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Friday, October 26, 2012

Cameron to Van Rompuy: No Negotiation on E.U. Budget

Just days before the House of Commons debated whether Britain should secede from the E.U., Prime Minister David Cameron and his deputy, Nick Clegg, met with Herman Van Rompuy, President (or chair) of the European Council, to discuss Cameron’s threat to veto any proposed seven-year E.U. budget that is higher than the previous budget (allowing for inflation). The European Commission had proposed a 5% increase over the current budget, setting the stage for a clash of the titans across the federal and state levels. The British refusal even to negotiate on the federal budget exposed a major vulnerability in the E.U. itself just as it was being relied on internationally to protect the euro from succumbing to the systemic risk of Greece or Spain defaulting.

The full essay is at "E.U. & U.S."

Anti-Federalist Britain: South Carolina on Steroids

If Douglas Carswell, a member of the House of Commons, had his way, Britain would secede from the E.U. before Prince Charles could say, “hip hip!” Carswell's Private Member's Bill, submitted for debate in late October 2012, would repeal the European Communities Act (1972), by which Britain became a state in the former European Economic Community in 1973 (after France had vetoed Britain’s first request). Although Private Member’s Bills rarely become law in Britain, merely having a debate on whether to have a referendum on the question of whether the Kingdom should secede from the empire-level union would stir the pot. The Prime Minister, who was on record in support of not pulling out of the union, but for only economic reasons as his state had been benefitting from the large common market. So even if Carswell’s effort is ultimately unsuccessful, even such a revolt by Tory back-benchers could undercut David Cameron’s power in the midst of a languid economy in the state.

                                     PM David Cameron of Britain at the European Council. Is he onboard?     AFP/Getty

The complete essay is at "Is the E.U. a Federal System?"

Thursday, October 25, 2012

The U.S. Sues Bank of America: A Spanking or Slap-on-the-Wrist?

In late October 2012, federal prosecutors in New York formally accused Bank of America of “carrying out a scheme, started by its Countrywide Financial unit, that defrauded government-backed mortgage agencies by churning out loans at a rapid pace without proper controls. In a civil suit, prosecutors seek to collect at least $1 billion in penalties from the bank as compensation for the behavior that they say forced taxpayers to guarantee billions in bad loans.” The guarantee can be considered a moral hazard, in that Bank of America (or Countrywide) was not the party on the hook. In other words, the mortgage service company had an artificial incentive to produce mortgages riskier than would otherwise be the case because they would be guaranteed by another party (i.e., American taxpayers).
Adding to the moral hazard, executives of companies that have engaged in fraud are typically not held personally guilty. Especially where the company is making a lot of money off the practice in question, the corporate treasury operates as a sort of moral hazard in that the executives need not pay personality, whether financially or in prison, for the fraud. Accordingly, the New York Times reported at the time, “the public has been frustrated with the limited number of criminal actions that have been filed since the financial crisis. Few cases have taken aim at top executives. Even in the latest case against Bank of America, no company officials were sued as part of the complaint. Angelo R. Mozilo, the former chief executive of Countrywide Financial, never faced criminal charges but did agree in 2010 to pay $67.5 million to settle a civil fraud case brought by the Securities and Exchange Commission.” You can bet future Mozilos got the message: moral hazard is alive and well, so go for it!

In terms of the major banks, President Obama’s mortgage task force had just announced its first case, against JPMorgan Chase over mortgage deals created by Bear Stearns, the firm that JPMorgan bought during the financial crisis of 2008. A case against Wells Fargo was also being considered. Still, the legal problems for Bank of America dwarfed those of JP Morgan and other American banks. The lawsuit announced in October, for instance, had the potential to “impose steep fines on Bank of America.
The Justice Department filed the case under the False Claims Act, which could provide for triple the damages suffered by Fannie and Freddie, a penalty that could reach more than $3 billion,” according to the New York Times. In particular, the Justice Department “attacked a home loan program known as the ‘hustle,’ which the bank inherited from Countrywide in 2008 and kept alive through 2009. Prosecutors say the venture was a symbol of Wall Street's slipshod standards during the mortgage bubble. According to the lawsuit, Countrywide rubber-stamped mortgage loans to risky borrowers and passed them on to Fannie Mae and Freddie Mac, the two government-controlled mortgage financial giants that guaranteed the loans. The two entities were ultimately stuck with heavy losses and a glut of foreclosed properties. The New York Times does a nice job of unpacking this operation:
“Short for ‘HSSL,’ or ‘High-Speed Swim Lane,’ the program adopted the motto ‘move forward, never backward,’ prosecutors said, citing Countrywide documents. With the goal of generating a high number of loans, Countrywide tore down internal controls known as tollgates that were in place to slow the mortgage process and root out risky borrowers. The firm at one point removed trained underwriters from the loan process, opting instead to rely on ‘unqualified and inexperienced’ loan processors. . . . Some ‘repeatedly did manipulate’ loan forms, jotting down higher incomes for borrowers so they would qualify for Fannie Mae's standards. By early 2008, (m)ore than a third of the unit's loans were defective, a significant jump over the industry standard of about 5 percent. Despite the poor performance, prosecutors said, the bank sold the loans to Fannie Mae and Freddie Mac and ‘concealed the defect rates and continued the hustle.’” One might wonder why managers at Fannie and Freddie did not suspect foul-play and investigate.
On just a lunch-hour visit to a bar near Countrywide’s headquarters in California, a few financial wonks from Lehman Brothers had been able to grasp the upshot of the racket simply from the mentality of a few of the salesmen.  “Cowboys” is what one of the guys from Lehman labeled the studs, who were immediately obvious due to their excess cologne and fancy sports cars (and high school class rings, no doubt). The air of easy money alone ought to have raised red flags.
From the account of the Lehman guys, it is clear that the fraud at Countrywide was systemic and widespread. As if Ken Lewis’s judgment in purchasing Countrywide in 2008 had not been sufficiently misguided, Bank of America enabled or inherited Countrywide’s bad practices. “The fraudulent conduct alleged in today's complaint was spectacularly brazen in scope,” Preet Bharara, the United States attorney in Manhattan, said in a statement in October 2012. “This lawsuit should send another clear message that reckless lending practices will not be tolerated.” Bank of America had reached a $2.4 billion deal in September 2012 to settle a class-action lawsuit over shareholder claims that it misled investors about the 2009 purchase of Merrill Lynch. Bharara might have been hoping for another such settlement figure. Moreover, the perception, likely desired by the Obama administration before the presidential election, was likely that the U.S. Government was finally getting tough with Wall Street’s complicity in the financial crisis of 2008.
However, given the continued moral hazard discussed above, it is difficult to take the lack of toleration seriously. The sheer extent and depth of the fraud at Countrywide renders any mere fine insufficient, absent hard time. Furthermore, the political calculus just before the election cannot be ignored—meaning that the actual penalties inflicted on Bank of America after the election could be considerably less than the headlines suggested. Such deals could have been reached in exchange for political contributions. This was not the first time the political angle had been raised in regard to holding Wall Street to account for its complicity in securitizing “crap” securities based on sub-prime mortgages. In 2011, for example, the Federal Housing Finance Agency “sued 17 big banks over losses sustained by Fannie Mae and Freddie Mac over different mortgage-related products. The flurry of litigation, which [came] on the cusp of the presidential election, . . . caused some on Wall Street to question whether the effort is rooted in political motivations.” In other words, a slap on the wrist might be more consistent with a political calculus than really making banks as well as bankers pay for having participated in fraudulent activities.
At the very least, criminal penalties for white-collar fraud in the financial sector could be strengthened in legislation such that in the wake of the next financial scandal the U.S. Justice department (and those of the states!) would not have as an excuse, “But we cannot legally go after the executives.” I am reminded of the leaked White House memo in 2012 to the drug companies thanking the industry for its help and promising to oppose the Democrats’ bill in the U.S. Senate to reduce drug prices (which Obama had campaigned on in 2008). However, if Wall Street really does own Congress and the president, the lack of criminal sanctions with teeth is no accident, and would not be likely to change. In short, the advent of plutocracy may mean that wealthy bankers can engage in fraud with personal impunity. Meanwhile, a bank’s treasury can handle the fines as a cost of doing (fraudulent) business.


