Concentration of Wealth and The Great Depression, as recounted by Marriner S. Eccles, FDR's Fed Chairman 1934-1948.

Inequality of wealth and income
Marriner S. Eccles, who served as Franklin D. Roosevelt's Chairman of the Federal Reserve from November 1934 to February 1948, detailed what he believed caused the Depression in his memoirs, Beckoning Frontiers (New York, Alfred A. Knopf, 1951)[26]:
As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth -- not of existing wealth, but of wealth as it is currently produced -- to provide men with buying power equal to the amount of goods and services offered by the nation's economic machinery. [Emphasis in original.]
Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.
That is what happened to us in the twenties. We sustained high levels of employment in that period with the aid of an exceptional expansion of debt outside of the banking system. This debt was provided by the large growth of business savings as well as savings by individuals, particularly in the upper-income groups where taxes were relatively low. Private debt outside of the banking system increased about fifty per cent. This debt, which was at high interest rates, largely took the form of mortgage debt on housing, office, and hotel structures, consumer installment debt, brokers' loans, and foreign debt. The stimulation to spend by debt-creation of this sort was short-lived and could not be counted on to sustain high levels of employment for long periods of time. Had there been a better distribution of the current income from the national product -- in other words, had there been less savings by business and the higher-income groups and more income in the lower groups -- we should have had far greater stability in our economy. Had the six billion dollars, for instance, that were loaned by corporations and wealthy individuals for stock-market speculation been distributed to the public as lower prices or higher wages and with less profits to the corporations and the well-to-do, it would have prevented or greatly moderated the economic collapse that began at the end of 1929.
The time came when there were no more poker chips to be loaned on credit. Debtors thereupon were forced to curtail their consumption in an effort to create a margin that could be applied to the reduction of outstanding debts. This naturally reduced the demand for goods of all kinds and brought on what seemed to be overproduction, but was in reality underconsumption when judged in terms of the real world instead of the money world. This, in turn, brought about a fall in prices and employment.
Unemployment further decreased the consumption of goods, which further increased unemployment, thus closing the circle in a continuing decline of prices. Earnings began to disappear, requiring economies of all kinds in the wages, salaries, and time of those employed. And thus again the vicious circle of deflation was closed until one third of the entire working population was unemployed, with our national income reduced by fifty per cent, and with the aggregate debt burden greater than ever before, not in dollars, but measured by current values and income that represented the ability to pay. Fixed charges, such as taxes, railroad and other utility rates, insurance and interest charges, clung close to the 1929 level and required such a portion of the national income to meet them that the amount left for consumption of goods was not sufficient to support the population.
This then, was my reading of what brought on the depression.

Congratulations to President Elect Obama

President Elect Obama,

I am delighted that you have been elected president of our country. This is the greatest example of tolerance and belief in fairness that I have personally witnessed in America. We all must be overjoyed that the majority of white people in America were able to put their own prejudices aside and elect a black man as President. There are billions of non-white people in the world, and this has given all hope for the future. I would just like to say that our troubles are many. Specifically, you are clearly the candidate who understood the gravity of the economic distress the majority of Americans are suffering from. So I hope and pray that you will approach the rebuilding of America with caution and humility, as you have promised. As someone who will definitely be paying more taxes, I say that I don't mind. BUT!!!!!!!!!!!!!!! I don't want my money going to the oligarchs on Wall Street. Please send my money to people who are suffering and need jobs, food, shelter or health care. Please don't destroy the dollar by massive inflation/debasement. If you need to default on our debt, please do it sooner rather than later so that we may recover. Regarding health care, I believe that all should have access to health care. BUT!!!!! We as a country must really look at where the majority of the costs really are. If anybody is interested in my opinion (truth) let me know.

P.S. Volcker for Secretary of Treasury (NO CLINTONITES/RUBINOMICS BUBBLE HEADS)

A sad but utterly predictable first move. Beginning of the End of Dollar Hegemony!

ECB's Nowotny Sees Global `Tri-Polar' Currency System Evolving
By Jonathan Tirone

Oct. 19 (Bloomberg) -- European Central Bank council member Ewald Nowotny said a ``tri-polar'' global currency system is developing between Asia, Europe and the U.S. and that he's skeptical the U.S. dollar's centrality can be revived.

``What I see is a system where we have more centers of gravity'' Nowotny said today in an interview with Austrian state broadcaster ORF-TV. ``I see for the future a tri-polar development, and I don't think that there will be fixed exchange rates between these poles.''

The leaders of the U.S., France and the European Commission will ask other world leaders to join in a series of summits on the global financial crisis beginning in the U.S. soon after the Nov. 4 presidential election, President George W. Bush, French President Nicolas Sarkozy and European Commission President Jose Barroso said in a joint statement yesterday.

Nowotny said he was ``skeptical'' when asked whether the Bretton Woods System of monetary policy, set up after World War II and revised in 1971, could be revived to aid global currency stability. The U.S. meeting should aim to strengthen financial regulation, define bank capital ratios and review the role of debt-rating agencies.

European leaders have pressed to convene an emergency meeting of the world's richest nations, known as the Group of Eight, joined by others such as India and China, to overhaul the world's financial regulatory systems. The meetings are to include developed economies as well as developing nations.

`Real Economy'

Bush, 62, has cautioned that any revamping must not restrict the flow of trade and investment or set a path toward protectionism. The G8 nations are Britain, Canada, France, Germany, Italy, Japan, Russia and the United States. The U.S. hasn't committed itself to the sweeping terms of Europe's agenda, White House press secretary Dana Perino said yesterday.

Sarkozy wants the G8 to consider re-anchoring their currencies, the hallmark of the 1944 Bretton Woods agreement that also gave birth to the International Monetary Fund and World Bank.

The current financial crisis, in which European governments have pledged at least 1.3 trillion euros ($1.7 trillion) to guarantee loans and take stakes in lenders, should be ``under control'' by mid-2009, Nowotny said. The economy will suffer longer.

``What comes then, unfortunately in parallel, will be the problems for the real economy,'' Nowotny said. ``The growth rate in 2009 will be significantly below what we have in 2008.''

He predicted gross domestic product growth around 1 percent in Austria next year.

To contact the reporters on this story: Jonathan Tirone in Vienna at jtirone@bloomberg.net

www.bloomberg.com/apps/news?pid=20601087&sid=apjqJKKQvfDc&refer=home

Wall Street Loves to play Brinkmanship!

Congressman Brad Sherman from California gives a chilling account of how Paulson warned of martial law if the bailout wasn't passed. You can deduce his argument rather easily. "We need money to get credit flowing because the banks will fail. And if the banks fail, there will be massive unemployment which will lead to civil unrest. We will have to call in the army and impose martial law and perhaps even have a dictatorship. Now you wouldn't want that on your tenure????? So give us $700 billion or else!!!!!!!! Also Senator Cantwell from Washington stating her opposition to the TARP.

Wall Street Journal Op Ed by Nobel Prize Winner Edmund S. Phelps

We Need to Recapitalize the Banks
Let's have cash infusions in return for warrants.

By EDMUND S. PHELPS

When the speculative fever finally broke in America's housing industry and house prices began falling in search of equilibrium levels, banks everywhere suffered defaults and subsequent losses on a range of assets. In short order, the housing contraction morphed into a banking crisis.


David Gothard
Among most economists, it came as a surprise that the banking industry and, indeed, most of the financial sector, was so devoted to houses. We had not realized that the investment and innovation in the country's business sector was largely getting by on rich uncles, a tiny cottage industry of venture capitalists out West, and a few private-equity funds doing alternative energy. And we didn't foresee that a trillion or two of losses in an economy with $40 trillion of financial wealth could bring high anxiety and, two weeks ago, near panic.

The banks' losses might seem poetic justice after their abominable performance. But costly feedback effects on the rest of us are in prospect. Uncertainty over the quantity and valuation of banks' "toxic assets" has meant that many cannot count on loans from each other to meet daily needs, and this illiquidity in the markets has impaired their ability to lend. Among banks that had excessively leveraged their capital through borrowing and other devices, the losses wiped out much or all of their capital, and this near-insolvency has dampened their willingness to lend.

The resulting credit contraction is starting to crimp working capital and investment outlay at small businesses and is having wider effects on business activity through its impact on interest rates, exchange rates and consumer loans. This feedback is causing a fall of employment on top of the direct effect of the housing contraction on employment in construction and finance. The added fall in jobs will in turn add to mortgage defaults.

Will this chain reaction produce a deep slump, like Japan's in the 1990s or, worse, America's in the 1930s? In my view, the claim by Keynesians that the economy can be stabilized around a satisfactory employment level, thanks to economic science, is false. So is the claim by latter-day neoclassicals that such stability is automatic, thanks to the market. Both dogmas fatally miss the point that the normal activity level is driven by structural shifts, which monetary policy and price-level changes usefully accommodate but cannot reverse. The end of the speculative fever and the credit crunch each have structural effects on the real prices of business assets, real wages, employment and unemployment. As I see it, the former has pushed up the normal, or "natural," volume of structural unemployment. The latter (and the excess houses) is pushing the economy into a temporary slump. It will last as long as required for the banks' self-healing and government therapy to pull us out of it and into the neighborhood of our new, postboom normalcy.

I believe that leaving the process of recovery entirely to the healing powers of the banking industry, as libertarians suggest, would be imprudent, even if the banks could manage it. Lacking much government intervention, Japan's recovery took a decade. Sweden's recovery, with state intervention, took hardly any time at all.

Right now our banking industry is barely operational. Whatever the corrective surgery indicated, the priority is to get the system operating again. Delay would be costly and risky.

