to individual banks to check on their foreign-currency holdings, said Stanislav Ponomarenko, chief economist in Moscow at ING Groep NV. President Dmitry Medvedev told the Federal Security Service, Russia’s spy agency, to monitor the allocation of state funds on Jan. 29, saying it is “doubly criminal” for investors to get rich off the crisis./blockquotepbr /strongVTB GDP Indicator Shows Severe Contraction/strongbr //ppIn any event, while a lot of people in the Russian establishment seem busy trying to decide which side they are batting for in all this, a Russian economy which is basically being starved of liquidity is now spirally downwards and downwards. The most recent piece of evidence for this comes from the latest reading on VTB’s Russian GDP Indicator which showed that economic output contracted at a year on year rate of 4 percent in January, down from December’s 1.1 percent decline, and November's 2.1 percent expansion.br /br //ppa href="http://2.bp.blogspot.com/_ngczZkrw340/SYrQqqST3oI/AAAAAAAAMko/mdVbzUd4Lmo/s1600-h/russia+gdp2.png"img id="BLOGGER_PHOTO_ID_5299277342878981762" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 400px; CURSOR: hand; HEIGHT: 244px; TEXT-ALIGN: center" alt="" src="http://2.bp.blogspot.com/_ngczZkrw340/SYrQqqST3oI/AAAAAAAAMko/mdVbzUd4Lmo/s400/russia+gdp2.png" border="0" //abr /br /According to Russian economy Ministry estimates the economy will contract by only 0.2 percent this year after expanding 5.6 percent in 2008, so this estimate now seems hopelessly out of date. If we look at the monthly contraction rate as a reflection of the current quarter on quarter contraction, we find a rate of minus 1.6%, which means that the present rate is something like a 6.5% annualised shrinkage rate. At present this is stationary and not accelerating, but it is quite strong, especially for an economy which only six months ago was expanding at a 6.5% annualised rate.br /br /a href="http://1.bp.blogspot.com/_ngczZkrw340/SYrQX0URIrI/AAAAAAAAMkg/pPq0d0ZpbNY/s1600-h/russia+GDP.png"img id="BLOGGER_PHOTO_ID_5299277019154031282" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 400px; CURSOR: hand; HEIGHT: 245px; TEXT-ALIGN: center" alt="" src="http://1.bp.blogspot.com/_ngczZkrw340/SYrQX0URIrI/AAAAAAAAMkg/pPq0d0ZpbNY/s400/russia+GDP.png" border="0" //a /pbr /br /pstrongServices Contract But Less Strongly Than Manufacturingbr //strongbr /Russia's services industries are still not contracting as fast as the manufacturing sector (34.4), but with the Russian economy shedding 800,000 jobs in December the outlook for improvement is not exactly bright. The PMI reading was little changed - and close to December's all-time low rising to 36.8 in January from 36.4 the previous month. Since a reading over 50 indicates expansion, and below 50 a contraction, this is still a pretty hefty rate of shrinkage. /pa href="http://2.bp.blogspot.com/_ngczZkrw340/SYrQ5M1tiwI/AAAAAAAAMkw/OVzMDbtLzZg/s1600-h/russia+services+PMI.png"img id="BLOGGER_PHOTO_ID_5299277592672439042" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 400px; CURSOR: hand; HEIGHT: 243px; TEXT-ALIGN: center" alt="" src="http://2.bp.blogspot.com/_ngczZkrw340/SYrQ5M1tiwI/AAAAAAAAMkw/OVzMDbtLzZg/s400/russia+services+PMI.png" border="0" //abr /br /Meantime retail sales grew at the slowest annual pace in nine years in December while disposable incomes fell 11.6 percent.br /br /br /blockquote“Business activity and incoming new business contracted further to record lows due to still weak demand,” said Svetlana Aslanova, senior corporate analyst at VTB Capital, in the report. “Low levels of workloads have forced companies to cut costs” resulting in jobs cuts, she added.br //blockquotebr /pbr /strongNew Policies From The Administration?/strong/ppWith declining reserves in the background, and oil prices which may well not rebound very much this year to concentrate their minds, the Russia adminstration indicated on Wednesday that it was about to make a significant change in the policies it is deploying to fight the financial crisis. The move basically involves switching from bailing out individual companies to attempting to directly support the economy through the banking sector. At the same time Moscow is planning large budget cuts in an attempt to limit the fiscal deficit since letting it run too high threatens to eat up Reserve Fund resources far too quickly if oil prices remain low for any length of time. The general impression is that the administration has now lost hope it can avoid the crisis simply by increasing public spending and is instead digging in deep in an attempt to endure what might turn out to be a rather prolonged recession.br /br /The policy change was announced by Igor Shuvalov, Russia's first deputy prime minister, who stressed the government was deliberately choosing to allow gross domestic product growth to fall to zero or below in 2009 to stabilise the economy and maintain foreign exchange reserves. He was thus explicitly rejecting the advice of those economists who had suggested using the reserves to finance a budget deficit of 10 per cent of GDP to promote growth. Of course the risk here is that this will produce a much stronger GDP contraction with unknown social consequences./ppShuvalov also indicated the government would invest “several percentage points of GDP” in strengthening the banking sector, covering “possible future losses” and supervising a consolidation plan that would see the number of banks cut from 1,100 to 500. Alexei Kudrin, the finance minister, confirmed during a visit to London that the state was preparing to inject $40bn (€31bn, £28bn) capital into banks provided that the money was channelled into the real economy. This would follow last year’s Rbs960bn package of subordinated loans.br /br /Shuvalov indicated some key industrial companies would continue to get priority, headed by military enterprises, Gazprom, the gas monopoly, electricity groups and the state railways. This is a far more tightly focused target than the previously announced list of 295 industrial companies deemed worthy of financial support that included oligarch-led groups such as Rusal, the aluminium company, and Norilsk Nickel, the metal combine. Shuvalov suggested that the state should not have lent $4.5bn to Rusal, Oleg Deripaska’s aluminium group, on the security of its 25 per cent stake in Norilsk Nickel, the metals company, when it was clear these shares were worth only $1.5bn. /ppIn line with the change in policy Vladimir Putin gave the go ahead on Thursday for a second wave of bank bail-outs to extend up to Rbs1,000bn ($28b) in order to refinance the banking sector with new capital and subordinated debt in an effort to transfer the burden for bailing out companies on to commercial banks. Of the three big state-controlled banks, VTB is to receive Rbs200bn in new capital, state-owned VEB is to receive Rbs100bn in capital and Rbs100bn in subordinated debt, and Sberbank, the huge savings bank, may receive funding in the region of Rbs500bn./ppThe moves will increase the state’s stakes in these three banks, boosting its role in the Russian economy. The state’s stake in the three banks are Sberbank 61 per cent, VTB 77.5 per cent and 100 per cent VEB. Vladimir Putin said Moscow could also inject up to 100bn roubles in subordinated loans – Tier 2 capital under international banking rules – into private banks but said the government would not seek stakes in return.br //pblockquoteAndrei Sharonov, a former deputy economy minister, who now works asbr /managing director of Troika Dialog, the Moscow investment bank, said the secondbr /bail-out of the banking system was part of an effort to switch the governmentbr /anti-crisis programme to the banking system instead of bailing out individualbr /companies, which must repay some $140bn in foreign debts this year.br //blockquotep/pblockquoteDanske Bank A/S, which ranks itself among the five biggest traders of the rublebr /through Finnish subsidiary Sampo Bank Plc, said yesterday the ruble will bebr /allowed to trade freely “within weeks,” because pressure on the currency won’tbr /abate after the decline in oil prices, according to Lars Christensen, Danske’sbr /head of emerging -markets strategy. Urals crude, Russia’s chief export blend,br /has fallen 70 percent to $43.01 a barrel since reaching a record in July, belowbr /the $70 average required to balance the government’s 2009 budget. Energybr /accounts for more than 70 percent of Russia’s exports./blockquote

Billions in U.S. Bank Rescue Funds are Fueling Buyouts Worldwide – Instead of Lending at Home

Contrarian Profits — Fri, 05 Dec 2008 14:57:31 +0000

pBank of American Corp. (a href="http://finance.google.com/finance?q=bac" target="_blank"BAC/a), which is getting $15 billion from the U.S. government as part of the Treasury Department’s $250 billion “recapitalization” effort, is doubling its stake in state-owned a href="http://finance.google.com/finance?q=SHA%3A601939" target="_blank"China Construction Bank Corp/a., and will hold a 20% stake worth $24 billion in China’s second-largest lender when that deal is finalized./p pPNC Financial Services Group Inc. (a href="http://finance.google.com/finance?q=NYSE%3APNC" target="_blank"PNC/a), which will get $7.7 billion from Treasury’s a href="http://en.wikipedia.org/wiki/United_States_Emergency_Economic_Stabilization_fund" target="_blank"Troubled Assets Relief Program/a (TARP), is using that cash infusion to help finance its $5.2 billion buyout of embattled National City Corp. (a href="http://finance.google.com/finance?q=NYSE%3ANCC" target="_blank"NCC/a)./p pAnd U.S. Bancorp (a href="http://finance.google.com/finance?q=usb" target="_blank"USB/a), which received a $6.6 billion capital infusion from that same rescue package, has acquired two California lenders – Downey Savings #38; Loan Association, F.A., a subsidiary of Downey Financial Corp. (a href="http://finance.google.com/finance?q=downey" target="_blank"DSL/a),#8230;/p