Ben Protess, “U.S. Sues Bank of America for $1 Billion Over ‘Brazen’ Fraud,” The New York Times, October 25, 2012.  

Wednesday, October 24, 2012

Political Risk in Systemic Risk: Finnish Pensions Err in Debt Crisis

Finland became a state in the European Union in 1995 and adopted the euro at its birth in 1999. In terms of population, the state is between Wisconsin and Minnesota, both of which are states in the United States. The Finnish culture prizes saving as well as paying-off debt on time. As the Wall Street Journal put it, the Finns are more German in this sense than are the Germans themselves. It is easy to understand, therefore, why the Finns would not have been excited about the write-offs in Greek government in 2012. The Finnish cultural attribute here is an ideological proclivity. Such a value-system so deeply held can even eclipse or interfere with an otherwise unfettered risk-return trade-off presumed to be part of the market mechanism. Just as the risk-return investment-pricing froze rather than adjusted upward with the leap in risk in CDOs and the related insurance swaps that occurred on Wall Street in 2007 and 2008, the decisions of Finnish pension fund officers in the wake of the European debt crisis to pull out of Greek and Spanish bonds rather than simply to demand a higher rate of return, given the higher risk, likely means that the market mechanism itself freezes rather than functions at levels of high risk (or when risk is increasing dramatically). In other words, the theory of the laissez-faire market, which Adam Smith never advocated, has a serious flaw that is reflected in the mechanism in operation when there is a spike in risk. Un prix ne marche pas quand il y a beaucoup du risque. The free market mechanism in the investment market tends to freeze up rather than re-price instruments whose risk is quickly increasing to a significant degree.
To be sure, Michael Milken’s high-yield “junk bond” craze in the 1970s and 1980s can be raised as a counter-example.  However, that risk was company- or instrument-specific, and therefore contained or buffeted because systemic risk was not a compounding factor. In other words, if one high-risk/yield corporate bond tanked in an investor’s portfolio, the investor did not necessarily worry about the entire financial system collapsing. The financial crisis of 2008 and the ensuing European debt crisis introduced “systemic risk” to our vocabulary, as broader collapses, including governments themselves (e.g., Iceland in 2008 and Greece in 2012), were now in the mix, at least as possibilities associated with particular defaults of bank or governmental bonds. In the case of an E.U. state defaulting on its debt, for example, systemic risk comes from not only so many investors taking a hit that the economy itself could go into recession, but also the very real possibility (though not certainty!) that the state would leave the euro as well as fall politically (i.e., collapse of the coalition, or of the democratic government itself). That is, systemic risk includes not just economic or financial collapse, but also political downfalls. In the case of a state in the E.U. such as Greece or Spain, financial default can lead to political contagion at even the E.U. level, as the state’s loss of the euro could be (wrongly) perceived to put the E.U. itself in jeopardy. Sadly, perception can become reality in politics. Substantively, a state losing the euro would not in itself compromise or ruin the European Union, which is much more than the euro. Indeed, the E.U. existed without the common currency and ten states (as of 2012) do not even use it. Even so, particularly at the state level, political risk can be tucked into systemic risk. That is, it is not merely the risk of a financial collapse that is beyond that of a particular investment instrument. We can add government to large bank and the financial system itself to our notion of systemic risk. It is a notion properly of political economy rather than simply finance. In other words, political as well as economic factors choke the gears of the risk-return pricing mechanism of the investment markets when systemic risk is suddenly put in play.
By implication, the notion of systemic risk, and efforts to estimate its severity, may be beyond the ken of financial analysts and business practitioners in general. The same can be said of government officials, as their expertise typically does not extend to the financial world. A financial analyst might be able to identify certain parts of systemic risk, while a legislator might grasp others. Meanwhile, the true severity of systemic risk may well elude both “sides” such that the political economy is left unwittingly holding too much of the risk without realizing it. In other words, the systemic risk that we agree to tolerate may be worse than we think because neither business nor government has the full picture and the two domains do not necessarily compare notes.
I contend that the Finnish pension-fund officers are not well-enough equipped to analyze the systemic risk in Europe associated with the debt “crisis” in Greece and Spain. This does not mean, however, that the officers have underestimated the risk; rather, I am questioning the ability of financial analysts to accurately assess such risk, as it has a significant political dimension. Indeed, the Finns may be overstating the systemic risk, and if so they would be hurting Greece and Spain (as well as Italy) unnecessarily. In fact, doing so could even be said to aggravate the risk to the European system from Greece or Spanish banks defaulting!
I turn first to how risk and return are supposed to work, which will quickly lead to a consideration of how systemic risk thwarts the mechanism, as illustrated by the Finnish pension funds. The Wall Street Journal applies the risk-return theory to the European debt crisis as follows: “(I)t matters a great deal where you invest. Lend to the German government for 10 years and you'll be paid a bit over 1.6% annually in interest. Lend to Spain and you'll get about 5.5%. That means a Spanish government bond is either a fantastic investment, if Spain survives the crisis, or a terrible one if its bonds, like those of Greece, are eventually defaulted upon. . . . The safe bonds of Germany, the Netherlands, Finland, Austria and even France provide a good basis of very-low-risk investments. For extra return, there is a plethora of choice: real estate, stocks, infrastructure.” To be competitive, the rates of return on Greek and Spanish bonds would have to at least match the rates on the “plethora” of similarly-risked instruments such as risky stocks and real estate. Otherwise, investors would simply invest in the latter and thus skip the extra, uncompensated risk associated with the Greek and Spanish bonds. That is to say, there should be investors willing to take on the risk of even Greek and Spanish bonds provided the rate of return is sufficiently adjusted by the market to the level of risk, given the comparable risk/return of alternative investment opportunities. That the investment market mechanism was not making the adjustment is evident from the Wall Street Journal reporting that “corporate bonds could provide the sort of higher interest payments that Spanish and Italian government bonds generate, “with far less headache.” That is to say, the market had not pushed the returns on the government bonds high enough, given the risk involved and the risk/return tradeoff of comparable alternative investments. Something was interfering with the full upward “shift” in the rate of return as Greek and Spanish bonds were becoming more risky. Accordingly, major Finnish pension fund officers decided to pull out and redirect investments into other vehicles.  