The most discussed of the proposed programs would address banks' toxic assets by authorizing the Treasury to buy them, issuing debt to finance the purchase. Proponents of this program add that the government's eventual sale of the assets purchased might repay the investment with a profit -- grossing, say, an 8% rate of return while paying 4% interest.

House Republicans and some economists object, saying that the government could attain its goal with a bigger or surer profit by selling the banks "default insurance" on their distressed assets: the premiums paid are hoped to far exceed the default costs. To me, government entry into the default insurance business is little different from government purchasing the assets. It is not clear to me that selling default insurance would be more profitable.

House Democrats want a parallel program that would help defaulting mortgage borrowers to avoid foreclosure -- to help them "stay in their homes." Such a step might set an undesirable precedent in economic policy. If, after investing in my vocational training, I cannot make it in the line of work I chose -- not at the real wage that the market has since established, at any rate -- will I be entitled to help from the government to "stay in my work"? Furthermore, many defaulters are housing speculators not families caught up in an adjustable rate mortgage they did not understand. Finally, the overinvestment in houses does not present the systemic risk of economic breakdown that the overextension of credit does.

However, the program to revive the operation of the banks through purchase of the toxic assets faces a sticky wicket. If the government sets the prices too low, the banks will supply little of their assets; they will prefer to hold them to maturity in order to get the price appreciation for themselves. The Treasury will then need to raise the terms. But that may cause the banks to hold off longer, speculating on still better terms ahead.

If, instead, the Treasury sets its prices too high, its funds will go far enough to buy only a portion of the toxic assets offered in response. Thus, it is not certain that such a program would work to clean out the toxic assets at all quickly. Subnormal operation of the banking industry might drag on for a few years.

A program of asset purchases, however needed, is limited in scope. It cannot be counted on to increase the equity capital of the banks -- to shore up their solvency. Underpaying for the toxic assets would actually inflict a further loss of capital. Overpaying the banks for their toxic assets could contribute capital, but that may not be politically feasible or attractive.

So it is clear that the main prong of any "rescue" plan must serve to advance the recapitalization of the banks. Cash transfusions in return for warrants are a good way to do it, as it lets taxpayers share in the upside. The rescue of Chrysler used warrants. This past Monday the FDIC got $12 billion in preferred stock and warrants in the deal that saw Citigroup buy Wachovia. The question is which banks are to be thrown a lifeline, which will have to sink or swim. This one-time dose of corporatism is unpleasant, though the banking industry is to blame for its necessity.

But these steps toward making the system operational again will leave it dysfunctional. We don't want to restore the system as it was. And the risk that the industry would cause another round of wreckage is not the only reason.

What has occurred is not just an old-fashioned banking crisis but also a banking scandal. Most of the big banks were shot through with short-termism, deceptive practices and self-dealing. We must institute basic changes in corporate governance and in management practice to restore responsibility and honesty for the sake of the economy and for the self-respect of the country.

We also need to return investment banking to its roots. There is more to the influence of the financial sector than merely its effects when it goes off the rails. The financial system is not a sort of circulatory system that passively carries fresh saving to the places in the economic body that demand the greatest investing -- as if guided by some "invisible hand." Judgment and vision -- of bankers, fund managers, angel investors and the rest -- matter hugely. So do the distortions, the limits and the license created by the regulatory system and the moral climate. To prosper and advance, the American business sector is going to need a financial system oriented toward business, not "home ownership."

Mr. Phelps, the winner of the 2006 Nobel Prize in economics, directs the Center on Capitalism and Society at Columbia University.

online.wsj.com/article/SB122282719885793047.html

Some Words of Wisdom From Soros

Recapitalise the banking system
By George Soros
Published: October 1 2008 02:05 | Last updated: October 1 2008 02:05
The emergency legislation currently before Congress was ill-conceived - or more accurately, not conceived at all. As Congress tried to improve what Treasury originally requested, an amalgam plan has emerged that consists of Treasury’s original Troubled Asset Relief Programme (Tarp) and a quite different capital infusion programme in which the government invests and stabilises weakened banks and profits from the economy’s eventual improvement. The capital infusion approach will cost tax payers less in future years, and may even make money for them.

Two weeks ago the Treasury did not have a plan ready - that is why it had to ask for total discretion in spending the money. But the general idea was to bring relief to the banking system by relieving banks of their toxic securities and parking them in a government-owned fund so that they would not be dumped on the market at distressed prices. With the value of their investments stabilised, banks would then be able to raise equity capital.

The idea was fraught with difficulties. The toxic securities in question are not homogenous and in any auction process the sellers are liable to dump the dregs on to the government fund. Moreover, the scheme addresses only one half of the underlying problem - the lack of credit availability. It does very little to enable house owners to meet their mortgage obligations and it does not address the foreclosure problem. With house prices not yet at the bottom, if the government bids up the price of mortgage backed securities, the taxpayers are liable to loose; but if the government does not pay up, the banking system does not experience much relief and cannot attract equity capital from the private sector.

A scheme so heavily favouring Wall Street over Main Street was politically unacceptable. It was tweaked by the Democrats, who hold the upper hand, so that it penalises the financial institutions that seek to take advantage of it. The Republicans did not want to be left behind and imposed a requirement that the tendered securities should be insured against loss at the expense of the tendering institution. The rescue package as it is now constituted is an amalgam of multiple approaches. There is now a real danger that the asset purchase programme will not be fully utilised because of the onerous conditions attached to it.

Different focus
‘Tarp’s adverse consequences could be mitigated by using taxpayers’ funds more effectively. If Tarp invested in preference shares with warrants attached, private investors, including me, would jump at the opportunity’

Nevertheless, a rescue package was desperately needed and, in spite of its shortcomings, it would change the course of events. As late as last Monday, September 22, Treasury secretary Hank Paulson hoped to avoid using taxpayers’ money; that is why he allowed Lehman Brothers to fail. Tarp establishes the principle that public funds are needed and if the present programme does not work, other programmes will be instituted. We will have crossed the Rubicon.

Since Tarp was ill-conceived, it is liable to arouse a negative response from America’s creditors. They would see it as an attempt to inflate away the debt. The dollar is liable to come under renewed pressure and the government will have to pay more for its debt, especially at the long end. These adverse consequences could be mitigated by using taxpayers’ funds more effectively.

Instead of just purchasing troubled assets the bulk of the funds ought to be used to recapitalise the banking system. Funds injected at the equity level are more high-powered than funds used at the balance sheet level by a minimal factor of twelve - effectively giving the government $8,400bn to re-ignite the flow of credit. In practice, the effect would be even greater because the injection of government funds would also attract private capital. The result would be more economic recovery and the chance for taxpayers to profit from the recovery.

This is how it would work. The Treasury secretary would rely on bank examiners rather than delegate implementation of Tarp to Wall Street firms. The bank examiners would establish how much additional equity capital each bank needs in order to be properly capitalised according to existing capital requirements. If managements could not raise equity from the private sector they could turn to Tarp.

Tarp would invest in preference shares with warrants attached. The preference shares would carry a low coupon (say 5 per cent) so that banks would find it profitable to continue lending, but shareholders would pay a heavy price because they would be diluted by the warrants; they would be given the right, however, to subscribe on Tarp’s terms. The rights would be tradeable and the secretary of the Treasury would be instructed to set the terms so that the rights would have a positive value.

Private investors, including me, are likely to jump at the opportunity. The recapitalised banks would be allowed to increase their leverage, so they would resume lending. Limits on bank leverage could be imposed later, after the economy has recovered. If the funds were used in this way, the recapitalisation of the banking system could be achieved with less than $500bn of public funds.

A revised emergency legislation could also provide more help to homeowners. It could require the Treasury to provide cheap financing for mortgage securities whose terms have been renegotiated, based on the Treasury’s cost of borrowing. Mortgage service companies could be prohibited from charging fees on foreclosures, but they could expect the owners of the securities to provide incentives for renegotiation as Fannie Mae and Freddie Mac are already doing.

Banks deemed to be insolvent would not be eligible for recapitalization by the capital infusion programme, but would be taken over by the Federal Deposit Insurance Corporation. The FDIC would be recapitalised by $200bn as a temporary measure. FDIC, in turn could remove the $100,000 limit on insured deposits. A revision of the emergency legislation along these lines would be more equitable, have a better chance of success, and cost taxpayers less in the long run.

www.ft.com/cms/s/0/d68e10cc-8f45-11dd-946c-0000779fd18c.html

What Next?

I must admit that I secretly hoped that John McCain would oppose the bailout, with the Republican Congressional Insurgency giving him the opportunity to be a “Maverick’. I thought he would then call this rubbish the Bush-Obama Wall Street bailout, thus covering his greatest weakness. But alas, it’s obvious after last night’s debates that it was just wishful thinking. In fact, it was like watching American Idol with two contestants singing the same song. So this is where we are. The Congress is receiving phone calls of up to 100 to 1 against the bailout, yet they are about to sign into law perhaps the most unpopular piece of legislation in the history of our Republic. So one has to ask. What will happen after $700 Billion is engulfed by the Disappearing Deep Hole of Derivative Destruction? What will happen after the MOAB (Mother of All Bailouts)?
One has to believe that there will be a temporary increase in liquidity, which will be quickly sucked up by the system. But it has been obvious that every Fed and Treasury intervention has had more ephemeral staying power. So this intervention will help for maybe 3-6 months. Maybe. But what will happen when the sequel comes out? MOAB II, or perhaps the Son of MOAB? Don’t you think Americans will be even more pissed off? They will say, and justifiably so, you told us that this will save the system and now we’re right back to where we were a few months ago, and you are asking for another massive bailout! I am afraid that we are going down the slippery slope of ill-guided intervention. Didn’t Paulson and Bernanke say that there is no housing bubble, then they said that Subprime is contained, then they said that by nationalizing Fannie and Freddie that it puts a floor under the mess? WHAT WILL THEY SAY? There will probably be new actors, buy they will still have to read the same poorly scripted lines.
We are going down the path of self-destruction. Lenin said that there is no surer way to destroy a nation than to debase its currency. There is no surer way to debase the dollar than to continue down this misguided path. We have become so caught up in stock market and real estate losses, that we have taken our eyes of the real prize! Our greatest asset as a nation is our currency. Today, the US Dollar reigns supreme. But one has to ask how much longer will our creditors keep the credit flows open while we debase and inflate our way out of this self-inflicted greed wound. There are already grumblings of a Sino-Russian alliance, one that could put significant pressure on other nations to abolish the dollar standard. Once the dollar standard is usurped, we are TOAST!!!!!!! Expect massive tax increases, spending cuts and a drastic decrease in our standard of living. Yet, the guys on the yachts are smart. They will have diversified into other currencies, homes in other nations, and accounts in safety deposit boxes around the world. Much like the Nazi’s who bought their freedom after WWII, these criminals will save their hides. Caviar for them and feudalism for us. You’ve been warned.