Bank Nationalization Day

Richard C. Wilson — Tue, 02 Dec 2008 17:04:45 +0000

h1 style="text-align: center;"bBank Nationalization/b/h1h2 style="text-align: center;"bspan class="Apple-style-span" style="color: rgb(102, 0, 0);"Bank Nationalization Day/span/b/h2a href="http://3.bp.blogspot.com/_tvshDVnXSLc/SS_l74vGpJI/AAAAAAAAAf4/J6EgOxMC024/s1600-h/RBS-DundasHouse.jpg"img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 320px; height: 200px;" src="http://3.bp.blogspot.com/_tvshDVnXSLc/SS_l74vGpJI/AAAAAAAAAf4/J6EgOxMC024/s320/RBS-DundasHouse.jpg" alt="" id="BLOGGER_PHOTO_ID_5273686505679135890" border="0" //a Old HQ pictured. Following failure of shareholders to buy more than 0.24% (only £36m for 56m shares) of the Royal Bank of Scotland Group's £20bn share issue, RBS (1) (including Citizens Bank, USA, and NatWest Bank, England) today became the third to be formally nationalised (nearly 58%). The small take-up of the issue by existing shareholders had been expected as the offer price of 65.5p was 10p higher than the price at which the shares were trading, so those who did buy on paper lost £5m doing so. The share issue by RBS was part of the government's plan to recapitalise banks. The government will pay £15bn for the majority stake in the bank plus £5bn of preference shares in the bank. Taxpayers too have an immediate paper loss of £2.4bn based on Thursday's closing share price. The bank's Chief Executive Stephen Hester said, "emWe regret that existing shareholders did not take up their pre-emptive rights but understand that market sentiment toward the banking sector made this uneconomic in the short term/em." That is the least of it. What is remarkable is that there is not more confidence in a regulated, government backed, major public company whose accounts are as transparent as the best standards demand, and whose market price is far below 'book value'? What has happened to investing in fundamentals for slightly longer than the immediate short term? Hester says,"emThere remain substantial uncertainties and challenges outside our control but for our part the job is underway/em." There are always uncertainties, but they should not any longer be called 'substantial' when a bank is covered with guarantees and writedowns and paperf losses are far ahead of any actual losses yet experienced in the underlying assets. The bank now needs its major shareholder's approval for executive pay and dividend, and has to agree to return to "normal" lending levels and more sensitive customer relations practices. Last week it said it is guaranteeing overdraft rates amp; contracts for business customers for a year at least. The UK government's shares of banks are held by a company called emUK Financial Investments Ltd/em, which is to emmaximise value for taxpayers and prevent politicians making business decisions about banks/em something that the Opposition Conservatives are keen to monitor to ensure this is true. a href="http://1.bp.blogspot.com/_tvshDVnXSLc/SS_mKgH5_KI/AAAAAAAAAgA/cYbDGrWqcj0/s1600-h/gogarburnHQ.jpg"img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 262px; height: 175px;" src="http://1.bp.blogspot.com/_tvshDVnXSLc/SS_mKgH5_KI/AAAAAAAAAgA/cYbDGrWqcj0/s320/gogarburnHQ.jpg" alt="" id="BLOGGER_PHOTO_ID_5273686756770315426" border="0" //aThe new RBS HQ (pictured) opened just as RBS-led consortium's deal to buy ABN-AMRO 'successully' closed, a deal paying 71bn euros ($91bn; £61bn) for the Dutch bank, that was the last great deal for a sold bank's shareholders, which lost RBS its creditworthiness, and also contributed to Fortis Bank's collapse after it agreed to buy ABN-AMRO's Benelux banks, while the third partner, Banco Santander, which got ABN-AMRO's Brazilian bank remained strongly priced (thanks to severe risk contols by Spain's Central Bank) and next bought Alliance amp; Leicester (Aamp;L) cheap, albeit that Santander now too has to make a rights issue and has cold-shouldered its many UK shareholders in an over-hasty process. Mortgage exposure proved to be the made risk to share value for UK banks as panic spread from the USA, however, even though the UK market has been a full 2 years or more behind the USA in mortgage defaults (currently 2% in UK and over 9% in USA), confidence fell mainly because of Northern Rock's bank run - a special calamity for all UK banks.a href="http://4.bp.blogspot.com/_tvshDVnXSLc/SS_n07B_NoI/AAAAAAAAAgI/qUYll2b0Lg8/s1600-h/UK_Mortgage_banks_jan08_image004.gif"img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 320px; height: 190px;" src="http://4.bp.blogspot.com/_tvshDVnXSLc/SS_n07B_NoI/AAAAAAAAAgI/qUYll2b0Lg8/s320/UK_Mortgage_banks_jan08_image004.gif" alt="" id="BLOGGER_PHOTO_ID_5273688585059382914" border="0" //a Previously nationalised UK banks are Northern Rock and Bradford amp; Bingley. I took my secretary to the House of Commons Treasury Committee: Nationalised Banks meeting on the 18th to find out how Government is managing its banks? Others to follow into Nationalisation soon include Halifax Bank of Scotland and Lloyds TSB, or possibly the combined Lloyds Bank Group, even though HboS Directors warn that Nationalisation is a ‘risk’ strenuously to be avoided (even if it means selling HBoS for a fraction of its book value by voting for the takeover by Lloyds TSB). The new combined Lloyds Bank Group could still be 43% Government-owned. To avoid this 'calamity', which would, of course, restrict the bankers’ bonus pay, though their first anxiety is to restore dividend payments to the much-abused shareholders. Hence, why Lloyds is in talks with sovereign wealth funds and UK insurance groups about selling stakes in a merged Lloyds-HBoS group, with a preliminary deal expected by January (subject to HboS shareholders voting for the takeover on 12 December). Lloyds want cash to redeem £4 bn of the ‘restrictive’ government-owned preference shares in Lloyds and HBOS at the earliest opportunity (as soon as HboS shares are delisted). But, what is there to fear about a commanding Government stake when this would guarantee the solvency of the bank and when major global banks such as Citigroup are finding that Government ownership is highly profitable? Reading from my secretary’s typed notes, from HoC Treasury Committee questioning of NR and Bamp;B banks, what do I find?br /br /1. HM Government (HM Treasury) are in daily contact by telephone with NR and Bamp;B, but do not steer the banks' commercial decisions.br /2. They face a potential conundrum, which is that while they have ‘frameworks’ in place whereby they must reduce the size of their balance sheets so as to be in better shape return to private ownership as soon as practical, Government also wants banks to maintain their lending levels, except this latter requirement is not being overtly applied to NR and Bamp;B. a href="http://3.bp.blogspot.com/_tvshDVnXSLc/SS_pRWQkCLI/AAAAAAAAAgY/mCmDzT9BEpk/s1600-h/bradford-bingley-9-7-08.gif"img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 320px; height: 227px;" src="http://3.bp.blogspot.com/_tvshDVnXSLc/SS_pRWQkCLI/AAAAAAAAAgY/mCmDzT9BEpk/s320/bradford-bingley-9-7-08.gif" alt="" id="BLOGGER_PHOTO_ID_5273690172916238514" border="0" //a3. Bamp;B has a £40bn mortgage loanbook of which £24bn is buy-to-let (B2L) mortgages (20% of UK total) and £8bn is self-certified mortgages (mainly for the self-employed). Government provides a £14bn guarantee. Bamp;B’s current defaults are 1.8% but 3% among B2L. Moody’s stress tested the loanbook and estimate through-the-cycle loss will be 3% in total or £1.3bn against £1.7bn capital reserve (76% capital wipeout). The Execs did not repeat anything about weakness in the bank’s accounting system that had been originally blamed for failure because the board simply did not know how bad its position was?br /br /4. The HoC Treasury Cmte was anxious to know if bonus culture (where execs get many times the % ratio to salary in bonus compared to all staff) was the cause of excessive book-building such as contracting to buy £6.5bn of buy-to-let mortgages from GMAC (owned by General Motors)? Bamp;B execs explained half of these were UK mortgages and seemed to fit with the bank’s speciality. 90% of all its book came to it via intermediaries anyway (and 2.5% fees were added into the mortgage loans while the GMAC arrears are just over 3% and the long term contract proved embarrassingly inflexible as credit conditions changed).a href="http://3.bp.blogspot.com/_tvshDVnXSLc/SS_o_hUj8AI/AAAAAAAAAgQ/yYrsYKMe2C4/s1600-h/NRock.jpg"img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 320px; height: 236px;" src="http://3.bp.blogspot.com/_tvshDVnXSLc/SS_o_hUj8AI/AAAAAAAAAgQ/yYrsYKMe2C4/s320/NRock.jpg" alt="" id="BLOGGER_PHOTO_ID_5273689866648154114" border="0" //a 5. NR was quizzed about bonuses too at 5 times ratio to salary as all staff (which by the way are subject to Government Approval), and about why its mortgage foreclosures seemed so much larger than the industry average. The execs countered that bonuses are linked to progress in redeeming the Government’s equity, while foreclosures only produce 1% of that revenue and its 4,200 stock of homes for sale were gathered over 18 months, not 1 year, hence it is not so draconian as the media speculated. (NR’s deposits business was sold to Abbey- Santander)br /br /6. NR has a ‘Together’ mortgage book for high loan to value borrowers (typically 115% of home purchase price, higher now that house prices have fallen) but these only show a 3.1% default against a general arrears of 1.87% when the industry is 1.33%. Only 10% of arrears result in repossessions and one third of these are voluntary.br /br /7. NR is designing MORTGAGE RESCUE PRODUCTS that will build on payment holidays and interest deductions 9currently negotiated case by case depending on individual circumstances). At the same time NR is writing little new business (and not trying to out-compete the market on price) and encouraging borrowers to re-mortgage elsewhere, except elsewhere doesn’t want to do so for any loan-to-value ratio of more than 80% (at present depressed and falling house prices), hence Government will probably continue to own the bank for about 3 years more.br /br /8. The Committee asked about the cost of Government support. Bamp;B said it was at full commercial rates (measured across a number of funding and guarantee types). NR said it was charged to them at above commercial market rates, something that may be currently reviewes. This is important to the European Commission's enquiry to ensure that Government support does not distort competition unfairly - report not expected until the Spring of next year.br /br /9. A risk consultants report into NR found that risk management was not independent of business operations, risk culture not imbedded, and need for induction training; all matters being fixed by a new Risk Head’s new structure, and new risk policies manual. The Treasury Cmte Chairman ended the meeting with reference to NR’s “shambolic organisation” and he was not being humorous about that. a href="http://3.bp.blogspot.com/_tvshDVnXSLc/SS_q9sAPWVI/AAAAAAAAAgg/j38SiPCrRQs/s1600-h/HOC+Treasury+Cmte"img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 317px; height: 239px;" src="http://3.bp.blogspot.com/_tvshDVnXSLc/SS_q9sAPWVI/AAAAAAAAAgg/j38SiPCrRQs/s320/HOC+Treasury+Cmte" alt="" id="BLOGGER_PHOTO_ID_5273692034179225938" border="0" //a(1) Note: The Royal Bank of Scotland was founded with Government support in 1728 to create a rival to the Bank of Scotland that was suspected of being Jacobite (anti-Hanoverian, supporter of the Stuarts). In 1728, the Royal Bank of Scotland became the first bank in the world to offer an overdraft facility when merchant William Hogg was allowed to take out £1000 unsecured (£65,000 today) more than he had in his account! a href="http://2.bp.blogspot.com/_tvshDVnXSLc/SS_lekR-wVI/AAAAAAAAAfw/CwCnzsmRmwM/s1600-h/I+shall+withdraw+my+overdraft.png"img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 233px; height: 320px;" src="http://2.bp.blogspot.com/_tvshDVnXSLc/SS_lekR-wVI/AAAAAAAAAfw/CwCnzsmRmwM/s320/I+shall+withdraw+my+overdraft.png" alt="" id="BLOGGER_PHOTO_ID_5273686001972068690" border="0" //a "emI warn you, Sir! The discourtesy of this bank is beyond all limits. One word more and I — I withdraw my overdraft!"/embr /br /The Committee members were all knowledgeable and asking intelligent questions intelligently, just as banking professionals might do if they have that much common sense about banking. I conclude that oversight by Government seems neither draconian (unless bankers are most anxious about their bonus levels) nor is it a shadow management, but more like an anxious major shareholder that is keen to sell out when the balance sheet is made safe and prospects are stable or positively improving. Why should Lloyds, HboS or Barclays (facing shareholder anger over the bank’s choice of expensive sovereign fund investors instead of Government backing) believe ‘nationalization’, which NR and Bamp;B execs always describe as ‘temporary’, is such a bad risk to be avoided even at substantially higher cost? Are the objections ideological, or driven by shareholders anxious to restart cash dividends, or by bankers afraid for their bonuses, or are they afraid of Government making them behave more sensitively and empathetically to customers? Or maybe the banks worry too that they might be restrained from making major foreign investments such as buying foreign banks or such as RBS’s recent participation in a gigantic $35bn loan to support Ontario Teachers Pension fund buyout of Telcom Company BCI for 52bn, that looks like failing to proceed at the last minute?!br /br /Contributed by a rel="nofollow" target="_blank" href="http://bankingeconomics.blogspot.com/"Robert Mcdowell/abr /h4Related to Bank Nationalization Daybr //h4ullia alt="Hedge Fund Tracker Tool" href="http://richard-wilson.blogspot.com/2008/08/hedge-fund-tracker-tool.html" title="Track over 1,000 Leading Hedge Funds"Hedge Fund Tracker Tool/a/lilia description="hedge fund marketing" alt="hedge fund marketing" href="http://richard-wilson.blogspot.com/2008/03/hedge-fund-marketing.html" title="Sharpen Your Hedge Fund Marketing Skills"Fund Marketing and Sales Advice /a/lilia href="http://richard-wilson.blogspot.com/2007/12/100-hedge-funds-to-watch.html"Top Hedge Fund Managers/a/lilia href="http://richard-wilson.blogspot.com/2008/04/hedge-fund-videos.html"Free Online Hedge Fund Videos/a/lilia description="Hedge Fund Employment, Hedge Funds Employment Openings, Employment at Hedge Funds, Careers amp; Employment at a Hedge Fund, Hedge Fund Employment Opportunities" alt="Hedge Fund Employment" href="http://richard-wilson.blogspot.com/2008/05/hedge-fund-employment.html" title="Enhance your Hedge Fund Career"Careers amp; Employment Guide/a/lilia alt="Geographical Guide to the Hedge Fund Industry, International Hedge Fund Guide" href="http://richard-wilson.blogspot.com/2008/08/geographical-guide-to-hedge-funds.html" title="Learn About Hedge Funds in over 200 Geographical Regions"Geographical Guides/a/lilia description="A collection of tools for hedge fund startups" alt="Hedge Fund Startup Tools" href="http://richard-wilson.blogspot.com/2008/09/hedge-fund-startup-tools-1-page-guide.html" title="Hedge Fund Startup Tools"Hedge Fund Startup Tools/a/li/ulTags: Bank Nationalization, Bank Nationalisation, Nationalization of Banks, What banks were take over by the government, government owned banks, bank owned by the governmentdiv class="feedflare" a href="http://feeds.feedburner.com/~f/richard-wilson-blog?a=y7bBo"img src="http://feeds.feedburner.com/~f/richard-wilson-blog?i=y7bBo" border="0"/img/a a href="http://feeds.feedburner.com/~f/richard-wilson-blog?a=i32MO"img src="http://feeds.feedburner.com/~f/richard-wilson-blog?i=i32MO" border="0"/img/a a href="http://feeds.feedburner.com/~f/richard-wilson-blog?a=aGdio"img src="http://feeds.feedburner.com/~f/richard-wilson-blog?i=aGdio" border="0"/img/a /divimg src="http://feeds.feedburner.com/~r/richard-wilson-blog/~4/472665587" height="1" width="1"/