Risto Murto, the chief investment officer of Varma Mutual Pension Insurance Co. in Finland decided to sell his fund’s investments in the heavily-indebted E.U. states, thereby reducing his fund’s risk even though doing so made the troubled states’ respective situations that much more dire. At the time of the debt crisis, Varma was Finland's largest investor. It managed €34 billion ($44 billion) and was responsible for the retirement savings of around 870,000 Finns. Finland's pension assets totaled about €150 billion, or 75% of GDP, according to the Paris-based Organization for Economic Cooperation and Development. The Wall Street Journal reports, “For years after the euro's creation in 1999, northern European investors like Varma spread their assets around the continent, helping create economic stability in the poorer south. . . . Worried about Greece's debt levels, however, the fund's executives sold their Greek government-bond holdings in 2008 and 2009, before the euro-zone crisis flared. Greece's debt restructuring in 2012, in which private investors suffered stiff losses, shattered any remaining illusion that the euro zone's strong countries would step in to forestall the default of a weaker peer. ‘We ‘communicated to the board that we stop investing in any problem countries,’ says Mr. Murto. No Greece, no Portugal, no Ireland, no Italy, no Spain. That summer, the board set a fresh guideline for government-bond investments: only the shortlist of countries rated triple-A—chiefly Germany, the Netherlands and Finland.” This had major implications for the flow of finance around the European Union—that is, its financial system.
Generally speaking, savings in the north of the E.U. was ceasing to finance the consumption in excess of production in the south. The “euro's integrated financial system [had] lent the savings of the north to the needy south,” but this system was being suspended by the north due to all the risk in the southern states due to the debt crisis (i.e., excessive use of leverage for consumption in excess of production). It was as if the gulf stream current in the Atlantic Ocean were finally stopping due to the infusion of fresh water from melted artic ice. Ironically, it would be the south that would “freeze,” or be frozen out of the investment market. In short, one of the major benefits of having a common market was drying up, and the “haves” would presumably have even more while the “have not” states would do with even less—even as their financial conditions were under severe strain. Nor was this change particularly momentary, as the shift in the Finnish approach to investments would not change any time soon.
Murto’s decision had considerable staying power. "We are not actively considering stepping back into the market," Mr. Murto insisted when his fund was well into its divestment strategy. "Not at the moment," says Jukka Järvinen, who runs fixed-income investments for the €15 billion State Pension Fund. He began selling bonds of troubled states in 2009 and got rid of his last holdings of Italian bonds in the summer of 2012. Similarly, Timo Ritakallio, head of investments at Ilmarinen Mutual Pension Insurance Co., the second-biggest pension fund in Finland, said, "We are not ready to jump in again. It's much easier for us to invest because we know the rules." For "government bonds, there are too many open questions. It is difficult to trust or believe in the political decision-making process." Watching politicians flail about for a solution to the Greek debt problem in the summer of 2010, Ritakallio admits he realized it was an impossible task. The European political system "doesn't work if you are in crisis," he says. "It takes too much time to make a decision." This response is in line with Murto’s observation that the “illusion that the euro zone's strong countries would step in to forestall the default of a weaker peer” had been broken. To be sure, Murto also expressed satisfaction that the European Central Bank ‘s governing board decided to try to relieve the euro crisis by buying state government bonds of troubled states like Greece and Spain. In late October 2012, for example, the Wall Street Journal reported that “Spain was able to sell €4.6 billion of debt, offering less in interest than it had in the past.” Even so, Murto was under no illusions concerning the ability of political officials in the E.U. to safeguard Greece, Spain and even Italy. I question the ability of financial analysts to make such a complex political judgment because they do not have the requisite expertise in the knowledge of political theory and experience in politics. The lapse has considerable importance not only because of the figures involved, but also on account of the staying power of the officials’ investment decisions.
 From the above-cited rationales of the pension managers, a distinctively political calculus can be seen as underpinning the financial decisions as regards systemic risk. That is to say, systemic risk is both political and financial. This is so because of the nature of the possible collapse being of such a scale that the losses would be huge and relatively broad throughout the financial system, even if only in the particular state. Greece exiting the euro, for example, would put the Greek government, financial system, and economy at risk. Accordingly, political officials and even governments are involved when systemic risk threatens to manifest in a collapse.
Confidence in the ability of political officials, which is itself a political judgment, turns out to be a key factor in the financial analysts’ reckoning of the systemic risk facing Greece and Spain. Yet how proficient, one might wonder, were the financial men in being able to assess the ability of the E.U. to act on behalf of the euro and the troubled southern states? In the wake of the Greek and Dutch state elections in 2012, federal and state officials active in E.U. policy-making, such as Jose Barroso and Angela Merkel, respectively, came out with statements indicated that the E.U. would try to keep Greece in the euro (not to mention the E.U.). Although not at break-neck speed, the European Council was working on a legal framework for a banking supervisor at the ECB, which would then be able to lend directly to Spanish banks. Perhaps from their cultural ideology concerning debt (and perhaps even the E.U. itself), the Finnish pension-fund managers were unduly harsh on the E.U. in judging the various strengths and weaknesses of the federal response to the crisis. The ideology can make such inroads in the judgment because of the financial officials’ lack of political expertise or knowledge. Although the admittedly-slow pace of the Council furnished its share of systemic risk into the equation, the financial analysts’ political judgments seem to be too over-simplified (and biased against the E.U.) to serve as a viable basis for a judgment on systemic risk as a whole, and thus on whether the pension funds should divest as much as they have of Greece, Spanish and even Italian bonds. Put another way, the financial managers did not have the political expertise to bracket the impact of their cultural ideology and sufficiently grasp the entirety of the concept of systemic risk in both its political and economic dimensions, especially given the political complications that exist in a federal system. Put simply, the financial experts are not experts on federalism, and thus they risk erroneous conclusions in so far as judgments on the workings of the E.U. and its states are involved.
In conclusion, systemic risk is not just a financial concept. The salience of political variables renders the concept beyond the expertise of financial analysts (and government officials too). Were the Finnish fund managers less pessimistic on state and federal officials in the E.U. having the wherewithal and determination to have Greece’s back (and the ECB having the back of the Spanish banks) even in spite of the cumbersomeness of the federal legislative process, the pension funds might not have divested so much from Greece, Spain and especially Italy. The European north-south financial flow would not have been so compromised, and the troubled southern states would be in a better position in terms of securing financing without having to pay through the nose. The problem is perhaps epistemological. In spite of their lack of political expertise/judgment, the Finnish pension officials presumed to have sufficient knowledge in political risk analysis to estimate the systemic risk that is associated with investments in Greek, Spanish and even Italian bonds. The officials’ misconstrual of the concept itself of systemic risk as being primarily or even exclusively financial or economic in nature ironically exacerbates the financial situation of the troubled southern states.