SERFS UP

Full court press.

Emperor Paulson is testifying in front of the Senate as I write this piece, but I have some preliminary observations. It is obvious that he is using this moment of crisis (or as the Chinese would say moment of opportunity) to push forward on his Wall Street debt reduction plan. He very well knows that neither party wants to be viewed as anti helping America so close to the elections. So he is taking away space and time from Congress, in order that they make a costly (700 billion) turnover. His argument is oddly amusing. He is saying that these "various assets and instruments" are very complicated. So complicated are they that only experts from Goldman and Morgan understand them. Thus, he needs a clean and simple plan to have a resolution. Funny guy! The next amusing area is in the logic behind this bailout. He's saying that Main Street needs to give money to Wall Street so they can turn around and lend it back to Main Street. Well if Main Steet needs the money, why don't they just keep it in the first place. The reason is simple. This is your classic bait and switch routine where we talk about house prices and complex derivatives, but in point of fact are just covering Wall Street's bad bets. I hope the Senate has the courage to stand up to Caesar, but I highly doubt it.

All Hail Emperor Paulson!

While the MSM lauds his actions, Emperor Paulson is about to impose economic martial law on the citizens of America. Outside the Treasury will read the moniker "Over 1 Trillion Served" (except not by choice)! I believe it is time that we change our Pledge of Allegiance to more accurately reflect the Imperial status of Mr. Paulson:

I pledge allegiance to the flag of the United States of Hank Paulson and to the kleptrocracy for which it has become, one nation, above God, divisible, with debasement and inflation for all.

Wall Street Perestroika

A Fait a Compli

Having watched the Sunday talk shows, it is obvious that the Wall Street Debt Reduction Plan is a done deal, with only minor detail to be discussed. I am not sure how to feel about it. But probably it is somewhere between bewilderment and incredulousness. Chutzpah, properly defined, is killing your parents and looking for sympathy that you have become an orphan. The one thing that this plan does not lack is chutzpah. The thieves on Wall Street have designed this plan so that they can improve their balance sheet, and in effect cover their losses on bad bets. Paulson will have absolute authority over the plan, and they will be able to buy instruments from foreign banks as well as commercial real estate paper. So the taxpayer has the added benefit of assisting his banker friends abroad and our Donald Trumps at home. This plan reminds me of another ambitious reform program. When Mikhail Gorbachev came to power, he knew that communism was not sustainable, and he believed it could be saved by a few reforms of the system, Perestroika and Glasnost (Rebuilding and Openness). The problem was that communism itself was a flawed system, and no amount of Perestroika could save it. The Soviet Union (and Russia today) had no finished product to sell abroad, and its collectivized farm system was unable to produce enough food for its population. It was completely reliant on oil exports to fund its ability to feed the masses, and when oil prices collapsed, it took out the USSR, despite all the attempts by the cronies to keep it propped up. So, as I look upon the landscape today, I see that Mr. Paulson is attempting a Wall Street Perestroika, so that the system can be saved!?!? However, one needs to ask a fundamental question, i.e. can our economic system, as currently designed, be saved? The parallels are frightening. As the USSR was dependant on oil exports to stay afloat, so to the USA is dependant on capital exports (treasuries/gse/mbs/derivatives etc…) to stay afloat. So just as a collapse of oil prices in the 80’s squeezed the USSR out of business, the last thing that the USA can tolerate is a new “price discovery’ on our capital exports. Because we are completely dependant on external powers to finance our budget and thus run our country is the reason why I believe these extraordinary measures are being undertaken. But just as Perestroika of the USSR failed because it was unsustainable, Wall Street’s Perestroika will probably fail. Adam Smith said that no country that has ever run up a large foreign debt has ever paid it back. I think that when foreigners understand that we do not have the capacity to pay back our debts, and that we are going to have to inflate our way our of our debt, they will pull the plug on the current finance agreements and in effect destroy the dollar’s standing as the world’s reserve currency. This may lead to the collapse of our whole economic system, despite Mr. Paulson’s best efforts to prop up the oligarchs.

Trickle Down Tax Cuts.

It has become obvious that this ridiculousness has left the realm of economics and is now a political problem. There is no question but that the Bush tax cut, spending increases and decreased regulations, all financed by borrowing, have allowed the Wall Street oligarchs to game the system in their favor and make an inordinate amount of money (who wouldn't want to pay 15% taxes on 100 million dollar bonus?). But we are well past the point where anybody thinks that this is either right or moral. The question is, what's next? What Mr. Paulson suggests is the largest tax cut for the rich in American history. 1 Trillion dollars of debt relief for the Wall Street oligarchs, financed either by tax increases or inflation, is what is on the table for us. I cannot for the life of me understand why the Democratic candidate for the US president, Mr. Obama, is favor of this solution. The Democratic party has always been the party of the working Joe, so how can Mr. Obama support one trillion dollars of debt relief for the Morgan Stanley's of this world. He is such a big critic of trickle down economics (rightly so), yet he is in favor of trickle down debt relief. Can you just imagine that you had one trillion dollars to play around with. You could give back to Wall Street, who created this mess, or you could spend it as your wish. How many factories, roads, power plants, schools, bridges, solar farms, etc.... could you build? How many jobs could you create with a trillion dollars. How many fiscal stimuli could one inject with a trillion dollars? But Mister Paulson believes the best utilization of our fiat currency is to fortify the Wall Street Oligarchs, "so credit could flow through our system!" This is bull shit!!!!! This is a false choice that is being presented to us!!!! I implore any and all who read my little blog to contact your congressman and senator and tell him/her that you do not want your money to go to Wall Street. Do you believe that is fair that the taxes paid by the brave men and women of our armed services, who put their lives on the line for us day in and day our, be sent to people vacationing on their yachts? If there is any debt relief to be had, let it be had by regular working people who were ensorcelled into taking excessive debt by the oligarchs' sales force. I propose that people have direct debt relief by sending any kind of debt that was incurred from 2003-2006 (or so) to a DRC (Debt Reduction Corporation), and thus 1 trillion dollars of debt relief can be had by the American consumer. Thus, they will have excess capital that can be used for spending, saving or investing. Much of this can be taxed by the government, so they will have a return on investment. I am shocked that Democrats have allowed Wall Street to flim flam them into their nonsense. Please, America, let us unite in this effort to end the Wall Street Debt Reduction plan. They don't deserve it!!!

That was short lived.

It obviously didn't take long for Misters Bernanke and Paulson to resume their bailout ways. I am not familiar enough with AIG to know how calamitous a Chapter 7/11 would have been, but I am sure that there could have been ways to work it out. Drexel and Lehman went belly up, and the world didn't end! Anyway, I have been thinking for a while as to what to post because I believe that at this point, the MSM has caught on to what has truly been happening vis-a-vis Wall Street, so I am not sure that I can add much, except my own little quirky commentary. As I am writing this blog entry, the government is considering the massive use of our money to buy "toxic debt" a-la RTC. I cannot even comprehend how much money all of this is going to cost, nor the consequences of such an action. It seems that at every stage of this crisis, the government has tried to throw good money after bad into some sort of damage control (does anybody remember the MLEC?). However, I cannot escape the feeling that this will not end well. The problems seem to be getting bigger and bigger, and the bailouts keep getting more and more expensive. Our government is now in the insurance, mortgage and securitization business. Barney Frank recommend that it opens up a Real Estate office with lots of new inventory. Far cry from laissez-fare. Everybody is now aware that the real culprits in this crime drama were the Wall Street oligarchs who, as financial mercenaries, have put this country on the precipice of disaster. I would like to offer one piece of advice, should anybody come across this little piece. I believe that it is absolutely necessary to prosecute the oligarchs! I know it may be extremely difficult from a political standpoint, but is so perversely injust that we will have to hand over our savings, while the oligarchs who pilfered this country's vast wealth are on their yachts. I believe that there can be great populist sentiment evoked if we prosecute and fine these criminals, as well as confiscate their wealth. This will end all moral hazard problems. If the federal reserve used special powers to assist in the take over of Bear Stearns, why can't we create a Guantanamo for Wall Street crooks (maybe we can even suspend habeas corpus). The government should have a rendition team ready to go to waterboard these guys into divulging information as to how these crimes were committed. But I digress. It need not go that far. Just take away their money in a grand public way, and use the proceeds to recapitalize the Federal Reserve, instead of printing $40 Billion new dollars.

Lehman/Merrill Day!