As Ukraine And Hungary Accept IMF Loans, Will Poland Be Next?

Edward Hugh — Tue, 28 Oct 2008 08:48:00 +0000

by Edward Hugh: Barcelona

Yesterday, the Ukraine received a USD16.5bn loan from the IMF and the IMF at the same time said that it would agree with the Hungarian government on a rescue package in the coming days. Under normally circumstances this would be good news for CEE assets. However, it seems like the markets are totally giving up on CEE. This morning the Hungarian stock markets have dropped more than 10% despite the promise of an IMF package.

......it is worrying that the CEE markets continue to sell-off despite IMF’s clear commitment to support the region’s markets and economies. One might in fact see the lack of positive response to IMF’s rescue packages for Hungary and the Ukraine as an indication that these packages are in fact making the markets even more nervous that something “is seriously wrong in CEE”.
Lars Christensen, Chief Analyst Danske Bank, CEE: Markets fail to respond to IMF packages, 27 October 2008

Stocks In Decline

Central European stocks declined for a fourth consecutive fourth day on Monday, with indexes in Vienna and Budapest heading for record monthly drops, as concern mounts that the global financial crisis is going to have a severe impact on economic growth across the entire region and amidst worries that the IMF sponsored rescue packages in Hungary and Ukraine simply won't be sufficient to avoid the worst of the damage. Concern is also mounting that there will be a process of "contagion" which will affect the whole region, and hence what we are now seeing is mounting pressure on Poland's financial system, despite the fact that the country's economy could be thought to be rather stronger than those in Latvia, Lituania, Estonia, Bulgaria, Romania and Hungary. Thus, if Poland falls, god help the rest of them.

Erste Group Bank AG slid to the lowest level in more than five years while Raiffeisen International Bank Holding AG, which operates in Russia and the Ukraine, plunged after mounting financial chaos forced Ukraine to seek help from the IMF.

Against the general trend Poland's WIG20 Index added 2.2 percent on the day, but this did follow a 5.9% fall on Friday. The MSCI Barra Core Poland Index (which is a measure of comparative equity values) is down 48% so far this month, and 61.24% over the last three months.

The Polish government has also announced on Monday that Poland is considering guaranteeing interbank transactions - according to Deputy Prime Minister Waldemar Pawlak speaking on Polish public radio. Pawlak said that the government is examining the possibility of taking bank shares as collateral in exchange for any guarantees offered. According to Pawlak external investors in Polish banks have been applying policies that are "too strict" in the Polish context, since the credit problems encountered elsewhere have not affected Polish banks in the same fashion. This is a classic example of what we economists call "contagion".

According to the draft of the new law which is set to go before the Polish cabinet on Tuesday, Poland's government will be empowered to guarantee commercial banks loans from the central bank and other lenders on the interbank markets. The government will also be able to lend cash and state securities to banks. Poland's central bank has already injected 9.3 billion zlotys ($3.42 billion) of liquidity into the banking sector (last week), in the form of 14-day repos. The latest decision seems to have been taken in order to try to ease strains on the Polish money market, and in particular the availability of forex loans.

Poland's deputy prime minister also issued a warning that local bank capital was at risk of capital being transferred to financially-strapped foreign banks who own the local banks and urged the country's financial watchdog to stay vigilant in the face of this. Here we see the reverse side of the coin of having non-national banks in such a dominant position. Previously this was thought to be a great advantage, since the parent banks were thought to be ready willing and able to fund domestic lending almost ad-infinitum. Now we see that this is not at all the case, and that their behaviour moves in a pro-cyclical direction, exaggerating the boom in the good times, and sharpening the downturn in the bad ones.

"There is a risk that the capital will be transferred from Polish institutions to their parents," Waldemar Pawlak, who is also the economy minister and heads the governing coalition's junior party, was quoted as saying by PAP newswire.

As a consequence of this governmental concern the Financial Oversight Commission (KNF) has asked banks domiciled in Poland to report all transactions with their foreign owners on a daily basis. KNF head, Stanislaw Kluza, said in a newspaper interview last week that the he considered the risk of capital transfers to be very low, however, because the European banks Polish outlets, with only $284 billion in total assets, were much too small to rescue large players in Europe and the United States. This is evidently true, but some of these bank are now under great pressure to avoid additional exposure in the East, and withdrawal of funds can equally correspond to this kind of damage limitation strategy.