Charles Forelle, “Northern European Investors Steer Clear of Needy South,” The Wall Street Journal, October 23, 2012.

Tuesday, October 23, 2012

Anticipating the U.S. Presidential Election of 2012

I wonder which has more import: which party gets its base out or which way the independents lean? Realistically, the result in a given state is likely to be a mixture of the two ( e.g., independents may lean toward Romney, overcoming the Obama campaign's excellent ground game). Even though the Electoral College is by state, I suspect that both in regard to the ground games and how the independents go, the trend will be the same from state to state because the campaigns are national and what independents are taking in does not differ from state to state. In other words, we should be able to discern a subtle "will of the People" at the national level in the election results.

My own hunch is that both parties will get their respective bases out. The big unknown to me is how or whether the independents will break one way or the other. I think the independents are the true "jury" on Obama, so I think how they vote as a group is the thing to watch as the returns come in. A leaning one way or the other can be taken as their verdict. I agree with commendators that the election really is a referendum on the incumbant, even though a myriad of reasons go into voters' decisions.

I had the sense in the second presidential debate that Obama looked smug, even arrogant, as if he were running the debate in virtue of his office. His tone directed at the moderated seemed to say, "Ok Candy, you may proceed with that." Perhaps the two labels are unfair, though people who have had contact with the president in person tend to provide similar feedback. I suspect the average Joe (not necessarily "the plumber") voter is turned off by conceit. Watching the debate, I had a subtle sense that whispered in my ears, "American viewers might be reacting negatively to his personality, as if saying to themselves, 'now we see how he really is . . . hmmm.'" There is the brand and the man. In other words, apart from the speeches and the orchastrated ads, Barak Obame might not be someone we would necessarily want to get to know, after all. I wonder if this recognition or awareness was occurring for the American people only then, during the debates, as we observed Obama interact with a rival in real time. "So this is how he plays with others . . . hmmm."