This day will obviously be remembered in the history books, with the full ramification of these event not known for years to come. But I must say that today I am proud that Misters Bernanke and Paulson had the courage to stand up to the oligarchs. Winston Churchill once said that America always does the right thing, after it tries everything else first. I am sure it was an extremely painful decision to inflict the death blow to such a venerable institution as Lehman, but I am also sure it was the right thing to do. The sooner these leveraged, poorly run businesses get taken out, the sooner we can clean out our financial system and get back on solid ground. It's obvious that a combination of greed, leverage and fraud combined to take out some of our great financial institutions, but out of the ashes, new dynamic institutions will arise. This crisis seems far from over, so I hope that our leaders will continue to allow the market to unwind without further subsidy to insolvent institutions. The business of America is business, it is not leverage buy outs and real estate transactions. Hopefully, some of these great minds will turn away from coming up with "business models" and go to work for our struggling manufacturing sector. The sooner we realize that the fraudulent "service economy" cannot be sustained, the sooner we can regain our status. This delevereraging should also serve as a warning about our national debt. We all see how margin call can be a real bitch! We must stop spending, start saving and investing into our manufacturing sector. Green technology and energy independence with other innovations may still save us. The politicians have to stop flim-flamming us by paying for tax cuts with borrowing. We will all have to tighten our belts, and be a little wiser with our money. The sooner we bury these charlatans, the sooner we can get to work to saving our country!

Bill Gross' 2 Billion Dollar Day. Thanks Easy Al for all of your insights!

Bail-out hands Pimco $1.7bn payday
By Deborah Brewster in New York
Published: September 9 2008 19:49 | Last updated: September 9 2008 19:49
The Bill Gross-managed Pimco Total Return fund reaped a $1.7bn payday following the US government takeover of home loan giants Fannie Mae and Freddie Mac.

While shareholders in Fannie and Freddie suffered deep losses, the world’s biggest bond fund saw its highest ever one-day rise against its benchmark index on Monday, benefiting from the bet made by Mr Gross on mortgage bonds issued by the agencies.

Mr Gross had made a big shift out of US Treasuries and corporate bonds over the past year and into agency bonds, betting that the government would support Fannie and Freddie Mac. By May this year, more than 60 per cent of his $132bn fund was in mortgage debt.

Mortgage-backed bond prices rose after the US government seized control of the agencies.

Mr Gross’s fund, which side-stepped the housing market slide, had risen strongly before Sunday’s government bail-out. In the 12 months to August 1, the fund returned 9.2 per cent, beating all of its peers, according to fund tracker Morningstar.

On Monday, the fund rose by 1.3 per cent, or $1.7bn, its biggest one-day rise ever against the Lehman Aggregate Bond index.

Mr Gross, who co-founded Pimco and has managed the Total Return fund since 1987, was one of the first to call for a bail-out of Fannie and Freddie.

In his latest monthly commentary, he also said that the government needed to use more of its own money to support financial markets, or risk a “financial tsunami”.

Mr Gross’ style is to take a macro-economic view and make tactical changes based on short-term movements in the economy.

The recent success of the Total Return fund has helped Pimco to be the only one of the 25 largest mutual fund managers to lift its assets under management in the year to date, according to Financial Research Corporation data to the end of July.

By contrast, several well-respected equity fund managers are suffering in the wake of the government move, which leaves Fannie and Freddie stock almost worthless. Legg Mason’s Bill Miller, Fidelity, Dodge & Cox and Wellington are among the fund managers that had heavy exposure to Fannie and Freddie – and had lifted that further this year, according to Bloomberg data.

Copyright The Financial Times Limited 2008

What's wrong with the Economy?

This is too complex a question for me to answer, but any chance I can get to take a swipe at Wall Street, well I can't resist. As the political season heats up, and we get to choose between Burger King and MacDonalds, people around me keep asking questions as to how we got into this giant mess. Which candidate has the best "economic plan". First, let's start with who is to blame. That answer is simple enough. The Wall Street initiated and Federal Reserve enabled "service" (really finance sector) economy, run by the professional crooks and gamblers of Wall Street is what ruined our economy. There, let's get that straight. It wasn't the coal miners or the auto workers or the engineers or the farmers who destroyed us. It was a laundry list of characters including, but not limited to, guys like Rubin, Greenspan, Boskin, Weil and other elite financiers who have done us in. Until people in America understand this fact, it is impossible to move forward with any kind of debate as to how to solve our economic mess. I have yet to hear either candidate state this, probably because they saw what happened to Ron Paul when he touched on some of these issues. Even as I write this, news is coming out of another massive government bailout of Fannie and Freddie. Can't piss of the Chinese?! Anyway, I would like to post the amount that was paid in Wall Street bonuses over the last 20 years or so. This doesn't include the money the Hedgies or Private Equity boys made, or dividends paid out, but they earned it?! What's remarkable is that there has been a 10 fold increase in bonuses over the last 15 years or so. I know of no other profession with such income growth. Maybe before taxpayer funds are confiscated to bail out these institutions that are too big to fail, the wealth of these elites should be sold off to help offset the bill. I mean, if a company dumps toxic waste, they get a fine, why not Wall Street? I know I am just dreaming, but it will be everybody's nightmare. I believe that at this point, nobody really knows where this is heading, but it probably won't have a happy ending.

www.osc.state.ny.us/press/releases/dec06/bonuses1206.pdf

It's not fair, but that's the way it is.

As this credit bubble continues to unwind, and more facts come to light, it become ever more apparent the immoral and ridiculous nature of the system. One goes through one’s life and is told by respected elders to do the right thing, follow the rules, be fair, don’t lie, don’t cheat, and don’t steal. But, it is in fact the ability to game the system in your favor, to bend the rules, to cheat, lie, steal and deceive that gets you a house in the Hamptons. The rest of us have become de-facto drones who must only sit and watch with bemused amazement at how institutionalized pilfering has become a state sponsored entity. On America’s Most Wanted, they show the foolish bank robber going in with a mask, risking his life, for an average of $2,000. The reality as it turns out is that the real thieves are in the Wall Street Cartel, backed by U.S. taxpayer largesse. How did we get here? Is this really the way our country works? Has it always been so? Perhaps we are just naïve in believing that justice will find it’s way to the canyons of Wall Street. That the U.S. has entered its inevitable decline from glory is almost beyond doubt, the only question is over what time period and who will bear the greatest pain. As the oligarchs have ensconced themselves in a citadel of deceit and power, the rest of us are left exposed to the erosion. I believe that the system has become so corrupt, that change from within is impossible. All our blogging and blathering about how unfair everything is will not change the facts on the ground. There is opportunity cost to all this ranting and raving, and the reward is diminishing quickly. The deck is heavily stacked in the favor of the financiers, one just needs to accept it and move on. Until our whole credit/debt finance system collapses in conflagration, nothing will change. Perhaps it has always been this way.

John Mauldin email.

How To Fix It
By Michael E. Lewitt

"This disposition to admire, and almost to worship, the rich and the powerful, and to despise, or, at least, to neglect, persons of poor and mean condition, though necessary both to establish and to maintain the distinction of ranks and the order of society, is, at the same time, the great and most universal cause of the corruption of our moral sentiments."

Adam Smith, The Theory of Moral Sentiments (1759)
Twelve Basis Points

One way of measuring how perilously close the U.S. financial system came to melting down in mid-March 2008 is to look at how low the rate on one-month Treasury bills fell at the depths of the crisis. That number is 12 basis points. 0.12%. The three-month Treasury bill rate, which our friend Jim Bianco of the highly respected Bianco Research points out is the "risk-free" rate for many models such as the capital asset pricing model, the arbitrage risk pricing model and the Black-Scholes pricing model, fell to a 50-year low of 56 basis points on Tuesday, March 25. 0.56%. As Mr. Bianco pointed out, these bills were yielding less than Japanese 3-month financial bills for the first time since July 14, 1993.

And it's not as though the Japanese economy is flourishing. In fact, quite the opposite is occurring as Japan continues to struggle with the aftermath of its lost decade (which is stretching into lost decades). Hilary Clinton, who looks increasingly unlikely to lead her party in the upcoming Presidential election, is definitely onto something when she warns that "[w ]e may be drifting into a Japanese-like situation. I don't think we can work our way out of the problems we're in for the broad-based economy through monetary policy alone. Japan tried that and tried and tried that."1 The structural problems ailing the U.S. economy are severe. They derive from bad economic policies and bad political values.

American Capitalism In Need of Repair2

We all know Adam Smith as the author of the bible of capitalism, The Wealth of Nations (1776). But he first wrote what is arguably a far more important book, The Theory of Moral Sentiments, from which the quote that heads this month's newsletter is drawn. America is rushing headlong into the 21st century without a proper understanding of what economic policies and financial tools are going to be required to prosper in a changing world. For more than two decades, the United States economy has favored financial speculation over production. Over the past century, our legal system had developed an increasingly outmoded concept of fiduciary duty that privileges short-term, single-firm interests over the kind of long-term, society-wide interests that could lead to prolonged prosperity. The current meltdown in the financial markets is a symptom of a serious disease that is eating away at the stability of our most important institutions. What we are witnessing might well be the end of American financial hegemony, which is the result of a burgeoning global economy. The current crisis in financial markets gives us an opportunity to evaluate how we can better prepare ourselves to deal with a borderless world.

In spite of claims to the contrary, the American economy has become increasingly unstable in recent decades. This phenomenon picked up momentum in recent years as financial markets focused on trading derivative financial instruments rather than cash stocks and bonds. Paradoxically, the very financial instruments designed to manage risk increase mark volatility. As the distance separating lenders and borrowers as well managers and stockholders increased, debacles such as the Enron and WorldCom frauds earlier this decade and, more recently, the subprime mortgage and structured credit meltdown of today became more common. By effectively reducing all financial instruments and measures of financial value to "one's and zero's" - by digitalizing value - Wall Street removed crucial checks and balances on financial behavior, which ultimately remains a human activity. The growing use of quantitative trading models led to a market dominated by traders directing money into companies about which they know little or nothing. This leveling of all economic values to indistinguishable signs did untold damage to economic actors' ability to distinguish valuable assets from worthless ones.