Foreign financial groups, among them Italy's UniCredit, the Dutch ING Groep, and KBC Group NV, Belgium's biggest bank and insurer by market value (all of whom are struggling with major problems at the present time), control two-thirds of the Polish banking sector after buying stakes in local lenders during the banking sector privatisation of the 1990s.

Polish lenders have been especially hurt in recent weeks by concerns over their ability to obtain foreign currency through interbank markets and worries about the fate of their foreign parents. Executives at some Polish banks have urged the government to consider introducing guarantees after the central bank's moves to boost liquidity on the interbank market, including foreign exchange swaps, failed to boost confidence between lenders. The financial watchdog KNF said on Saturday that Poland should think about measures to boost the Swiss franc positions of Polish banks, along with guarantees of interbank transactions or an eventual "institutionalisation" of the interbank market. But the regulator, the government and central bank insist Polish banks remain solvent and enjoy "over-liquidity."

Many of Poland's banks, like other lenders in the region, have been forced to introduce severe curbs on mortgages in Swiss francs due to pressure on their own liquidity and balance sheets. Such lending had become popular in Poland in recent months due to lower interest rates available from Switzerland and what was once favourable exchange rate.

Millennium BIGW.WA and PKO BP PKOB.WA, two of Poland's top home loan lenders, have gone so far as to announce that they were going to tighten rules for new mortgages due to the rising cost of money and fears that global financial nervousness may lead to much slower economic growth in Poland. Millennium Chief Executive Boguslaw Kott said last week that the group - which is Poland's third-biggest mortgage lender would ask for a 35 percent downpayment for popular Swiss francs-denominated home loans, a move which is likely to put a sharp brake on the growth of its mortgage portfolio.

PKO, Poland's largest mortgage lender, also confirmed it would ask new clients to put up 20 percent of the value of property when borrowing in francs. Millennium, which is controlled by Portugal's Millennium bcp, will now also require customers to cover 20 percent of investment when borrowing in Polish zlotys. Both banks had previously been offering mortgages equal to the entire value of the new home (100 LtV). Basically, what the hell these people thought they were doing by continuing to lend at 100% LtV after we have seen all that has happened in the US, and that is now happening in the UK and Spain is totally beyond "my ken", it really is.

Chief Executive Boguslaw Kott described the move as a precautionary one, and said it did not reflect any liquidity problems, adding that it was now more difficult to get Swiss francs on the interbank market. Marek Juras, head of research at BZ WBK brokerage is quoted as saying: "At times like these it is more important for banks to take care of their liquidity than drive their sales even higher." He estimated that for some lenders this would translate into a drop in new mortgages by between one-third and one-half.

The two market leaders join other smaller lenders, which in recent days moved to raise the bar for mortgage lending in foreign currencies as banks become more conservative and try to lure more cash on deposits by offering even higher yields. Mortgage adviser Expander said Getin's DomBank and Santander and GE Money had tightened their lending requirements. Many banks have also boosted margins on their mortgages in the past two weeks.

The Polish mortgage market has expanded rapidly since 2003, driven by economic growth and soaring wages, with annual growth exceeding 40 percent in the first half of this year. Large numbers of central and Eastern European housebuyers hold loans in foreign currencies, especially Swiss francs.

Most major Austrian banks, including UniCredit's Bank Austria, Erste Group Bank and cooperative Raiffeisen have now completely stopped lending to Polish domestic retail customers in foreign currencies.

After a meeting with economic advisers President Kaczynski advised Poles to keep faith in the zloty as the currency suffered further setbacks on the markets on Friday. Kaczynski recommended that loans should be taken in zlotys, not foreign currencies in order to avoid losing money on currency exchange.

"The depreciation of the zloty, which has its good sides for exports, boosts
mortgage loan installments for those who took them especially in the Swiss
franc. This may, however, be a lesson to us all to take loans in the Polish
currency. Considering low inflation, this gives the best results," Polish
President Lech Kaczynski told a press conference last Friday.

Seventy percent of the Polish banking sector is owned by foreign banks leading to concern that the impact of the general crisis in the banking sector will be felt in Poland. On Tuesday, Polish business Daily, Gazeta Prawna wrote, "The global financial crisis may cause large shifts in the Polish banking sector, AIG Bank Polska will soon be sold and there has been speculation that Fortis, Dominet, Citi Handlowy and even Bank Pekao may change hands."

Sell off speculation has surrounded the Italian owned Pekao bank over the last two weeks. It was subject to a 20 percent share price decrease in October prompting concerns that owner UniCredit may have been considering selling of all its Central and Eastern European assets. This has since failed to materialize but shows the current lack of faith surrounding the Polish banking sector.

Slawomir Skrzypek, president of The National Bank of Poland stated it had no intention of stepping in to help the zloty as it continues to weaken on the foreign currency market in a statement to reporters on Friday.

The sale of apartments in Poland has dropped by 70 percent in comparison to the same time last year, showing that the credit crunch is beginning to bite in Poland. The tightening of lending policies by banks has caused demand to fall and though prices are decreasing by 10 to 20 percent in some areas, buyers are looking for smaller flats, or withdrawing from the transaction altogether. The financial crisis has also influenced the situation of those clients who wanted to buy apartments without needing to get a mortgage, the number of which is declining due to losses on the stock market, says Gazeta Prawna.

Polish banks are to crack down on credit lending for housing loans after Poland’s financial regulator asked them to get tougher on lending practices. Millennium bank is one of the first high street banks to react and will now expect customers to cover 35% of the loan if they borrow in a foreign currency or 20% if borrowing in Polish zloty. The move is thought to be a precautionary one and not an indication of any liquidity problems, according to CEO Boguslaw Kott who told a news conference on Tuesday, “The decision practically blocks an increase of our mortgage portfolio.” He also told reporters that Swiss francs are harder to come by on the interbank market. Millennium Bank has been a dominant force in the Polish housing lending market with 80% of its mortgages being in Swiss Francs. This reflects a trend across Central and Eastern Europe where many house buyers have loans in either Swiss or other foreign currencies.

PKO BP, another major Polish mortgage lender, has joined Millennium in giving credits up to 80% of the value of the real estate. Fears that the Polish housing market could suffer similar repercussions to that of some western banks are as yet premature although the move does indicate a degree of uncertainty on behalf of the lending sector’s big hitters.

"We are extending between 35 and 60 million zlotys worth of mortgages each day, the vast majority of those in Swiss francs." Mariusz Grendowicz Head of BRE Bank BREP.WA "To fund our growth in mortgages, we were the only bank to the best of my knowledge that was using not swaps, which were the cheapest alternative, but actually taking a three- to four-year loan in Swiss francs to fund the book,"

The impact of the seize up in Swiss Franc housing loans is hard to guage at this point, although all the indications are that it will be serious. Foreign currency lending has not been such an important phenomenon in Poland as it has been in other CEE countries, but its weight has been growing in the last 18 months or so (see chart below).

The role of forex lending is clearly more important in housing loans than in general lending (see chart below).

One of the reasons for the recent uptick in Swiss Franc lending has been the monetary tightening cycle initiated by the central bank (see chart below), which made the cheaper interest rates available in CHF more attractive even though there was an evident currency risk involved.

If we look at the next chart the year on year rate of increase in the forex loans (the Polish central bank don't distinguish in their data between CHF and Euro, but all the anecdotal evidence cited above points to a significant role for the CHF, and especially given the role of Austrian banks were this type of lending has been commonplace.

The big problem is really that the CHF is a "carry trade" currency, and carry currencies have a strong tendency to shoot up in value as risk sentiment retreats, quite simply because people all try to liquidate their positions at the same time. Hence carry currencies have a kind of "pro-cyclical" role, adding to the boom during the good times, and making the bad times even worse. Which would be one very good reason why if you really do want an fx mortgage, using a currency other than a carry one would be a good idea. Obviously those who have euro denominated mortgages - while not being immune from the present problems (see the Baltics) - are less exposed, since the movements in the relative value of the euro tend to be in the opposite direction to those of the CHF and the Japanese yen.

Where Does All This Leave Us?

Well obviously Polish GDP growth is now set to slow quite dramatically. At this point just how dramatically is hard to see. Credit Suisse Group recently cut its forecast for Polish economic growth next year, predicting that the global financial crisis will hurt consumption and investment.

Credit Suisse said Poland's gross domestic product will rise by less than 4 percent in 2009, compared with the 4.4 percent rate it had previously forecast, according to a note to clients last week. The revision, amid rising aversion to risk in emerging markets, pushed the zloty to a two-year low against the euro. I think, basically, even Credit Suisse are being over optimistic at this point, although I think we need to see some real economy data before putting numbers on just how over-optimistic they may be.

Poland's `` private consumption and investment should fall further than we had anticipated due to our expectations of an increasingly restrictive credit environment in 2009,'' Jacqueline Madu, an emerging-markets research analyst at Credit Suisse in London, wrote in the note.

.

One of the first areas where we should expect this crunch to be felt is in construction activity itself. There is no doubt that Poland has been "enjoying" the fruits of a construction boom since the second half of 2006. It seems to have come in two "waves" if we look at the chart below, with the first wave being much stronger than the second one.

If we actually look at the level of the seasonally adjusted index, then the steep increases in the levels of construction output become apparent. We should also notice how since about April the level has stopped rising, and this seems to suggest that the expansion in the industry had been slowing even before the latest credit shock. Be ready for this to be followed by a sharp slowdown in the months to come.

If we look at the chart for year on year industrial activity, then it is clear that the expansion in output has been fading for months now - not a good sign, not good at all, since it means that there is little underlying stability to resist the knock. The thing is running out of energy.

This becomes even clearer when we look at the seasonally adjusted index, since it is pretty evident that industrial output went into decline at the end of last year, killed-off in part by the high zloty, and in part by excess internal wage and cost push inflation.