In divining what prompts the electorate's leaning one way or the other in a given election, we would be wise not to leave out "comfort level" with seeing and hearing the candidate at issue. Mentality or attitude is relevant because we know that whoever is elected president will be a regular fixture in our lives, albeit vicariously through electronic means. I am not referring only to whether we like the guy; the matter extends to our comfort with his attitude. This is a very subtle thing. Personality and attitude can thus be understood to play a role, albeit a subtle one, in how a candidate for president is "evaluated." An election is not simply about policy, which is a reason why the latter should be included on a ballot separately. 

Of course, Obama's attitude was not the only one on display during the debate. I have in mind Romney's duplicity, even lying, in his claim, "I care about all Americans" during the debate after he had said in private that it would not be his job to worry about 47 percent of us if elected no doubt turned many people off (at least those of us who follow politics). As he looked straight into the camera and made his statement as though sincere, I wondered whether the highest politicians have such an astonishing ability to act. That is to say, the true gift of a politician could be the ability to come off as incredibly sincere when he or she is simply acting the part. "Wow he's good" was what came to my mind. Of course, the excellence of a skill is of little value if the skill itself is a vice. Perhaps what we are left with is a fleeting glimpse of how little we know about either candidate, and yet we presume we know so much about both. "Obama cares" and "Romney is compassionate" may turn out to be marketing-driven rather than real, yet we cannot be wrong about what we believe to be the case, right?

To give another example, we watched Andy Taylor, the nice sheriff in Mayberry; from this experience of the man we felt a loss when Andy Griffith died in the summer of 2012 even though the man was reportedly not "good with people." That is to say, the man behind the sheriff was not as kind, yet we mourned as if we had lost the sheriff. For some reason, the human mind is susceptable to acting. Where most of an electorate do not get to meet the candidates in person, as in the case of the election for an empire-scale office such as the U.S. Presidency, the susceptability is particularly strong because the contact comes only through television and perhaps a mass rally.

I suspect that many independents (and perhaps even Republicans and Democrats) were left after the debates with the sense of why we as a people could not have done better in coming up with two nominees (and why not more than two?). This suspicion was confirmed for me when I learned after the third debate that the candidates presumed to discuss domestic policy even though the debate was to be on FOREIGN policy. Such a lapse can itself be a red flag respecting boundary issues or problems with "keeping within the lines" (i.e., as in coloring books).

Moreover, the sheer length of the primary "season" (year) and the general election campaign suggest that something rather basic in the American electoral system is off-balance, both relative to presidential campaigns in U.S. history and simply in terms of efficacy. Stretching something out for months does not necessarily mean better quality as a result. In fact, tangents can fill voids as the media seeks to keep up their viewers' attention when it naturally goes to something else. So I suspect that a lot of us will feel a sense of relief on "the day after" simply because the damn thing is done.

Sadly, we will then likely have gridlock to look forward to, regardless of which party has the White House, because of the expansive use of the filibuster in the U.S. Senate and the fact that one party is not likely to control both chambers of Congress and the Presidency. In terms of policy, the presidential election matters to be sure (and even more in terms of judicial appointments), but not nearly as much as we suppose. It is not as though whoever occupies the White House can simply snap his fingers and one of his campaign promises is enacted into law. I think we, the American People, need a strong dose of reality when it comes to buying into all the hype surrounding the alleged importance of the campaign and what a president can do. In other words, we need to tone it down a bit and come down to earth. Maybe then we can address the matter of the sheer length of the campaign "season" and how we can come to know the candidates behind the actor-personas and one-liners.


Monday, October 22, 2012

Predicting Future Events in Political Risk Analysis: On the European Debt Crisis

Political risk assessment is a nasty business in that the future has a stubborn habit of not wanting to be too predictable. Even though tomorrow displays a remarkable tendency to be similar to the world of today—the status quo enjoying the right of default—forecasting future events is notoriously difficult. To use statistics to nail down probabilities may actually involve considerable luck. Not even the stature of the person making the predictions may be decisive, after all. I have in mind the predictions of Alexei Kudrin, the former Russian finance minister, on the European debt crisis and the euro.

                                                             Map of the European Union: a political union and economy.

Prime facie, Kudrin is just the sort of person whom corporations should listen to regarding political risk around the world. After all, he was named finance minister of the year by various publications on four separate occasions during his tenure. Keeping Greece in the euro zone? "Already impossible," he says in an interview. Spain and Italy next out? "The probability is very high." He sees both Greece and Spain defaulting on their sovereign debt, though as in a Hollywood script the euro survives (and even gets the girl, brilliantly played by Angela Merkel). "Everything should be done to avoid it, but I don't feel that the process is under control," says the finance minister who according to the Wall Street Journal “shepherded Russia from default to financial stability.” Who better situated and constituted to opine on the future outcome of the European debt crisis? He undoubtedly knows more of the “stubborn facts” known only to the insiders than you or me. He might have access to the “by the way” comments being made by E.U. and state leaders in Europe, as well as the bankers at the “hot spots.” 

However, what if that which is required in order to grasp the eventual outcome surpasses even such a competent insider as Kudrin?  Even well-justified respect can easily be surpassed by the sheer indeterminacy of a multitude of factors and human nature itself. Greek and Spanish finances are very risky, at least as of the final quarter of 2012. To move from this assessment of high risk to a particular event requires a leap of faith given all the variables in human organization. It is not as though we could predict Greece or Spain as though we were testing a chemical equation by running an experiment in a lab. Indeed, social science itself, including economics and political “science,” may gild the lily in appropriating the certainty that is possible in the natural sciences. Not even a very competent and respected man like the former Russian finance minister can give us the sort of certainty that can be found in a chemistry lab. He may well turn out to be correct; my point is simply that we over-reach in reaching this conclusion beforehand on the basis of his person.