In addition, unstoppable economic and historical trends such as globalization caused a shift of jobs and factories to geographic locations with lower labor and materials costs, resulting in a transformation of the U.S. economy from one that manufactures goods to one that traffics in intangible items. The result has been a shift from investing in activities that add to the productive capacity of the country to transactions and activities that are merely speculative in nature, i.e., that merely spawn more money but not more physical or capital assets. This shift from a tangible to an intangible economic base was accompanied by a change in the way in which businesses are financed. At the same time as the business base became increasingly intangible, so did the financial base. Equity was replaced by debt, and cash securities were replaced by derivatives. Much of the new financial architecture is now constructed outside the purview of the Federal Reserve and other regulators, allowing economic actors to avoid margin requirements and other limits on leverage that can prevent systemic threats. The new foundations of corporate finance can vaporize in the blink of a trader's eye. These trends have enormous policy consequences for the United States and our future standard of living.

The fiduciary law that governs our business culture reaches back to the 15th century and requires those who are entrusted with managing our largest corporations or pools of money to act in the best interests of their shareholders or clients. But the evolution of fiduciary law has developed into a mode of thinking that privileges short-term, single-company results over long- term, society-wide results. Consequently, fiduciaries are driven by a logic that dictates a focus on the short-term, which can be more accurately predicted than the long-term. But there is something deeper at work in this mindset. Fiduciary thought privileges form over substance, procedure over justice. Decisions that serve a single corporation's shareholders may cause significant harm to a wider array of interests. The entire concept of fiduciary duty must be rethought if capitalism is going to flourish in a borderless, digitalized world. Instead of a narrow focus on the interests of a single firm's shareholders, the fiduciaries of our large business enterprises are going to have to widen their arc of concern to a wider group of constituencies. Without such a broadening of focus, narrow interests will continue to place the entire system in jeopardy because of the networked nature of today's financial markets.

Some Specific Recommendations for Financial Reform

Nano-scopic interest rates are a sign of just how corrupted our financial system has grown from the twin diseases of leverage and greed. The collapse of Bear Stearns was an all-too predictable byproduct of a system that refuses to look itself in the mirror. The bailout of Bear was an obnoxious necessity in view of the fact that the firm was too interconnected as a Wall Street counterparty and prime broker to be permitted to fail. Its collapse would have placed many hedge funds and other financial firms at risk.3 So instead of being able to allow the firm to enter bankruptcy as a just dessert for its failure to properly manage the risks inherent in its business, the Federal Reserve and Treasury Department had to place the interests of the financial system first. The time to ask about moral hazard is not when the system is about the implode - the appropriate time for such questions is much earlier, when the seeds of destruction that lead to the necessity to bail out players that act in ways that threaten long-term systemic stability are being sown. Such questioning, and the requisite action to avoid future problems, requires degrees of forethought and forthrightness for which the power players on Wall Street and in Washington have little tolerance. Even when we skirt complete systemic collapse - and make no mistake about it, we have come as close to such an event as anyone should dare imagine - those with a stake in the game continuing are working behind the scenes to protect their interests.

The Bush Administration, under the intellectual leadership of Treasury Secretary Henry Paulson, has proposed a broad reorganization of financial industry regulation. Unfortunately, this plan merely addresses form over substance and does little or nothing to address the underlying problems that are eating away at the system like a cancer. If reform ultimately follows the path proposed by Mr. Paulson and goes no farther to outlaw the reckless practices that place the system at risk in order to line the pockets of a privileged few, we will have sadly learned nothing from the current crisis. The system is infected by deep, inbred flaws that are rendering it increasingly unstable. Free-market capitalism as practiced on Wall Street and in The City has run amok. If the current crisis, and the recurring crises of the last twenty years, tell us anything, it is that market solutions are insufficient to protect the system from the greed and fear that drive markets. If the deep structural cracks in the system are not addressed and corrected, the markets may not survive the next near-death experience.

This is not a time to mince words. As the poet William Blake wrote, "Opposition is true friendship." At the risk of offending many of our readers, here are HCM's thoughts on how to reform the financial system.

Financial Industry Regulation: There is too little, not too much, financial industry regulation. The problem with our current regulatory regime is that too many of our current regulations serve little or no purpose (for example, the pages of meaningless disclosure in Wall Street research reports that nobody reads and are often longer than the research reports themselves) or are enforced in a capricious and arbitrary manner by unqualified regulators and overzealous prosecutors. This breeds disrespect for the law and resentment among the regulated. As a result, we have a system of laws, not values, a system that privileges form over substance, process over justice. We are never going to have a sound regulatory system until we raise the compensation levels for those who are charged with insuring that millionaires are following the rules.

HCM often hears the argument that too much regulation will force business offshore and render the U.S. financial industry less competitive. Our response to that argument is that institutions and fiduciaries in the end will gravitate to the system with the strongest and wisest regulatory protections. Moreover, we should be pushing the most reckless practices out of our markets and into other markets. We should be creating global competition over best regulatory practices, not worst ones.

Wall Street Compensation: The financial incentive system that governs Wall Street - and by "Wall Street," we mean the investment and commercial banks, private equity firms and hedge funds - requires dramatic rethinking. As compensation is meted out today on Wall Street, too much is paid to too few for doing too little of value for society. Too much capital is allowed to exit investment banks in the form of annual cash compensation. Executive compensation should be calculated based on multiple years of performance and subject to high water marks and claw backs in the event one year's profits from a transaction or a specific activity are lost in later years when that activity turns out to have been fraudulent or flawed. The subprime mortgage business is a case in point. Why should bankers be permitted to retain bonuses earned with respect to the closing of subprime mortgage CDOs that subsequently led to losses for their firms and investors? Compensation should be based on a longer-term view of value-added. Furthermore, regulators should permit firms to maintain reserve accounts and make other arrangements to facilitate a more nuanced compensation structure with adequate disclosure to keep investors fully informed.

Private equity managers and hedge fund managers should not be compensated based on returns attributable to inflation or the market. Their performance fees should be subject to a hurdle rate that is based on annual inflation rates and the applicable asset class performance (equity market performance in the case of private equity firms, for instance) to insure that investors are really paying fees for performance, not for fortuity.

Private Equity: The private equity business has resulted in the overleveraging of American business. One result is that many businesses are short-changing capital expenditures and research and development in order to service debt. Despite the statistics promulgated by self-serving, private equity-financed industry groups, it is irrefutable that companies would have more money to contribute to the productive stock of the economy if they were devoting less money to servicing their enormous debts. We will look back at the private equity boom as a phenomenon that damaged the American economy and impaired America's competitive position in the world.

The private equity boom is the quintessential example of what the economist Hyman Minsky termed "speculative finance" and, in its most extreme form, "Ponzi finance."4 Private equity deals add little or nothing to the productive capacity or capital base of the economy. Instead, they merely create debts that have to be serviced and divert cash to the activity of servicing debt rather than creating jobs or funding new projects or research. In 50 years, it is going to be clear that the U.S. economy has paid a terrible price for this.

Private equity managers' (and hedge fund managers') "carried interests" should be taxed at ordinary tax rates, not at the capital gains rate. Such earnings are nothing other than compensation, not earnings on risk capital.5 The arguments that private equity firms have tried to promote on Capitol Hill that such a taxation regime would reduce risk-taking are completely unsupportable from a factual standpoint. Henry Kravis and Stephen Schwarzman are not going to stop doing deals because they have to pay taxes at the same rate as their chauffeurs. These arguments are also the most cynical kind of politicking that insults the intelligence of every American. If politicians want to be held in even lower regard than they already are, supporting these arguments is a good way to go.

Finally, private equity firms should not be permitted to go public. The discipline of the markets - i.e. 50 percent or more declines in the price of private equity firms' stocks such as The Blackstone Group (BX) and Fortress Investment Group (FIG) - is inadequate to police the abuses of such transactions. These firms are hopelessly and terminally conflicted between their fiduciary obligations to their limited partners and their fiduciary obligations to their shareholders. The fact that investors are willing to ignore the mind-boggling hypocrisy of IPOs of businesses that are built on the premise that public ownership is economically inefficient is a tribute to the insatiable greed that has consumed investors. That greed has not only corrupted investors' moral sentiments, as Adam Smith wrote more than two centuries ago, it has crippled their common sense.

Financial Institution Leverage: Allowing investment banks to be leveraged to the tune of 30 to 1 is the equivalent of playing Russian roulette with 5 of the 6 chambers of the gun loaded. If one adds the off-balance sheet liabilities to this leverage, you might as well fill the 6th chamber with a bullet and pull the trigger. If this continues, the odds of a systemic crisis more severe than the one we are experiencing are near 100%. An absolute leverage limit should be imposed on investment banks and other financial institutions.6 Some will argue that limiting financial institution leverage will render these businesses less profitable and less competitive with non-U.S. companies. HCM's response is - "so what?" Perhaps less profitable investment banks will result in more of America's talented students becoming scientists, engineers, doctors and teachers instead of investment bankers and mortgage traders. What would be so terrible about that?

Off balance sheet entities should be outlawed immediately, plain and simple. If first Enron and now the SIVs haven't taught us the necessary lessons about hidden liabilities, the system probably doesn't deserve to survive. Speaking as someone with extensive knowledge of these off-balance sheet entities, it would not be difficult to render them extinct relatively easily. It would be doing the world a favor.