And So It Ends – Hungary’s Government Announces Foreign Currency Loan Wind-up Package

Edward Hugh — Fri, 24 Oct 2008 08:26:00 +0000

by Edward Hugh: Barcelona

Hungarian Prime Minister Ferenc Gyurcsány announced yesterday (Wednesday) that the government had reached an agreement with commercial banks intended to protect the interests of those who have taken out foreign currency loans.

The agreement, which is expected to be signed early next week, has three key components:

1) At the request of the debtor the banks will allow the duration of the loan to be extended (with fixed monthly instalments) so that the depreciation of the forint “does not place an unbearable burden on the debtors".

2) FX debtors who deem that exchange rate fluctuations carry excessive risks for them will be allowed to convert their foreign currency-based loan to a forint loan. In this case the banks “will accept this request and make the switch without extra charges".

3) If a debtor finds him- or herself in a position where he or she cannot pay the monthly instalments, e.g. due to becoming unemployed, the banks will be amenable to transitionally reducing the instalments or even suspending them entirely at the request of the debtor.

I say "agreement" here, but in fact the banks had little alternative, since Gyurcsány made it plain to them that if they did not agree then legislation would be introduced to enforce the government package.

So here, right now, and on 23 October 2008 in Budapest ends, in my opinion, a fashion for taking out non-local currency denominated loans, which lasted the best part of a decade and sewpt across half a continent, and especially in Central and Eastern Europe . Basically government after government in one CEE country after another will now find themselves with little alternative but to follow Hungary's lead, as the parent banks turn off the tap on the one hand and the citizens themselves grow more and more nervous on the other.

The situation is in fact a little bit complicated, since (unless there is some part of the fine print which has not been made public yet) we have to assume that the conversion rate be the going market one, which will mean that many of those who such mortgages will take some form of capital loss on the transfer, which can thus only be seen as some form of "late in the day" protection against subsequent falls in the value of the forint. Jiri Stanik at Wood & Co estimates that most bank clients took out their FX loans at a level of around CHF/HUF 170, so despite the fact that the forint has depreciated by some 30% against CHF over the last two months, its current level (HUF/CHF is about 185 at the time of writing) only represent s an 8/9% depreciation from the average client purchase price. Most of the risk and all the really bad news will come for these mortgage holders if the forint were to continue to depreciate further against CHF. Will this depreciation continue? Well, even we economists don't really know the answer to that question, and certainly Hungarian householders have no idea at all, which is one very good reason why most of these clients may decide to get out now. Ceraintly they will probably be uncomforable with the realisation that they have suddenly all become day traders in the forward HUF/CHF swap market using their homes as security.

Also the rate of interest to be charged on the HUF morgtgages will be based (it would seem, again there are no details) on some mark-up or other over the current base rate of the the NBH, which was, we will remember hiked to 11.5% yesterday. So at the end of the day the people who make the transition will take a (small, at this point) capital loss, but at the same time their short term interest servicing payments will skyrocket (this is presumeably why Gyurcsány has insisted on their being able to extend the term of the payments) . Thus, in terms of the macroeconomic recession, here we go.

For this all to form part of a coherent rational policy (perhaps a very large assumption indeed at this point) , it can only suggest one thing, in my opinion: that the base rate hike is a TEMPORARY support for the forint while people move over (which we could expect to see in the form of a flood, rather than a trickle - see the point about "herd behaviour" below). Basically when you have half your army trapped in an excessively advanced position, you need the heavy artillery to lay on some cover while you pull them back.

Once the troops are safely back under cover, then, in my humble opinion, we should anticipate a rapid easing cycle on the part of the NBH, and a sudden tanking in HUF partities, since the looming priorities will be to ease distress on all the new HUF mortgage payers, and an attempt to "jump start" a new export-driven Hungarian economy. I think it is important to bear in mind that Hungary is now about to head into quite a severe recession, and the fiscal stimulus door is effectively closed. Monetary easing is the only real policy tool the Hungarian authorities have available. And remember, we are going into all of what is now to come with national morale severely weakened by two years of policy measures which didn't work, to cut a very long story down to a very, very short one.

In other words the current situation is like having your population distributed across two very high buildings, one of which is about to collapse (or at least disappear), and the Hungarian government has just thrown a plank across from one building to the other so that people can "move over" in single file, before the one which is about to go, goes. The people in the other building may suffer from overcrowding and shortage of food, but they will at least be "safe". But the big danger might be, just how many will get trampled in the rush?

Basically, and to cut another very long story down into a very, very short one, the building which is about to disappear is the one which was to have housed Hungary (and several other of the EU12) as a full member of the Eurozone. This, ever more distant possibility in recent months, is now about to move off into a much longer term futures, and it is this distancing, of course, which makes all the forex borrowing suddenly unsustainable. The man who has been hanging desparately over the parapet by his fingernails for two years, now finally lets go.

Plus there is still the thorny little issue of just how Hungary is going to fund the conversions, and how much bad news there might be for the banks here.

“We think the most important announcement at this stage is the possibility to convert CHF loans to HUF. If households chose to do this it would ultimately mean a switch in FX mismatch from households to banks (who would then hold HUF assets but CHF liability). Banks in turn would then need to close their FX mismatch, through FX swaps (buying CHF).........It's not clear who would provide sufficient HUF liquidity to do this. Ultimately the NBH would presumably provide liquidity to avoid banks being left with a significant FX mismatch."
Martin Blum, Gyula Tóth, UniCredit, Vienna

At the end of August total housing loans were running at around 3,380 billion HUF or about EUR 12 billion equivalent at todays prices. Of these around 18 billion HUF (or 53%) were fx housing loans. Which means there are something like 6.5 billion euro in fx housing lonas which could be translated over. To this could be added another 1,500 billion HUF in mortgage financed personal loans (so say around another 5 billion euros to cover this). These numbers put the recent 5 billion euro loan from the ECB in some sort of perspective I think.

My impression is that this move by the Hungarian administration will soon be followed by one government after another across the other central and Eastern European Economies where forex mortgage borrowing had become so popular. So basically, the situation is that Hungary can, to some extent, protect its citizens from excessive exposure in times of turbulence, via this channel. The foreign banks who have been providing this service, and who in the main come from other EU member states, will then be left to pick up the exposure tab themselves, and my guess is that several of them will need to seek protection via the EU15 bank support scheme thrashed out in Paris on 12 October last, in just the same way that other financial entities have been receiving protection from the US Sub-prime write-downs.

In the meantime, we can expect to see the shares of the main banks involved coming under severe attack. Erste Group Bank AG, Austria's biggest publicly traded bank, lost 1.95 euros, or 8.8 percent, on Tuesday to hit 20.10, a five-year low, while Italy's Unicredit - another very exposede bank in CEE terms - fell to an 11-year low in Milan this morning (Wednesday) on market speculation the company will need to further strengthen its already recently "strengthened" finances. Italy's biggest bank by assets declined as much as 8.8 percent to 1.90 euros, its lowest price since September 1997. Unicredit is now down 65 percent since the beginning of the year and shares in the bank were again suspended from trading earlier today due to excessive declines.

A Ten Year Craze Comes To An End

As I say above "and so it comes to an end". A phenomenon which in many ways has served to characterise an epoch is now being drawn to a close, and as my own personal contribution to commemorating this pretty historic moment, I would like to take you all back a deceade or so to take a look at how the whole thing got started in the Austria of the late 1990s, since it was in Austria that the fashion for CHF mortgages really took off, and it is no coincidence that in Hungary it has been CHF and not euro denominated borrowing (as for example in the case of the Baltics or Romania) which has been the hallmark, since the Asutrian banks have played a key role in the Hungarian "transition". Dimitri Tzanninis explains the origins of Autrian CHF borrowing as follows:

The practice of borrowing in foreign currency (mainly Swiss francs) began in the western part of the country, where tens of thousands of Austrians commute to work in Switzerland and Liechtenstein. This partly explains why the share of these loans was higher in Austria, even during the 1980s. Word of mouth and aggressive promotion by financial advisors helped spread the popularity of these loans to the rest of the country. By the mid-1990s, newspaper ads placed by banks began to appear, fueling public interest.

Now Dimitri Tzanninis refers to this as an example of "herd behaviour" (see note at foot of post, and of course herd behaviour is the word, since his is about fads and fashions, and largely "non-rational behaviour - since if people understood the risk they were taking on board, then basically they wouldn't do it, and it is precisely herd-behaviour that we are now about to see in action again as people "unleverage" from the CHF as best they can). So, herd behaviour is essentially a non-linear process, and one which in this case is characterised by a lot of press and "word of mouth" driven "copycat"decision taking. The following charts of news stories in the Austrian press sum the situation up pretty well:

Herd Behaviour

For the record book I reproduce below the explanation of the herd behaviour phenomenon offered by Dimitri Tzanninis.

"Herd behavior occurs when people do what others do rather than rely on their own (incomplete) information, which might be suggesting something different (Banerjee, 1992). The suppression of private information could lead to “information cascades” when decisions are made sequentially and a large enough number of people choose identical actions. In such settings, the decisions of a critical few people early on are enough to tilt group behavior toward a certain direction. Mimicking the behavior of others might be rational because of uncertainty about one’s own information as well as the need to economize on information-gathering costs. Rational herd behavior is the subject of a recent strand of behavioral finance (see Montier, 2002, for an introduction). "

Herd behavior can arise in a variety of environments, including in financial markets. However, it is difficult to disentangle empirically the effects of macroeconomic or other fundamental determinants from those caused by herd behavior. Herd behavior often results in volatility because it is susceptible to abrupt shifts or reversals, and thus has the potential to destabilize markets.