To take a related example, Kudrin also predicts that the E.U.’s economic problems could turn into political ones. More than mere possibility is implied here. The Wall Street Journal reports his reminder for us that “democracies do not always survive when their citizens are asked to make the kinds of economic sacrifices” that Europe was facing in 2012. Furthermore, he was thinking “that citizens of the Western countries aren't ready to accept the steep drop in living standards they face, but that if governments fail to cut spending they will get even deeper collapses.” Kudrin points out that Russia faced such a crisis in the 1990s, but thanks to Russian President Boris Yeltsin the country “passed it peacefully,” whereas Western Europeans may not be able to pass through such painful hardships without tossing democracy over-board (as if Russia had retained it).  Through my sarcasm, I am suggesting that even a man like Kudrin has his subjective biases that come into play in assessing future events.

Particularly when phenomena of one domain (i.e., politics) are mixed in with another (i.e., economics), future events can be especially difficult to nail down in advance; there are so many variables, and they differ qualitatively. It is a mistake, therefore, to put political risk analysis to quantification because exact numbers, even as probabilities, overstate the certitude goes with such prediction. In the case of Europe, we can add the invariability of two different though related systems of government being involved—that of the E.U. and that of its states. How far will the E.U. go to keep Greece using the euro? How much pressure would be exacted against “radical parties” even though they are duly elected at the state level. The case of the right in Austria that was effectively blacklisted by the E.U. is a case in point.

To be sure, Kudrin might be right, particularly on Greece defaulting, though it could be piecemeal via continued percentage write-offs rather than “default” per se. The Council’s admittedly incremental action in October 2012 on a banking supervisor at the ECB could be fast enough for the Spanish banks to receive bailout funds before they have to default. As in the case of the TARP legislation in the U.S. Congress, the E.U. legislative infrastructure would likely swing into swift motion if really up against a cliff. In fact, the history of European integration has proceeded from such circumstances, including the debt crisis.

When France vetoed the accession of Britain in the EC in the 1970s, for example, there must surely were cries that the enterprise was at a crisis point, and yet the E.U. came out of the EC and other entities in 1993 and the euro itself some years later. This historical perspective I am offering effectively regularizes the Greek and Spanish debt crisis from the standpoint of the E.U., which can be viewed as a nonlinear work in process. From his vantage-point, Kudrin may not have weighed this less-exciting perspective against his more dire yet ultimately happy scenario that is admittedly more dramatic. The eventual results may be with him, or less dramatic. My point is simply that human nature does not get us as close to an answer beforehand as we might tend to suppose. The opera isn’t over till the fat lady sings (or gets the euro in the end).


Alexander Kolyandr, “Kudrin’s Outlook for Euro Zone Is Grim,” The Wall Street Journal, October 22, 2012.

Putin Embraces BP

The Russian state-owned company, Rosneft, reached separate agreements in October 2012 to buy TNK-BP from BP and a group of Russian billionaires. According to the Wall Street Journal, the deal represents “an acquisition that promises to reshape the Russian oil industry in favor of the state-owned company.” The Russian federal government was set to own or control nearly 50% of the Russian oil industry. Lest it be supposed that the legacy of inefficient state enterprise might compromise that industry in Russia, the state would have the benefit of literally sitting on the same board with representatives of the experienced oil producer from the private sector. By implication, the traditional dichotomy between public and private could be further blurred, such that the easy labels of “socialism” and “capitalism” may become less and less relevant or useful (except in the rhetoric of American presidential contests). Rosneft itself is a case in point of privateness and publicness coming together with a shared vocabulary or at least financial aim. Before addressing this point, I present the basics of the deal itself.

                                                     Robert Dudley, CEO of BP, talking with Vladimir Putin at the Kremlin.   Source: Telegraph