Tying this issue to the compensation question in the financial industry, if investment banks want to leverage themselves 30 to 1, their executives should be required to retain 97 percent of their compensation in their firms in the form of equity capital. The way it stands now, the ratio between capital retained and cash out is much lower (perhaps 1:1) and effectively creates a "heads-I-win, tails-you-lose" culture. For institutions that play a central role as financial counterparties and lenders, this is an unacceptable risk-sharing arrangement for society to bear. These institutions need to understand that they have responsibilities to the system, not just to their own shareholders and employees. Sure, Jimmy Cayne sold stock once worth $1.2 billion for only $61 million, but he also took out hundreds of millions of dollars in cash compensation over the years. Nobody can argue that his incentives were anything but grossly asymmetric, which may explain his ability to keep his job while demonstrating a much greater understanding of the strategies of the game of bridge than of the balance sheet risks his firm was undertaking.

Hedge Fund Leverage: Allowing unregulated entities such as hedge funds to be leveraged 10 to 1 or 15 to 1 would be laughable if it wasn't so dangerous. Prime brokers continue to be suckers for big names and big clients (and especially for big name clients). As a result, they often extend credit to parties who are not qualified to employ it prudently. HCM has expressed its view on more than one occasion that fixed income strategies that require excessive amounts of leverage do not make sense and have never made sense. We would refer anybody who disagrees with us to the recent collapses of Sowood Capital Management, LP, Peloton Partners LLP and Carlyle Capital Corp. Each of these firms reportedly employed high amounts of leverage (reportedly more than 15x) in their strategies. An absolute leverage limitation should be placed on hedge funds immediately. Since the prime brokers don't seem to want to impose such a limitation, the Federal Reserve should do so with its new powers. If investors can't generate decent returns without employing grotesque amounts of leverage, they should find another profession.

We recently read7 that John Meriwether of Long Term Capital Management infamy is at risk of blowing up a hedge fund that was leveraged 14.9 to 1 as of the end of February (and is reportedly down 28 percent year-to-date). The fund in question, Mr. Meriwether's Relative Value Opportunity Fund, reportedly has earned about 7 percent per annum since inception in 1999 through February 2008 (according to The Wall Street Journal) despite the use of generous amounts of leverage. According to the Journal article, Mr. Meriwether, like many hedge funds, charges a 2 percent management fee and 20 percent performance fee for managing his fund. We really don't mean to pick on Mr. Meriwether. Everybody is entitled to a second chance. But one would hope that an individual whose firm almost cratered the entire financial system in 1998 would have learned from his mistakes. Any way you slice it, 15x leverage is imprudent. It may look prudent compared to the 100x leverage employed at Long Term Capital Management a decade ago, but that is like saying 2 degrees below zero isn't cold because it isn't 30 degrees below zero.

Of course, the real question is why hedge fund investors are still willing to risk their money in such highly leveraged strategies. HCM has been asking that question for years but has yet to hear a satisfactory explanation. But since the market won't impose the type of discipline that is necessary to protect the system from boom and bust cycles, it is time for the regulators to step in.

Quantitative Strategies: Quantitative investing has not only introduced an unhealthy amount of volatility into the markets, but has contributed to a larger trend in the financial markets that divorces the investment process from the concept of fundamental value. HCM would defy the quants to explain in any degree of detail what the companies in their portfolios do. This is another type of investing activity, like private equity, that does little or nothing to provide capital to increase the productive capacity or physical stock of the economy. In fact, quantitative investment strategies are the quintessential "hot money." Enslaved by their computer models, they trade in and out of positions at the blink of an eye. When things go wrong, they blame everybody but themselves. Being a quant means never having to say you're sorry.

At some point, society has to figure out that the way an investor earns his money is even more important than the amount of money he makes. This is why human beings were vested with moral sentiments, so they could distinguish the quality of human conduct from the quantity of its results. Until that happens, we will continue to extol the types of investment activity that contribute little to our world. HCM would respectfully propose that a new school of "ethical investing" be adopted that takes into account how particular kinds of investments contribute to the economy. On this basis, quantitative strategies would be eliminated from consideration.

Short Selling: Short selling is an absolutely legitimate way to invest or hedge a portfolio. The SEC made a major error when it repealed the downtick rule last year. The repeal of this rule increased downside volatility exponentially and contributed to the ability of quantitative and other computer-driven selling to push the market lower based on technical rather than fundamental investment considerations. The SEC should reinstitute the downtick rule immediately.
Financial Triage

The magnitude of the unprecedented steps that the Federal Reserve and U.S. Treasury have had to take to bail out the U.S. financial system speaks to the depth of the problems we are facing. We may have left some steps out, but by our account the following is a list of the extraordinary actions that the U.S. central bank has been required to take to address the current crisis.

Since last summer, the Fed has cut interest rates by 300 basis points. The result? Mortgage rates have barely budged, but they are finally starting to move lower. Unfortunately, this comes too late for many homeowners who are losing their homes.

On December 12, 2007, the Federal Reserve created the Term Auction Facility (TAF) whereby the Fed will auction term funds to depository institutions against a wide variety of collateral that can be used to secure loans at the discount window. On March 7, 2008, the Federal Reserve increased the size of the TAF to $100 billion and initiated a series of term repurchase transactions that were expected to cumulate to $100 billion. As with the TAF auction sizes, the Fed said it would increase the size of these term repo operations if necessary. No doubt these facilities will need to be increased.

On March 11, 2008, the Federal Reserve created a $200 billion Term Securities Lending Facility (TSLF) whereby primary dealers could borrow Treasury securities for a period of up to 28 days using as collateral federal agency debt, federal agency residential mortgage backed securities (MBS) and non-agency AAA/Aaa-rated private-label residential MBS.

On March 17, 2008, the Federal Reserve opened up the discount window to the investment banks, which are not subject to the same regulatory limitations as the commercial banks that have traditionally had access to the window.

The Federal Reserve made a $29 billion line of credit available to JP Morgan Chase in connection with its takeover of Bear Stearns.

The Office of Federal Housing Enterprise Oversight (OFHEO) announced on March 19 that it would reduce excess capital requirements for Fannie Mae and Freddie Mac by one-third, from 30 percent to 20 percent. This is calculated to permit these two entities to add another $200 billion of mortgages to their existing $1.4 trillion portfolios (on an equity base of less than $70 billion). The two agencies shortly thereafter announced that they were authorized to raise an additional $5-10 billion of equity capital each, which would still leave them grossly leveraged by HCM's count.

The Federal Housing Finance Board announced that it would increase the limit on Federal Home Loan Banks' MBS (mortgage backed securities) investment authority from 300 percent of capital to 600 percent of capital for two years. This is estimated to enable these institutions to purchase another $200 billion of this paper.
While these moves were probably necessary to save the system from complete collapse, it is abundantly clear that these drastic steps are going to have enormous negative long-term effects on the U.S. economy. Among those effects will be higher future inflation and an extension of the high levels of leverage in the system that pushed the economy to the precipice this time. Does anybody really think it's a good idea to have Federal Home Loan Banks buy more MBS paper? Or for Fannie and Freddie to leverage their balance sheets further? All of these actions are going to have to be unwound at some point, which means that the day of reckoning is simply being delayed.8 It is clear that the authorities are engaged in a desperate attempt at economic triage that bodes poorly for the future economic health and stability of the United States. Looked at in this context, it is difficult to argue against those who believe in long-term U.S. dollar weakness. If you want to look at the end of American economic hegemony, just look at the list of desperate actions taken by U.S. financial authorities above. It is a sad commentary on how the greed and short-sighted actions and policies of U.S. politicians and businessmen have inflicted permanent damage on our economy.

There is a way out, but it will not be easy. The way out is to accompany the drastic steps taken by the Federal Reserve and Treasury with a comprehensive regulatory revolution that addresses the flaws embedded in the system. HCM does not use the word "revolution" loosely, but nothing less than a drastic rethinking of our current system accompanies by action to change it is going to be required if we are to strengthen the global economic system for the challenges to come.

Michael E. Lewitt

Ten Fundamental Issues in Reforming Financial Regulation and Supervision in a World of Financial Innovation and Globalization

Nouriel Roubini | Mar 31, 2008
Today U.S. Treasury Secretary Hank Paulson presented his proposals for a reform of the system of supervision and regulation of financial markets following the most severe – still ongoing – financial crisis in the U.S. since the Great Depression. And soon the Draghi Commission within the Financial Stability Forum will report its conclusions and proposals for reform of the financial system to the G7 Finance Ministers.

To understand whether the U.S. Treasury proposals make sense one should first analyze what are the problems that an increasingly complex and globalized financial system face and what are the shortcomings of the current system of financial regulation and supervision, in the U.S. and around the world. Only a detailed consideration of such problems and shortcomings can lead to the recognition of the appropriate reforms of the system.So, let us consider in more detail such problems and shortcomings of the financial system and of its regime of regulation and supervision.

They can be summarized in ten points or issues…

First, the system of compensation of bankers and operators in the financial system is flawed as a source of moral hazard in the form of gambling for redemption. The typical agency problems between financial firms’ shareholders and the firms’ managers/bankers/traders are exacerbated by the way the latter are compensated: since a large fraction of such compensation is in the form of bonuses tied to short-term profits and since such bonuses are one-sided (positive in good times and, at most zero, when returns are poor) managers/bankers/traders have a huge incentive to take larger risks than warranted by the goal of shareholders’ value maximization. The potential solutions to this gambling for redemption bias are varied: restricted stock that has to be maintained for a number of years; or a pool of cumulated bonuses that is not cashed out yearly but that can grow or shrink depending on the medium terms returns to particular investments.