Empirical studies have shown that the dynamics of herd behavior often resemble an S curve: initially only a few adopt a certain behavior, but, past a certain critical mass, a take-off state takes hold where a rapidly growing number of people adopt this behavior. Toward the end of this process, a moderation of the dynamics takes place as the potential pool of adoptees is exhausted.

References:

Banerjee, A. V., 1992, “A Simple Model of Herd Behavior,” The Quarterly Journal of Economics, Vol. CVII(3), pp. 797-817.

Montier, J., 2002, Behavioural Finance: Insights into Irrational Minds and Markets (Chichester: John Wiley & Sons Ltd.)

Waschiczek, W., 2002, “Foreign Currency Loans in Austria—Efficiency and Risk Considerations,” in Financial Stability Report 4, OeNB, pp. 83-99 (Vienna: Oesterreichische Nationalbank).

And to close this little commemoration of the closing of an epoch, here is a post I put up on this blog on 5 November 2007.

Swiss Franc Morgtages in Hungary

The use of non-local-currency denominated loans has become a widespread phenomenon in Eastern Europe in recent years. In Hungary the most common currency for such purrposes is the Swiss Franc and around 80% of all new home loans and half of small business credits and personal loans taken out since early 2006 have been denominated in Swiss francs. A similar pattern of heavy dependence on foreign currency denominated loans is to be found in Croatia, Romania, Poland, Ukraine (US dollar) and the Baltic States, although the mix between francs, euros, the dollar and the yen varies from country to country.

So let's look at the extent of the issue in Hungary, and some of the likely implications. First off, here's a chart showing the evolution of outstanding mortagages with terms over 5 years since the start of 2003. As we can see the outsanding debt is now over 5 time as big as it was then.

Now if we look at the growth of forint denominated mortgages over the same period, we can see that while they initially expanded very rapidly, they peaked around the start of 2005, and since that time they have tended to drift slightly downwards.

Then if we come to look at the growth of non-forint mortgages, we will see that since early 2005 the rate of contraction of such mortgages has increased steadily.

Finally, if we look at the distribution of non-forint mortgages between those in euros, and those in "other" currencies (which may contain some yen, and some USD mortgages, but in the main will be Swiss Franc ones) we can see that those in euro form only a very small part of the total.

It is perhaps also worth pointing out that the fashion for non-forint loans is not restricted solely to mortgages, car loans and other longer duration personal loans also tend to be denominated in Swiss Francs or other currencies. The reason for this is obvious, the rate of interest is cheaper. But this non forint loan predominance has two important consequences.

In the first place the Hungarian central bank does not have sufficient control over monetary policy inside the country, being to some significant extent influenced by monetary policy in Switzerland, a country we may note which is not even inside the European Union. Secondly, the difficulties which would present themselves in the event of any substantial reduction in the value of the forint would be considerable - the is known as the translation problem, and is ably reviewed by Claus in this post here - and as a result the central bank is one more time a prisoner of others in terms of monetary policy, since it cannot take interest rate decisions which might influence excessively the swiss franc-forint crossover rate.

The fashion for borrowing in Swiss francs really took off in Eastern Europe after the Swiss National Bank dropped interest rates to 0.75% in 2003 in order to stave-off a perceived deflation threat, a move which at the same time converted Switzerland into the cheapest source of loan capital in Europe. External lending in Swiss francs reached $643 billion in 2006, according to data from the Bank for International Settlements . The huge scale of the borrowing in fact drove the Swiss franc to a nine-year low against the euro, and has lead to an accelerating slide in its value over the last two years - even though by this point the Swiss National Bank had been busy raising rates (Swiss interest rates have now been increased 7 times since the 2003 trough). The extreme weakness in the Swiss Franc is in fact rather perverse (shades of Japan, of course, here), since currently Switzerland enjoys the highest current account surplus in the developed world (some 17.7% of GDP in 2006). At the same time the Swiss hold more than $500 billion in net foreign assets, making them in these terms the wealthiest nation on earth.

A recent issue of the Bank for International Settlements publication Highlights of International Banking and Financial Market Activity has some revealing comments on the Swiss situation(the data used for the report came from 2006):

Total cross-border claims of BIS reporting banks expanded by $1 trillion in the last quarter of 2006. After more modest growth in mid-2006, a pickup in interbank claims accounted for 54% of this expansion. A surge in credit to nonbank entities contributed $473 billion, pushing the stock of cross-border claims to $26 trillion, 18% higher than in late 2005.

The flow of credit to emerging markets reached new heights through the year 2006. Claims on emerging markets grew by $96 billion in the final quarter of 2006, bringing the volume of new credit throughout the year to $341 billion. This amount exceeded previous peaks ($232 billion in 2005 and $134 billion in 1996), both in nominal value and in terms of growth. The current annual growth rate has risen to 24%, having surpassed for the sixth consecutive quarter the previous peak of 17% recorded in early 1997.

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.

The currency denomination of cross-border claims on emerging Europe tilted further towards the euro. In the stock of claims outstanding, the euro and dollar shares were 44% and 31%, respectively, but the gap in the latest flow data was more pronounced (61% and 5%). While the sterling share has remained close to 1%, the yen has lost ground to the Swiss franc, thus continuing a trend seen over the last six years. Yet there is little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending in several countries. Borrowing in the Swiss currency remains on average below 4% of cross-border claims, and exceeds 10% only in Croatia and Hungary.

Nearly 20% of reporting banks’ foreign claims were in the form of funds channelled to emerging market borrowers. Claims on residents of emerging Europe continued to account for the largest share of these funds.

So, although the BIS find "little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending", they do make an exception in the cases of Hungary and Croatia, where they note that lending in Swiss francs to retail clients reaches over 10% (and of course in the Hungarian case well over 10%) of the total retail loans in those countries. Indeed, as I indicate above, swiss franc loans now seem to account for over 80% of all newly generated housing related credit in Hungary. The reason why Hungary has gone for Swiss franc rather than euro denominated loans undoubtedly has to do with the role of the Austrian banking sector in Hungary, as is explained in my fuller posting on this topic linked to below.

Additional References On Swiss Franc Loans and "Translation"

For fuller examination of just why it is that Switzerland (or for that matter Japan) have such low interest rates, see my "Swiss Franc Loans and Ageing" post.

For an examination of the potential implications of the presence of all these foreign currency loans across the EU10 in the event of any generalised emerging markets crisis see Claus Vistesen "Translation Risk in the Baltics and Other Matters".

Balance Sheet Consequences: The Academic Research

Well, given what I am saying above about the rapid and imminent demise of foreign exchange loans among Central and East European nationals, it is clear that the topic which is now about to come back into fashion (and to replace the forex loans themselves as the centre of attention - at least among theoretical economists) is that of the so called "balance sheet consequences" of excessive forex leveraging, so to give people some background, and a bit of a push start, I have hastily compiled a brief reading list on the topic.

Do Balance-Sheet Effects Matter for Brazil? Felipe Farah Schwartzman, May 2003

The past ten years have seen a number of currency crises, typically followed by a sharp drop in output in the countries involved. An explanation advanced for both the crisis and the recession is that firms in these countries had a large amount of debt indexed in foreign currency (Krugman, 1999). The exchange rate devaluation left the firms insolvent, reducing credit and production in the economy. Apart from crisis, balance-sheet effects have been advanced as an explanation for the “fear of floating” detected by Calvo and Reinhardt (2000) in developing economies in normal times.

Krugman, P. (1999), “Balance Sheets, the Transfer Problem and Financial Crisis,” in: International Finance and Financial Crises, P. Isard, A. Razin and A. Rose (eds.)

For the founding fathers of currency-crisis theory ..........the emerging market crises of 1997-? inspire both a sense of vindication and a sense of humility. On one side, the number and severity of these crises has demonstrated in a devastatingly thorough way the importance of the subject; in a world of high capital mobility, it is now clear, the threat of speculative attack becomes a central issue - indeed, for some countries the central issue - of macroeconomic policy. On the other side, even a casual look at recent events reveals the inadequacy of existing crisis models. True, the Asian crisis has settled some disputes - as I will argue below, it decisively resolves the argument between “fundamentalist” and “self-fulfilling” crisis stories........ But it has also raised new questions.

One way to describe the problem is to think in terms of Barry Eichengreen’s celebrated distinction between “first-generation” and “second-generation” crisis models. First-generation models, exemplified by Krugman (1979) and the much cleaner paper by Flood and Garber (1984), in effect explain crises as the product of budget deficits: it is the ultimately uncontrollable need of the government for seignorage to cover its deficit that ensures the eventual collapse of a fixed exchange rate, and the efforts of investors to avoid suffering capital losses (or to achieve capital gains) when that collapse occurs provoke a speculative attack when foreign exchange reserves fall below a critical level.

Second-generation models, exemplified by Obstfeld (1994), instead explain crises as the result of a conflict between a fixed exchange rate and the desire to pursue a more expansionary monetary policy; when investors begin to suspect that the government will choose to let the parity go, the resulting pressure on interest rates can itself push the government over the edge. Both first- and second-generation models have considerable relevance to particular crises in the 1990s - for example, the Russian crisis of 1998 was evidently driven in the first instance by the (correct) perception that the weak government was about to be forced to finance itself via the printing press, while the sterling crisis of 1992 was equally evidently driven by the perception that the UK government would under pressure choose domestic employment over exchange stability.

In the major crisis countries of Asia, however, neither of these stories seems to have much relevance. By conventional fiscal measures the governments of the afflicted economies were in quite good shape at the beginning of 1997; while growth had slowed and some signs of excess capacity appeared in 1996, none of them faced the kind of clear tradeoff between employment and exchange stability that Britain had faced 5 years earlier (and if depreciation was intended to allow expansionary policies, it rather conspicuously failed!) Clearly something else was at work; we badly need a “third-generation” crisis model both to make sense of the recent crises and to help warn of crises to come.