According to the Wall Street Journal, “(u)nder the terms of the transaction, BP will receive $17.1 billion in cash for its 50% stake plus shares representing 12.84% of Rosneft, worth $9.7 billion on the bid date. It will then use $4.8 billion of that cash to purchase an additional 5.66% of shares Rosneft from the Russian government, taking its total holding up to 19.75%, BP said in a statement. . . . BP will get two seats on Rosneft's nine-person board as part of the deal and expects to be able to account for its share of Rosneft's earnings, production and reserves on an equity basis.” Rosneft would acquire the other half of TNK-BP for $28 billion from the AAR consortium of Russian oligarchs. “Rosneft will finance the transactions, which have a total cash value of $45.1 billion, from a combination of existing cash resources and new borrowings.”  In short, we’re talking about a lot of money—a lot at stake. In other words, the implications of the deal deserve a lot of attention and analysis.
Expanding on the traditional notion of interlocking directorates, BP would be sitting on the board alongside officials or representatives of the Russian government. The latter would be able to nurture and develop contacts in the corporate world and BP would have access in Russia far beyond Arctic exploration rights.  That is to say, collusion could become worse, and this could undercut the public interest in the interest of private gain—private here applying both to corporate retained earnings and government coffers. That is to say, government itself could become more “private” and less “public,” leaving the public interest without a proper guardian or advocate.
The deal gives the Russian state an interest in the well-being of a foreign private company. This in turn would give the company some leverage in terms of Russian regulations. In other words, BP could use its alliance with the state to essentially “capture” Russian regulatory agencies. "This is a good, big deal, not only for the Russian energy sector, but also for the Russian economy," said Russian President Vladimir Putin, after a meeting at which he approved Rosneft's acquisition of TNK-BP in a meeting with the company's Chief Executive, Igor Sechin. The Russian president would thus have an interest in protecting BP as well as the joint venture. That is to say, from the standpoint of the bipolar dichotomy of “socialism vs. capitalism,” the cosy relationship proposed in Russia puts government and private ownership literally in the same room and having the same financial purpose. Mutual back-scratching would be almost inevitable, not only concerning the interests of the Russian state and BP, but also particular government officials and company executives.
Lest it be thought that privatizing the nearly 50% of the Russian Oil industry that would be controlled by the Russian state would be preferable—this option being more in line with the traditional “public vs. private” paradigm—it can be asked whether Russian oligarchs are preferable to Putin’s state. The tradeoff might come down to one of whether the state is really distinct from organized crime in Russia. There might not be much of a difference, with the exception that state-corruption is slightly more transparent. Even if the distinction is meaningless practically speaking, it can also be asked whether the oligarchs deserve their wealth and profits, especially if they came out of cheap post-Soviet sell-offs based on connections. For that matter, the anti-democratic response of Putin can cause one to ask whether his government deserves the added revenue. The Wall Street Journal reports, “A Rosneft takeover of TNK-BP would bring the Russian state's control over oil production to nearly 50% and mark a major milestone in Mr. Putin's reassertion of Kremlin control over the strategic oil sector, much of which was sold off in the privatizations of the 1990s to well-connected tycoons like AAR's owners. Since Mr. Putin came to power in 2000, the tide has turned the other way in an industry the Kremlin depends on both as a source of international influence and more than half of all tax revenues.” One might ask whether Putin deserves this even as he represses political opposition—even arresting a major figure following a “documentary” on television produced by the state. Faced with the abuses that more wealth and BP-connections might give the Russian president,  a reasonable person might be left with the conclusion that neither Putin’s pals nor his government is worthy of owning vast wealth; the world envisioned by Adam Smith as against the concentration of great wealth might come out the winner, even if only in the world of thought.
In addition to the downside, which may admittedly be so abstract and contrary to the status quo to be of any practical effect,  it is also worth pointing out that putting government officials and business managers in the same room could enhance both the efficacy of government regulation and corporate public affairs departments.  That is to say, knowing the otherness of the other could improve how one relates to the other “above board.”
Being on the same board, government officials or their representatives in Russia would no doubt see up close how private business executives “think” (i.e., the logic of business), while executives in the private sector (at BP) would gain a better understanding of the political calculus of government officials. That is to say, business and government would take one step closer together from that of “arm’s length” transactions and the regulatee-regulator relationship. Understanding how the other thinks is indeed a good thing where two parties must interact (e.g., regulation). At the very least, the efficacy of government regulation could in principle be enhanced as it could be put in sync with how managers think.
Understanding how business managers use regulation strategically—even preferring more regulation because it is easier for one’s own company than one’s competitors to comply—can enhance a regulator’s ability to craft regulations that achieve the desired public-policy outcome.  In other words, being able to anticipate the policies that business managers would enact in reaction to a proposed regulation can give the regulator a sense of the outcome up front. The regulation can thus be tailored with the anticipated reaction in mind such that the outcome sought would stand a better chance of resulting. A regulator could anticipate, for example, how managers would attempt to circumvent the proposed regulation, and the latter could be adjusted to close off that possibility.  A Russian official who has seen BP executives in action on Rosneft’s board could say to a regulator of another industry, “No, that won’t work; they would only do X to get around it. I know how they think.”
In terms of corporate public affairs departments (and corporate lobbyists in general), feedback from a company executive who knows how government officials think could advise on how to appeal to them on their own terms. A BP executive with experience with Russian government officials on Rosneft’s board could say to the director of BP’s government affair’s department in Russia and even another country, “If you really want the legislator to pay attention, bring up X because X is likely to be on his or her mind.” That is to say, fit the company’s strategic objective within the political calculus. Knowing the otherness of the other is necessary both to regulators in crafting more effective regulations that are not undercut by the other and to corporate public affairs directors who want to influence legislators and regulators.  As discussed above, however, there is also a downside, and it should not be disregarded either.
In summary, the modern world of extensive territorial empires and great concentrations of private wealth in the form of corporations can leave the individual business practitioner and the small investor in the dust along with the public at large. There is indeed value to public policy and government regulation in government officials deepening their understanding of how business executives think. Similarly, corporate public affairs departments could use more insight on how government officials tick. At the same time, the financial stakes and related cosy relationships as evinced in the proposed deal in Russia increase the risk of collusion at even personal financial benefit at the expense of the common wealth and general welfare of the people and even society at large. Putin might conclude, for example, that what is good for BP is good for Russia. This represents a very dangerous step (similar to “What is good for GM is good for the U.S.”) away from democracy in the direction of plutocracy. The question is perhaps less on whether the old “public vs. private” world is antiquated than whether government is really still government—governing the whole in the interests of the whole rather than certain parts—and whether large corporations are still private. On the latter point, it is worth remembering that Clive of the East India Company had a private army in Bengal at his disposal and the title of governor from the state. Indeed, the notion that the CEO of a private company would also be the governor of a territory might give us pause in reflecting on the governmental power that a large public-private partnership might have in Russia.

Selina Williams and James Marson, “Rosneft to Buy Entirety of TNK-BP,” The Wall Street Journal, October 22, 2012.

Sunday, October 21, 2012

Should Citi Be Broken Up or “Prodded”?