But even leaving aside the problem of how to change such compensation in a highly competitive labor market talent in the financial sector, it is not obvious that the suggested solutions would fully work: for example in the case of Bear Stearns about 30% of the firm was owned by its employees and such employees had restricted stock. However this system of compensation did not prevent Bear Stearns from making reckless investment that eventually made it insolvent. Possibly this was the case because the individual compensation was not tied to the individual investment/lending decision. Still, compensation of bankers/traders should be considered as a crucial factor that distorts lending and investment decisions in financial markets.

Second, the current models of securitization (the “originate and distribute” model) has serious flaws as it reduces the incentive for the originator of the claims to monitor the creditworthiness of the borrower. In the securitization food chain for U.S. mortgages every intermediary in the chain was making a fee and eventually transferring the credit risk to those least able to understand it. The mortgage broker, the home appraiser, the bank originating the mortgages and repackaging them into MBSs, the investment bank repackaging the MBSs into CDOs, CDOs of CDOs and even CDO cubed, the credit rating agencies giving their AAA blessing to such toxic instruments: each of these intermediaries was earning income from charging fees for their step of the intermediation process and transferring the credit risk down the line.

One possible solution to this lack of incentive to undertake a proper monitoring of the borrower would be to force the originating bank and the investment bank intermediaries to hold some of the credit risk, for example in the form of their holding some part of the equity tranche in the CDOs or holding some of the MBS that they originate. But it is not obvious that such solutions would fully resolve the moral hazard problems faced by financial intermediaries. In fact, while the securitization process implied a partial transfer of the credit risk from the mortgage originators and the managers of the CDOs to final investors the reality is that banks and other financial institutions maintained a significant exposure to mortgages, MBS and CDOs. Indeed in the US about 47% of all the assets of major banks are real estate related; and the figure for smaller banks is closer to 67%. I.e. the model of “originate and distribute” securitization did not fully transfer the credit risk of mortgages to capital market investors: banks and broker dealers (say Bear Stearns) did keep in a variety of forms a significant fraction of that credit risk. Indeed, if that credit risk had been fully transferred such banks and other financial intermediaries would have not suffered the hundreds of billions of dollars of losses that they have recognized so far and that they will have to recognized in the future.

Thus, excessive risk taking and gambling for redemption did occur in spite of the fact that financial institutions were holding part of the credit risk. So proposing that such institutions hold some of that risk – rather than try to transfer it all – does not seem to be a solution that will resolve fully the problems deriving from the wrong set of financial incentives faced by bankers and the poor risk management by financial institutions. If the fundamental problem is one of the moral hazard deriving from the way that bankers are compensated forcing financial institutions to hold more of the credit risk will not resolve the problem that led in the first place to the poor monitoring of the creditworthiness of the borrowers and to poor underwriting standards.

Third, the regulation and supervision of banks and the lighter – on in some cases such as that of hedge funds non-existent – regulation and supervision of non-bank financial institutions has led to significant regulatory arbitrage: i.e. the transfer of a large fraction of financial intermediation to non-bank financial institutions such as broker dealers, hedge funds, money market funds, SIVs, conduits, etc.

The problems with this financial innovation are twofold: first, some of the institutions in this shadow banking system (or shadow financial system) are systemically important. Two, most of these institutions are at risk of bank-like runs on their liabilities as they borrow in short and liquid ways, they are highly leveraged and they invest in longer and more illiquid ways.

The risk of runs is significantly prevented for banks by the existence of deposit insurance and by the lender of last resort support that the central bank can provide. Publicly provided deposit insurance is generally not warranted for non-bank financial institutions as the protection of small investors/depositors - who don’t have the expertise to monitor the lending/investment decisions of banks - is not generally an issue for such non banks. But as the recent Bear Stearns episode as well as the run on and collapse of other components of the shadow financial system suggest bank-like runs on non-banks can occur and are more likely to occur more often if such institutions do not properly manage their liquidity and credit risks.

While provision of lender of last resort to non-bank institutions that are not systemically important is not warranted such support may be warranted for the few institutions that are systemically important. And indeed the recent Fed actions - $30 billion rescue of Bear Stearns, and two new facilities that allow non-bank primary dealers to access the Fed ‘s discount window and to swap their illiquid MBS products for safe Treasuries – imply that the lender of last resort support of the Fed has been now extended to systemically important non-bank institutions. Thus, the same regulation and supervision that is applied to banks should also be applied to these systemically important financial firms, not just in periods of turmoil (as recommended by Hank Paulson) but on a more permanent basis.

But if these institutions should be regulated like banks because they are systemically important and receive the Fed’s lender of last resort support one cannot have a system where the regulation and supervision of a subset of non-bank financial institutions is different depending on whether the institution is systemically important or not. Otherwise regulatory arbitrage will lead financial intermediation to move from banks and systemically important broker dealers to more lightly regulated smaller broker dealers and other non-bank financial institutions.

Thus, while the safety net of the Fed and other central banks should remain restricted to banks/depository institutions and to – subject to some constructive ambiguity - systemically important non-bank firms, the regulatory and supervisory framework should be similar for banks and non-bank financial institutions: regulatory capital, type of supervision, liquidity ratios, compliance and disclosure standards, etc, should be similar for banks and other financial institutions. Otherwise regulatory arbitrage will shift financial intermediation and risks to other more lightly regulated institutions.

For example, the loophole that allowed SIVs and conduits to operate with little supervision and no capital standard under the pretense that these were off-balance sheet units – while the sponsoring bank was providing large credit enhancements and systematic liquidity lines that made these units de facto on-balance sheet assets and liabilities – was deeply flawed. Unless these and a whole host of other special purpose vehicles are regulated and supervised as if they were on-balance sheet units this type of regulatory arbitrage will lead again to the disaster that SIVs created.

Moreover, a comprehensive supervisory and regulatory regime that covers both banks and non-bank would also allow a better monitoring and assessment of systemic financial risks that at the moment are not properly supervised. Providing both regulators/supervisors as well as investors and the reporting and disclosure of information that allows an assessment of systemic financial risks will be essential.

Poor liquidity risk management and the risk of bank-like runs on non-bank financial institutions has been shown as a severe problem in the shadow financial system: the entire SIV/conduit regime has recently collapsed given the roll-off of their ABCP liabilities; hedge funds and private equity funds collapsed because of risky investments and redemptions or roll-off of short term credits; money market funds whose NAV fell below par had to be rescued to avoid a run on them; Bear Stearns collapsed because of poor credit/investment choices but also because of a sudden run on its liquidity. While banks have are fundamentally maturity-mismatched given their reliance on short-term deposits there is no reason for non-bank financial institutions to run large liquidity/rollover risk especially as they do not have deposit insurance and no access – apart from the systemically important ones - to the central banks’ lender of last resort support.

Thus, an essential element of the common regulation of all non-bank financial institutions should be a greater emphasis given to the management of liquidity risk. Such firms should be asked to significantly lengthen the maturity and duration of their liabilities in order to reduce their liquidity risk. A firm that makes money only because it borrows very short, has little capital, leverages a lot and lends long and in illiquid ways is reckless in its risk management. It should certainly disclose fully to supervisors and to investors the liquidity and other risks that it is undertaking. But it should also be required to reduce its liquidity risk with a variety of tools provides it with a greater liquidity buffer.

Fourth, most regulatory and supervisory regimes have moved in the direction of emphasizing self-regulation and market discipline rather than rigid regulations. One of the arguments in favor of this market discipline approach is that financial innovation is always one or more steps ahead of regulation; thus, one need to design a regime that does not rely on rigid rules that would be easily avoidable via financial innovation.

This market discipline approach is behind the reliance on “principles” rather than “rigid” rules, the reliance on internal models of risk assessment and management in determining how much capital a firm needs, the reliance on rating agencies assessments of creditworthiness, and a key element of the philosophy behind the Basel II agreement. But this model based on market discipline has been proven vastly flawed given that the way bankers are compensated and the risk-transfer incentives provided by the “originate and distribute” model implies that internal risk managers are effectively ignored in good times when “the music plays and you gotta dance”; similarly the conflicts of interests of rating agencies lead to mis-ratings of new and exotic financial instruments.

Thus, while reliance on principles is useful to deal with financial innovation and regulatory arbitrage a more robust set of rules that go with the grain of principle-based regulation and supervision is necessary. Strict reliance on market discipline has been proven wrong in a world where bankers are improperly compensated, agency problems lead to poor monitoring of lending, a flawed transfer of credit risk to those least able to understand it and manage it, and where regulatory arbitrage is rampant.

Fifth, even before being fully implemented the Basel II agreement has shown its flaws: capital adequacy ratios that pro-cyclical and thus inductive of credit booms in good times and credit busts in bad times; low emphasis on liquidity risk management; excessively low capital ratios given the risks faced by banks; excessive reliance on internal risk management models; excessive importance given to the rating agencies. These are serious shortcomings of the new capital regime for large internationally active banks and depository institutions.

How to reform Basel II given the current severe financial crisis is not an easy task; but the urgency of this reform is undeniable. Particular importance should be given to: measures that would reduce the pro-cyclicality of capital standards that is a source of boom and busts in credit cycles; and to measures to increase – rather than decrease - the overall amount of capital held by financial institutions as recent history suggests that most financial institutions were vastly undercapitalized given the kind of market, liquidity, credit and operational risks that they were facing in an increasingly globalized financial system.

Sixth, by now the conflicts of interest and informational problems that led the rating agencies to rate – or better mis-rate – many MBS and CDO and other ABS products as highly rated are well known and recognized. With a large fraction of their revenues and profits coming from the rating of complex structured finance products and the consulting and modeling services provided to the issuers of such complex and exotic instruments it is clear that rating agencies are ripe with conflicts of interests. Add to this the flaws of a system where competition in this rating market is limited given the regulatory barriers to entry and the semi-official role that rating agencies have, in general and in Basel II in particular; the potential biases of a system where rating agencies are paid by issuers rather than the investors; the informational problems of raters that know little about the underlying risks of new complex and exotic instruments.