In the paper which follows Krugman sketches out yet another candidate for third-generation crisis modeling, one that emphasizes two factors that had been omitted from previous formal models to date: the role of companies’ balance sheets in determining their ability to invest, and that of capital flows in affecting the real exchange rate. The model was at that point (and as Krugman himself says) quite raw, with lots of loose ends hanging about. However, it did seem to tell a story with a much more realistic “feel” than some of the earlier efforts. It could be hoped that now that he has had time to recover from the shock of his recent Nobel, he may get interested once more in this earlier centre of his attention, since the model badly needs updating, and in particular to take account of the shift in the risk away from the corporate and towards the household balance sheet.

Balance Sheet Effects, Bailout Guarantees and Financial Crises
MARTIN SCHNEIDER UCLA and AARON TORNELL UCLA and NBER

This paper provides a model of boom-bust episodes in middle income countries. It features balance of- payments crises that are preceded by lending booms and real appreciation, and followed by recessions and sharp contractions of credit. As in the data, the non-tradables sector accounts for most of the volatility in output and credit. The model is based on sectoral asymmetries in corporate finance. Currency mismatch and borrowing constraints arise endogenously. Their interaction gives rise to self-fulfilling crises.

In the last two decades, many middle-income countries have experienced boom-bust episodes centered around balance-of-payments crises. There is now a well-known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large “fundamental” shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output.

This paper proposes a theory of boom-bust episodes that emphasizes sectoral asymmetries in corporate finance. It is motivated by an additional set of facts that has received little attention in the literature: the tradables (T-) and nontradables (N-) sectors fared quite differently in most boom-bust episodes. While the N-sector was typically growing faster than the T-sector during a boom, it fell harder during the crisis and took longer to recover afterwards. Moreover, most of the guaranteed credit extended during the boom went to the N-sector, and most bad debt later surfaced there. Our analysis is based on two key assumptions that are motivated by the institutional environment of middle income countries. First, N-sector firms are run by managers who issue debt, but cannot commit to repay. In contrast, T-sector firms have access to perfect financial markets. Second, there are systemic bailout guarantees: lenders are bailed out if a critical mass of borrowers defaults.

And please note the last sentence: "lenders are bailed out if a critical mass of borrowers defaults", this, I imagine, is what we are about to see happen next.

A Balance Sheet Approach to Financial Crisis
Mark Allen, Christoph Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini :

The paper lays out an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis. The paper also discusses the potential of macroeconomic policies and official intervention to mitigate the cost of such a crisis.

And So It Ends – Hungary’s Government Announces Foreign Curreny Loan Wind-up Package

Manuel Alvarez-Rivera — Fri, 24 Oct 2008 08:24:00 +0000

Hungarian Prime Minister Ferenc Gyurcsány announced this morning (Wednesday) that the government had reached an agreement with commercial banks intended to protect the interests of those who have taken out foreign currency loans.

The agreement, which is expected to be signed early next week, has three key components:

1) At the request of the debtor the banks will allow the duration of the loan to be extended (with fixed monthly instalments) so that the depreciation of the forint “does not place an unbearable burden on the debtors".

2) FX debtors who deem that exchange rate fluctuations carry excessive risks for them will be allowed to convert their foreign currency-based loan to a forint loan. In this case the banks “will accept this request and make the switch without extra charges".

3) If a debtor finds him- or herself in a position where he or she cannot pay the monthly instalments, e.g. due to becoming unemployed, the banks will be amenable to transitionally reducing the instalments or even suspending them entirely at the request of the debtor.

I say "agreement" here, but in fact the banks had little alternative, since Gyurcsány made it plain to them that if they did not agree then legislation would be introduced to enforce the government package.

So here, right now, and on 23 October 2008 in Budapest ends, in my opinion, a fashion for taking out non-local currency denominated loans, which lasted the best part of a decade and sewpt across half a continent, and especially in Central and Eastern Europe . Basically government after government in one CEE country after another will now find themselves with little alternative but to follow Hungary's lead, as the parent banks turn off the tap on the one hand and the citizens themselves grow more and more nervous on the other.

The situation is in fact a little bit complicated, since (unless there is some part of the fine print which has not been made public yet) we have to assume that the conversion rate be the going market one, which will mean that many of those who such mortgages will take some form of capital loss on the transfer, which can thus only be seen as some form of "late in the day" protection against subsequent falls in the value of the forint. Jiri Stanik at Wood & Co estimates that most bank clients took out their FX loans at a level of around CHF/HUF 170, so despite the fact that the forint has depreciated by some 30% against CHF over the last two months, its current level (HUF/CHF is about 185 at the time of writing) only represent s an 8/9% depreciation from the average client purchase price. Most of the risk and all the really bad news will come for these mortgage holders if the forint were to continue to depreciate further against CHF. Will this depreciation continue? Well, even we economists don't really know the answer to that question, and certainly Hungarian householders have no idea at all, which is one very good reason why most of these clients may decide to get out now. Cerainly they will probably be uncomforable with the realisation that they have suddenly all become day traders in the forward HUF/CHF swap market using their homes as security.

Also the rate of interest to be charged on the HUF morgtgages will be based (it would seem, again there are no details) on some mark-up or other over the current base rate of the the NBH, which was, we will remember hiked to 11.5% yesterday. So at the end of the day the people who make the transition will take a (small, at this point) capital loss, but at the same time their short term interest servicing payments will skyrocket (this is presumeably why Gyurcsány has insisted on their being able to extend the term of the payments) . Thus, in terms of the macroeconomic recession, here we go.

For this all to form part of a coherent rational policy (perhaps a very large assumption indeed at this point) , it can only suggest one thing, in my opinion: that the base rate hike is a TEMPORARY support for the forint while people move over (which we could expect to see in the form of a flood, rather than a trickle - see the point about "herd behaviour" below). Basically when you have half your army trapped in an excessively advanced position, you need the heavy artillery to lay on some cover while you pull them back.

Once the troops are safely back under cover, then, in my humble opinion, we should anticipate a rapid easing cycle on the part of the NBH, and a sudden tanking in HUF partities, since the looming priorities will be to ease distress on all the new HUF mortgage payers, and an attempt to "jump start" a new export-driven Hungarian economy. I think it is important to bear in mind that Hungary is now about to head into quite a severe recession, and the fiscal stimulus door is effectively closed. Monetary easing is the only real policy tool the Hungarian authorities have available. And remember, we are going into all of what is now to come with national morale severely weakened by two years of policy measures which didn't work, to cut a very long story down to a very, very short one.

In other words the current situation is like having your population distributed across two very high buildings, one of which is about to collapse (or at least disappear), and the Hungarian government has just thrown a plank across from one building to the other so that people can "move over" in single file, before the one which is about to go, goes. The people in the other building may suffer from overcrowding and shortage of food, but they will at least be "safe". But the big danger might be, just how many will get trampled in the rush?

Basically, and to cut another very long story down into a very, very short one, the building which is about to disappear is the one which was to have housed Hungary (and several other of the EU12) as a full member of the Eurozone. This, ever more distant possibility in recent months, is now about to move off into a much longer term futures, and it is this distancing, of course, which makes all the forex borrowing suddenly unsustainable. The man who has been hanging desparately over the parapet by his fingernails for two years, now finally lets go.

Plus there is still the thorny little issue of just how Hungary is going to fund the conversions, and how much bad news there might be for the banks here.

“We think the most important announcement at this stage is the possibility to convert CHF loans to HUF. If households chose to do this it would ultimately mean a switch in FX mismatch from households to banks (who would then hold HUF assets but CHF liability). Banks in turn would then need to close their FX mismatch, through FX swaps (buying CHF).........It's not clear who would provide sufficient HUF liquidity to do this. Ultimately the NBH would presumably provide liquidity to avoid banks being left with a significant FX mismatch."
Martin Blum, Gyula Tóth, UniCredit, Vienna

"Herd behavior occurs when people do what others do rather than rely on their
own (incomplete) information, which might be suggesting something different
(Banerjee, 1992). The suppression of private information could lead to
“information cascades” when decisions are made sequentially and a large enough
number of people choose identical actions. In such settings, the decisions of a
critical few people early on are enough to tilt group behavior toward a certain
direction. Mimicking the behavior of others might be rational because of
uncertainty about one’s own information as well as the need to economize on
information-gathering costs. Rational herd behavior is the subject of a recent
strand of behavioral finance (see Montier, 2002, for an introduction). "

Total cross-border claims of BIS reporting banks expanded by $1 trillion in the last quarter of 2006. After more modest growth in mid-2006, a pickup in interbank claims accounted for 54% of this expansion. A surge in credit to nonbank entities contributed $473 billion, pushing the stock of cross-border claims to $26 trillion, 18% higher than in late 2005.

The flow of credit to emerging markets reached new heights through the year 2006. Claims on emerging markets grew by $96 billion in the final quarter of 2006, bringing the volume of new credit throughout the year to $341 billion. This amount exceeded previous peaks ($232 billion in 2005 and $134 billion in 1996), both in nominal value and in terms of growth. The current annual growth rate has risen to 24%, having surpassed for the sixth consecutive quarter the previous peak of 17% recorded in early 1997.

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.

The currency denomination of cross-border claims on emerging Europe tilted further towards the euro. In the stock of claims outstanding, the euro and dollar shares were 44% and 31%, respectively, but the gap in the latest flow data was more pronounced (61% and 5%). While the sterling share has remained close to 1%, the yen has lost ground to the Swiss franc, thus continuing a trend seen over the last six years. Yet there is little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending in several countries. Borrowing in the Swiss currency remains on average below 4% of cross-border claims, and exceeds 10% only in Croatia and Hungary.

Nearly 20% of reporting banks’ foreign claims were in the form of funds channelled to emerging market borrowers. Claims on residents of emerging Europe continued to account for the largest share of these funds.