In 2011, the office of the special inspector general for the Troubled Asset Relief Program published a report on the aid provided to Citigroup by the U.S. Government during the financial crisis of 2008. “Unless and until an institution such as Citigroup is either broken up,” the report concludes, “so that it is no longer a threat to the financial system, or a structure is put in place to assure that it will be left to suffer the full consequences of its own folly, the prospect of more bailouts will potentially fuel more bad behavior with potentially disastrous results.” The Dodd-Frank Act of 2010 was an attempt to provide such a structure, with the federal government’s role being oriented to upping reserve requirements for the biggest banks and ordering the liquidation of big banks in bankruptcy, rather than to break up the banks too big to fail. That is to say, rather than add systemic risk to the restraint-of-trade criterion of anti-trust law, Congress and the U.S. president decided in 2010 to allow the banks with $1 to $2 trillion in assets to decide whether to downsize of their own volition or continue to face the raised reserve requirements.
Philosophically, the American body-politic in very general terms tends to view the proper role of government as tinkering with the contours of markets to affect business incentives rather than intervening directly in a company, as in breaking those up that have grown too big (and powerful) for the public good. Making it more costly for a big bank to retain all its lines of business (i.e., its size) instead of breaking it up is believed on a rather subtle level by the society at large give due regard to property rights (i.e., economic liberty). The public tends to view such an approach as balancing property rights with the public good. More nefariously, the approach can also be viewed as a manifestation of the political power of corporations on K Street in Washington, D.C. over Congress and the White House. Actually, adjusting market incentives via regulation can be said to prioritize property rights and private wealth over the public good where the threat to the market mechanism itself and the financial system (not to mention the republic!) is particularly grave. The American orientation to the market mechanism in preference to "big government" tends to disregard this scenerio wherein an improbable systemic collapse is part of the equation.
The fear that the fall of Lehman Brothers would trigger the collapse of the American financial system “by Monday” led Congress to put hundreds of millions of TARP money up for a vote on a “fast-track” that is astonishing by Congressional standards, not to mention democracy itself. The American "approach" itself had to be temporarily put on hold, and by a Republican administration! Not to be outdone, the free market orientation held on in the form of no-strings on the bailout money.

It can be argued that TARP itself was not only insufficient, but also that it actually enabled the marginally-run banks that were too big to fail to endure and thus continue to inflect the system with systemic risk. In terms of the ensuing reform law on financial regulation in 2010, it can be argued that to enable a mammoth bank that is regarded as too big to manage to continue to exist by rejecting the break-up approach (or reinstating the Glass-Steagal Act) in favor of relying only on setting up differential reserve requirements (i.e., regulatory costs) based on total assets and otherwise helping to order the liquidation process of an already-defunct bank may be too detrimental to the public interest. In other words, the tremendous size of the banks and the associated systemic risk may make the market-oriented American approach too property-rights oriented for the public good.

                                                                                          Is Citibank so tall that its fall would wreck the financial system?    Washington Post.

In terms of unmanageable banks, I have in mind Citigroup in particular, which I will turn to below, though Bank of America could easily be added to this list, given Ken Lewis's "empire-building" moves to acquire Countrywide and Merrill Lynch. He might as well have hung a sign outside of headquarters in Charlotte, "Dump Your Crap With Us! We'll Buy It!" Being the biggest bank, as though a Walmart in the financial world, is not necessarily a good thing both on the firm level and in terms of systemic risk in the economy.
Referring to Citi, Gary H. Stern, former president of the Federal Reserve Bank of Minneapolis, said, “I ask myself, ‘Could I manage one of these places with lots of capable senior officers?’ and I think the answer is no.” That is to say, the bank had become too large to manage. Like blindfolding a car driver or putting a confused drunk driver behind the wheel, having a heavy piece of machinery running not fully under control can be to invite an accident. It is very risky, even self-destructive, merely to allow such a thing to go on. Relying on the CEO to “pull over” and by analogy reduce obstructions by reducing the vehicle’s size (maybe unhooking a trailer) can be viewed as a luxury that the public interest cannot afford.
Gretchen Morgenson of the New York Times writes that “(g)iven Citi’s close ties to Washington, we can only hope that the change of command [of CEO] also reflects a regulatory prodding to overhaul the company. And if that involves cutting this behemoth down to a manageable size, then taxpayers should definitely cheer.” Regulatory “prodding” can be viewed as woefully insufficient if we are to rely on an empire-building CEO to voluntarily bring his “behemoth down to a manageable size.” That is, the fact that Pandit had felt perfectly fine with Citi being beyond a manageable size does not bode well for taxpayers cheering any time soon on hopes that Mike Corbat might suddenly see the light as he entered the corner office on his first day as CEO. He was more likely to see the power of his new office over such an expansive empire than to reflect on how he could have less under him. The motivation of a CEO is crucial to the question of whether the American market-oriented approach is sufficient to deal with something on the order of systemic risk.
The “regulatory prodding” approach that tends to sway the American electorate as a whole, even if subtly, may be fatally flawed in that economic efficiency and even profit-seeking itself are presumed in the approach to be the exclusive or primary motivators of CEOs and even boards. In actuality, the empire-building motive of power may eclipse even greater profitability, and therefore be oblivious to the prodding of additional reserve requirements. That is to say, the "market-prodding" approach may fall short by treating non-financial motives as extrinsic to the business calculus. Such motives may ignore or even trump "new and improved" regulations designed to channel financial motives in business. A bank's CEO might say, "I'll put up the additional reserves! I don't want to cut off product-lines that otherwise tie into my overall strategy synergistically."  Translation: I want to expand my empire even if it costs more proportionately because I like the pleasure that comes from the additional sense of power. Nietzsche could hardly have put it better.

For our purposes, the following axiom can be set forth for business as a phenomenon as well as at the managerial level:

Business is not only economic or financial in nature; it is also political in the sense that power is in the mix.

Managers are motivated not just by financial considerations such as efficiency, cost-containment, and revenue maximization, but also by the desire to control, which is an application of power.

The market-oriented approach to regulation may not sufficiently take into account this axiom. Structuring the market mechanism itself may need to be supplemented by a more direct intervention in private companies so systemic risk is lowered to a level that does not present taxpayers with a "high risk, low probability" collapse of the financial system itself. The sheer continued existence of Citibank (and even Bank of America) may point to the inadequacy of the Dodd-Frank Act as “reform” adequate to the purpose, given what we learned, or should have learned, from living through the financial crisis in September 2008.


Gretchen Morgenson, “Citi’s Torch Has Passed. Now Find a Knife,” The New York Times, October 20, 2012.