What are the potential solutions to these conflicts of interest and other problems? Open up competitions in the rating agency business; drop the semi-official role that rating agencies have in Basel II and in the investment decisions of asset managers; forbid activities (such as consulting or modeling) that cause conflicts of interest; drop the reliance on ratings paid by issuers rather than by investors (the free riding problem of having investors pay for ratings can be solved by pooling the investors’ resources in a pool that can be used to collectively purchase the ratings). Certainly rating agencies have lost a lot of their reputation in this ABS ratings fiasco; and only serious and credible reforms – not just cosmetic changes – will be required to restore their credibility in the rating business.

Seventh, there are fundamental accounting issues on how to value securities, especially in periods of market volatility and illiquidity when the fundamental long term value of the asset differs from its market price. The current “fair value” approach to valuation stresses the use of mark-to-market valuation where, as much as possible, market prices should be used to value assets, whether they are illiquid or not.

There are two possible situations where mark to market accounting may distort valuations: first, when there are bubbles and the market value may be above fundamental value; second, when bubbles burst and, because of market illiquidity, asset prices are potentially below fundamental value. The latter case has become a concern in the latest episode of market turmoil as mark-to-market accounting may force excessive writedowns and margin calls that may lead to further fire sales of illiquid assets that, in turn, could cause a cascading fall in asset prices well below long term fundamentals. However, mark to market accounting may also create serious distortions during bubbles when its use may lead to excessive leverage as high valuation allow investors to borrow more and leverage more and feed even further the asset bubble. In either case, mark to market accounting leads to pro-cyclical capital bank capital requirement given the way that the Basel II capital accord is designed.

The shortcomings of mark-to-market valuation are known but the main issue is whether one can find an alternative that is not subject to gaming by financial institutions. Some have suggested the use of historical cost to value assets (where assets are booked at the price at which they were bought); others propose the use of a discounted cash flow (DCF) model where long run fundamentals – cash flows – would have a greater role. However, historical cost does not seem to be an appropriate way to value assets. The use of a DCF model may seem more appealing but it is not without flaws either. How to properly estimate future cash flows? Which discount rate to apply to such cash flows? How to avoid a situation where those using this model to value asset subjectively game the model to achieve the valuations that they want as the value of the asset in a DCF model strongly depend on assumptions about future cash flows and the appropriate discount factor? Possibly mark-to-market may be a better approach when securities are held in a trading portfolio while DCF may be a more appropriate approach when such securities as held as a long term investment, i.e. until maturity. But the risk of a DCF approach is that different firms will value very differently identical assets and that firms will use any approach different from mark-to-market to manipulate their financial results.

The other difficult problem that one has to consider is that any suspension of mark-to-market accounting in periods of volatility would reduce – rather than enhance – investors’ confidence in financial institutions. Part of the recent turmoil and increase in risk aversion can be seen as an investors’ backlash against an opaque and non-transparent financial system where investors cannot properly know what is the size of the losses experienced by financial institutions and who is holding the toxic waste. Mark-to-market accounting at least imposes some discipline and transparency; moving away from it may further reduce the confidence of investors as it would lead to even less transparency.

Some suggest that the problem is not mark-to-market accounting but the pro-cyclical capital requirements of Basel II; that is correct. But even without such pro-cyclical distortions there is a risk that financial institutions – not just banks - would retrench leverage and credit too much and too fast during periods of turmoil when they become more risk averse. Thus, the issue remains open of whether there are forms of regulatory forbearance - that are not destructive of confidence - that can be used in periods of turmoil in order to avoid a cascading and destructive fall in asset prices. But certainly solutions should be symmetric, i.e applied both during periods of rising asset prices and bubbles (when market prices are above fundamentals) and when such bubbles go bust (and asset prices may fall below fundamentals). But so far there is no clear and sensible alternative to mark-to-market accounting.

Eighth, the recent financial markets crisis and turmoil has been partly caused by the fact that the – over the last few years – financial markets have become less transparent and more opaque in many different dimensions. The development of news exotic and illiquid financial instruments that are hard to value and price; the development of increasingly complex derivative instruments; the fact that many of these instruments trade over the counter rather than in an exchange; the fact that there is little information and disclosure about such instruments and who is holding them; the fact that many new financial institutions are opaque and with little or no regulation (hedge funds, private equity, SIV and other off-balance sheet special purpose vehicles) have all contributed to a lack of financial market transparency and increased opacity of such markets.

But private financial markets cannot function properly unless there is enough information, reporting and disclosure both to market participants and to relevant regulators and supervisors. How much reporting and disclosure - and to whom - is appropriate is a difficult question. But it is clear that for the last few years financial market have become excessively opaque in ways that are destructive of investors’ confidence. When investors cannot prices appropriately complex new securities, when investors cannot properly assess the overall losses faced by financial institutions and when they cannot know who is holding toxic waste securities risk (that can be priced) turns into generalized uncertainty (that cannot be priced) and the outcome is an excessive increase in risk aversion, lack of trust and confidence in counterparties and a massive seizure of liquidity in financial markets. Greater transparency and information – including the use of fair value accounting (that, in spite of its shortcomings, is still the best way to value assets) – as well as prompt recognition by financial institutions of their exposures and losses are essential to restore the investors’ confidence in financial markets.

Some specific ideas on how to make new complex and exotic financial instruments more liquid and easier to price would be to make such instrument more standardized and have them traded in clearing house-based exchanges rather than over the counter. The benefits of standardization are clear as such standardization would allow to compare securities with similar characteristics and would thus improve their liquidity. Moreover, instruments that are exchange-traded through a clearing house would have much lower counterparty risk, would be subject to appropriate margin requirements and would be appropriately marked-to-market on a daily basis.

Ninth, what are the appropriate institutions of financial regulation and supervision and the system of such regulation and supervision in a world of financial innovation and globalization? There are many alternative models that have different pros and cons.

An increasingly popular model is the one of a unique and centralized financial regulator and supervisor, as in the case of the UK’s FSA where all financial policies – for banks, securities firms, other financial institutions, insurance companies, etc. – are under one umbrella. Another model is the US one where you have more than half a dozen or more of financial regulators and supervisors at the federal level and another layer of them at the state level. While some have argued that the US system because it foster beneficial competition about the best practices among different regulators the shortcoming of the US system, an incoherent set of overlapping regulators and a race to the bottom – rather than to the top – in terms of excessively deregulatory competition, have now become clear. One overall financial regulator may be too little but sixty plus of them is obviously way too many. A streamlining of such institutions and concentration of most regulatory and supervisory activities among a smaller number of institutions is certainly necessary.

Further, whether supervisory and regulatory power over banks – and possibly other systemically important financial institutions – should be kept within the central bank (as in the US) or whether it should be given to another regulator (as in the case of the UK FSA) is a difficult and controversial issue. Some worry that taking such powers away from the central bank – while maintaining its role as the lender of last resort - would reduce the ability of the central bank to oversee financial vulnerabilities in specific institutions and in the overall financial system (systemic risk). But as long as there is a proper exchange of information between the regulator and supervisor of banks and of other financial institutions and the central bank these informational issues can be properly managed. The UK debacle over Northern Rock was caused not by the existence of a single financial authority (the FSA) but rather – in part – by the lack of coordination and proper information exchange between the FSA, the Bank of England and the UK Treasury. Thus, the UK model of a single financial regulator/supervisor is – in principle – superior to a model where such powers are fragmented among many and different institutions. But proper coordination and information exchange is essential to make this system work.

Tenth, and finally, reforms of financial regulation and supervision cannot be done only at the national level as regulatory arbitrage may lead financial intermediation to move to jurisdictions with a lighter – and less appropriate - regulatory approach. Indeed, the recent US debate on reforming capital markets was driven – before the current market turmoil – by the concerns that a tighter regulatory approach in the U.S. (say the Sarbanes-Oxley legislation) was leading to a competitive slippage of New York relative to London in the provision of financial services.

In a world of financial globalization, mobile capital and lack of capital controls capital and financial intermediation may move to more lightly regulated shores. While the idea of a global financial regulator – or a global financial “sheriff” – is for the time being a bit far-fetched a much stronger degree of coordination of financial regulation and supervision policies is necessary to avoid a race to the bottom in financial regulation and supervision and to prevent excessive regulatory arbitrage. Such international coordination of financial policies is currently occurring on a very limited scale and will have to be seriously enhanced over time. Certainly within the Eurozone a system where bank supervision and regulation occurs only at the national level while only the ECB would be able to provide lender of last resort support in the case of a systemic banking crisis or when a major systemically important cross-border institution gets into trouble is an untested model. Over time financial supervision and regulation within the Eurozone will have to move from the national level to a Eurozone-wide level.

Finally, how do the U.S. Secretary Paulson proposals for the reform of the financial system compare with the principles and ideas for optimal financial regulation and supervision discussed above? An appropriate answer requires a detailed discussion that will be provided in the near future in this forum. But in brief summary, such proposals - while representing a step forward – have many shortcomings and they overemphasize the role of self-regulation, market discipline and reliance on principles rather than rules that have miserably failed to deliver an appropriate regulation and supervision of the financial system. Given that we are still in the midst of the worst U.S. financial crisis since the Great Depression, a crisis that has shaken the foundations of modern financial capitalism, the current US Treasury proposals have significant shortcomings that don’t address the core and structural financial risks and vulnerabilities that the current crisis has revealed.