Balance Sheet Consequences: The Academic Research

Well, given what I am saying above about the rapid and imminent demise of foreign exchange loans among Central and East European nationals, it is clear that the topic which is now about to come back into fashion (and to replace the forex loans themselves as the centre of attention) - at least among theoretical economists) is that of the so called balance sheet cosnequences of excessive forex leveraging, so to give people some background, and a bit of a push start, I have hastily compiled a brief reading list on the topic.

Do Balance-Sheet Effects Matter for Brazil? Felipe Farah Schwartzman, May 2003

The past ten years have seen a number of currency crises, typically followed by a sharp drop in output in the countries involved. An explanation advanced for both the crisis and the recession is that firms in these countries had a large amount of debt indexed in foreign currency (Krugman, 1999). The exchange rate devaluation left the firms insolvent, reducing credit and production in the economy. Apart from crisis, balance-sheet effects have been advanced as an explanation for the “fear of floating” detected by Calvo and Reinhardt (2000) in developing economies in normal times.

Krugman, P. (1999), “Balance Sheets, the Transfer Problem and Financial Crisis,” in: International Finance and Financial Crises, P. Isard, A. Razin and A. Rose (eds.)

For the founding fathers of currency-crisis theory ..........the emerging market crises of 1997-? inspire both a sense of vindication and a sense of humility. On one side, the number and severity of these crises has demonstrated in a devastatingly thorough way the importance of the subject; in a world of high capital mobility, it is now clear, the threat of speculative attack becomes a central issue - indeed, for some countries the central issue - of macroeconomic policy. On the other side, even a casual look at recent events reveals the inadequacy of existing crisis models. True, the Asian crisis has settled some disputes - as I will argue below, it decisively resolves the argument between “fundamentalist” and “self-fulfilling” crisis stories........ But it has also raised new questions.

One way to describe the problem is to think in terms of Barry Eichengreen’s celebrated distinction between “first-generation” and “second-generation” crisis models. First-generation models, exemplified by Krugman (1979) and the much cleaner paper by Flood and Garber (1984), in effect explain crises as the product of budget deficits: it is the ultimately uncontrollable need of the government for seignorage to cover its deficit that ensures the eventual collapse of a fixed exchange rate, and the efforts of investors to avoid suffering capital losses (or to achieve capital gains) when that collapse occurs provoke a speculative attack when foreign exchange reserves fall below a critical level.

Second-generation models, exemplified by Obstfeld (1994), instead explain crises as the result of a conflict between a fixed exchange rate and the desire to pursue a more expansionary monetary policy; when investors begin to suspect that the government will choose to let the parity go, the resulting pressure on interest rates can itself push the government over the edge. Both first- and second-generation models have considerable relevance to particular crises in the 1990s - for example, the Russian crisis of 1998 was evidently driven in the first instance by the (correct) perception that the weak government was about to be forced to finance itself via the printing press, while the sterling crisis of 1992 was equally evidently driven by the perception that the UK government would under pressure choose domestic employment over exchange stability.

In the major crisis countries of Asia, however, neither of these stories seems to have much relevance. By conventional fiscal measures the governments of the afflicted economies were in quite good shape at the beginning of 1997; while growth had slowed and some signs of excess capacity appeared in 1996, none of them faced the kind of clear tradeoff between employment and exchange stability that Britain had faced 5 years earlier (and if depreciation was intended to allow expansionary policies, it rather conspicuously failed!) Clearly something else was at work; we badly need a “third-generation” crisis model both to make sense of the recent crises and to help warn of crises to come.

This paper provides a model of boom-bust episodes in middle income countries. It features balance of- payments crises that are preceded by lending booms and real appreciation, and followed by recessions and sharp contractions of credit. As in the data, the non-tradables sector accounts for most of the volatility in output and credit. The model is based on sectoral asymmetries in corporate finance. Currency mismatch and borrowing constraints arise endogenously. Their interaction gives rise to self-fulfilling crises.

In the last two decades, many middle-income countries have experienced boom-bust episodes centered around balance-of-payments crises. There is now a well-known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large “fundamental” shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output.

This paper proposes a theory of boom-bust episodes that emphasizes sectoral asymmetries in corporate finance. It is motivated by an additional set of facts that has received little attention in the literature: the tradables (T-) and nontradables (N-) sectors fared quite differently in most boom-bust episodes. While the N-sector was typically growing faster than the T-sector during a boom, it fell harder during the crisis and took longer to recover afterwards. Moreover, most of the guaranteed credit extended during the boom went to the N-sector, and most bad debt later surfaced there. Our analysis is based on two key assumptions that are motivated by the institutional environment of middle income countries. First, N-sector firms are run by managers who issue debt, but cannot commit to repay. In contrast, T-sector firms have access to perfect financial markets. Second, there are systemic bailout guarantees: lenders are bailed out if a critical mass of borrowers defaults.

The paper lays out an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis. The paper also discusses the potential of macroeconomic policies and official intervention to mitigate the cost of such a crisis.

India’s Inflation Holds Steady In Mid July

Edward Hugh — Sun, 27 Jul 2008 12:35:00 +0000

India's inflation held near it's fastest pace in more than 13 years in the middle of July, raising the prospect the Reserve Bank of India will once more raise borrowing costs when it meets again next week. Wholesale prices rose 11.89 percent in the week to July 12, after gaining 11.91 percent in the previous week, the commerce ministry said in New Delhi last Friday.

India's stubbornly high inflation may well force the Reserve Bank of India to increase interest rates for the third time in less than two months at its next meeting on July 29. The Reserve Bank raised its benchmark interest rate twice in June, to a six-year high of 8.5 percent. It also increased the cash reserve ratio in stages to 8.75 percent, with the last rise coming into effect July 19. Clearly there are issues here of balancing growth needs and inflation fears, but my impression is that the Reserve Bank of India well understands the threat posed by the danger that inflation expectations become engrained and will continue to act with vigilance. In which case we may well see a continuing slowdown in India - but certainly a very soft, not a hard landing - and an early resumption of growth as inflation fades while energy prices will probably settle at what will undoubtedly be a rather high level in historic terms.

Foreign Exchange Reserves

India's foreign exchange reserves fell to $307.107 billion as on July 18, from $308.520 billion a week earlier, the central bank said in its weekly statistical supplement on Friday.

Reserves rose to a record $316.171 billion in late May and the decline since then is largely due to dollars being given by the central bank to oil refiners in exchange for their oil bonds and intervention in the currency market to support a falling rupee.

India's build up in foreign exchange seems to have peaked for the time being as a result of a variety of factors. Capital inflows have not been matching importers’ demands (and thus covering the trade deficit) with the consequence that the central bank has had to sell dollars. At the same time foreign investors have been pulling out of India's stock markets and inflows from overseas borrowing has also slowed due to the slowing consumer boom.

India's central bank has increased the ratio of its rising foreign exchange reserves invested in foreign bonds but has cut deposits held with foreign banks, it said in its half-yearly report. The Reserve Bank of India (RBI) invested $36 billion in overseas bonds, three-fifths of its $60 billion increase in its reserves for the six months ended March 2008, according to the central bank's report on foreign exchange reserves. The percentage of its currency reserves invested in sovereign bonds rose to 34.4 percent from 27.9 percent six months earlier. But the amount of reserves it held with foreign commercial banks as deposits and with external asset managers shrunk to $6 billion at end-March 2008 from $35.4 billion six months ago. Deposits with other central banks, the Bank for International Settlements and the International Monetary Fund rose by $52 billion.

India's total reserves grew 25 percent in 2007/08, and have remained largely steady since the end of the financial year. India's foreign exchange reserves are the third-largest holdings in Asia behind China and Japan.

Foreign direct investment rose to $15.5 billion in 2007/08 from $8.5 billion a year earlier, the RBI said.

Money Supply and Liquidity

Overnight cash rates rose to a fresh six month high in the middle of last week due to the tightening of liquidity following the increase in banks' cash reserve ratio and as a resukt of treasury bill auctions . On Wednesday call rates hit a high of 9.85 per cent, which is the highest since January 18. They were however back down to the 9.50/9.60 per cent range on Thursday.

The Reserve Bank of India increased the banks' cash reserve ratio, or the amount of deposits bank's have to keep with it, by 50 basis points last month. The two stages taken together are expected to have drained about 180 billion rupees from the banking system. The central bank is selling a total of 45-billion-rupees worth of treasury bills later in the day, the outflows towards which will take place on Friday. The central bank infused 474.80 billion rupees into the banking system through its daily money market operation, indicating the extent of cash crunch in the system.

Meanwhile M3 money supply grew an annual 20.5 per cent in early July, still way above the central bank's aim of 16.5-17.0 per cent for 2008/09.

The Rupee

The rupee had its best week in four months last week as the decline in crude oil prices reduced demand for dollars from refiners. The rupee was up for a third consecutive week on optimism exporters may have converted their overseas earnings into rupees to guard against further gains. The rupee gained 1.2 percent on the week and closed at 42.265 per dollar at 5 p.m. in Mumbai. Crude oil has now dropped 14 percent from a record $147.27 a barrel on July 11, curbing the demand for dollars in India, which imports a very large part of its energy needs.

The rupee also gained on speculation overseas funds will stop selling local shares after Prime Minister Manmohan Singh won a confidence vote in Parliament this week, giving him greater scope to liberalize the economy. Singh, with the help of his newly political ally Amar Singh of the Samajwadi Party won a majority in the lower house at the first confidence vote in a decade on July 22. The Samajwadi Party have indicated they will support legislation to reduce restrictions on foreign companies expanding in the insurance, pension and banking industries.

Overseas funds have sold $6.6 billion more Indian shares than they have bought so far this year.

Financials offer good value compared to resources

Prieur du Plessis — Fri, 30 May 2008 12:02:37 +0000

Investors have been surprised by the FTSE/JSE All Share Index’s strong rally of 24,9% since the market’s low on 23 January 2008. What is even more surprising is the large difference in the improvement of the major sub-indices. Resources companies have rallied by an incredible 44,8% on the back of only [...]