Just like poor Pip Dickens’ Great Expectations, central banks keep inheriting unwelcome bequests.

Today’s “legacy assets” are toxic derivatives; a decade ago it was gold reserves. Both are proving hard to shrug off, but for very different reasons. Both legacies also come thanks to previous central-bank history; the fossils remain only too livid today.

And 10 years from now, if not sooner, just how welcome will the current central bank must-have become – freshly printed government debt, bought with money that doesn’t exist until the central bank wills it?

Seeking first to defend against inflation and war, the West’s central banks built up huge reserves of the ultimate hard money –gold bullion– during the early-to-mid 20th century. Long before the turn of the millennium, however, these hoards grew to look quaint and expensive. Unyielding and relatively useless to industry, gold simply sat there, down in the vaults, costing money to store but returning no interest.

Who needed crisis-proof gold when Western Europe (if not the Balkans or Mid-East) was enjoying its first generation of peace-time in history? And who needed fine gold when the Nasdaq index of tech stocks was priced for 20% annual earnings growth over the next decade and more?

In short, who needed gold when we’d got Alan Greenspan, as the New York Times asked in May 1999. “The argument against retaining gold is that its day is past,” wrote Floyd Norris with uncanny timing, just two days before Gordon Brown’s Treasury announced its ham-fisted sale of half the UK’s gold bullion hoard.

“Once it was useful as a hedge against inflation that would hold its value when paper currencies did not. Now financial markets have their own sophisticated ways, using exotic derivative securities, to hedge against inflation.”

You could butter your toast with the irony. But it wouldn’t taste sweet or provide much nutrition. Whereas a further glance back at history might.

“With huge gold stocks available for sale, [governments] may discourage excessive price increases but naturally do nothing to prevent sharp decreases,” reported an investment piece for Medical Economics published in October 1977. (Our thanks to the author for finding and faxing it to BullionVault this week.)

“The government specter [over the gold market] can’t be expected to disappear quickly,” F.D.Williams continued, some 32 years ago. “Gold will continue to be part of many national reserves for a long time. The stocks are so large, they can’t all be dumped at once.”

Compare and contrast with today’s unwanted bequest – those toxic derivatives the US Treasury chooses to call “legacy assets” as if it played no role at all in producing them. Unlike state-hoarded gold, it only encouraged their creation; it didn’t want to look after the damn things. And quite unlike the market for state-hoarded gold, a ready stock of willing mortgage-bond buyers also looks unlikely to gather.

“The PPIP, which was beset by multiple delays as regulators tried to figure out the best means of removing many of the troubled assets from banks’ books,” as CNN reports, “is still not up and fully running yet.” It’s not been for lack of incentives. The $2 trillion Public-Private Investment Partnership, announced to much fanfare in March, offers huge leverage – entirely at tax-payer expense – plus some or other hold-to-maturity value to risk-cushioned investors, albeit as yet unknown. Private investment groups can use up to $1 of non-recourse loans, plus another dollar of Treasury finance, for every $1 they spend on taking toxic housing derivatives off the banks’ busted balance-sheets. Yet as a report published this week by the Congressional Oversight Panel put it:

“Whether the PPIP will jump start the market for troubled securities remains to be seen. It is also unclear whether the change in accounting rules that permit banks to carry assets at higher valuations will inhibit banks’ willingness to sell. Similarly, it is unclear whether wariness of political risks will inhibit the willingness of potential buyers to purchase these assets.”

Funnily enough, as the US authorities struggle to sell toxic debt, Western Europe’s Central Bank Gold Agreement has also stalled in 2009. This comes, however, despite prices and private-investor demand both holding near record levels. First signed ten years ago this September, back when no one at the New York Times, Economist, Financial Times or big central banks could see a use for the metal (simply owning this secure, liquid store of value is use enough, by the way), the CBGA capped annual gold sales and made them plain in advance for the coming five years. It aimed to avoid a repeat of May 1999, when the UK Treasury’s announcement drove prices down to what then proved their floor. In contrast to Washington’s PPIP, however, central-bank gold sales weren’t arranged in the hope of achieving maximum price, but merely curbing a rush for the exits instead. And as it is, they needn’t have bothered.

Gold prices have since risen three-fold and more against all major currencies, even while the 16 signatories to date sold almost one-fifth of their hoard in aggregate. Thus gold’s weighting in their reserves portfolio has doubled regardless, rising as gold outperformed all other assets from the start of this decade.

Hence the dramatic slowdown in central bank gold sales since the financial crisis began in August ‘07. Because it’s tough selling gold when its use becomes so clear, so present. Here in the fifth and last year of 2004’s renewed CBGA, “Net central banks sales likely to be in the order of 140 tonnes this year, down from 246 tonnes in 2008,” reckons London market-maker Scotia Mocatta. Yet the annual ceiling for CBGA sales currently stands at 500 tonnes!

The new agreement – just signed and due to commence on Sept. 27th – tips its hat to the facts, reducing that limit by one fifth. But who’s left to sell any way? Just as in the gold mining sector worldwide, the “easy metal” has already gone from West Europe’s vaults, pretty much emptying Spain, the UK and those excess Swiss holdings which maintained the Franc’s 100% gold-backing until the turn of this century. The two largest holders, Germany and Italy, continue to face down political calls for “mobilization”, refusing to yield one ounce so far despite signing all three agreements. France, the third largest owner, has pretty much sold the 600 tonnes from its hoard announced when it joined the central-bankers’ Cash4Gold party in 2005. That leaves only the International Monetary Fund’s 400-tonne sale, hardly enough by itself to meet the next half-decade’s 2,000-tonne limit.

Back at the Federal Reserve, meantime, tomorrow’s central-bank legacy – of freshly printed Treasury bonds bought with magic money from nowhere – continues to swell. Yes, the Fed’s stockpile of T-bonds may be smaller today than it was back in August ‘07 before the Great Inevitable broke, thanks to record Wall Street demand for the safety of Washington’s debt. And yes, the Fed isn’t quite collecting new bonds from the Treasury door directly, waiting instead a few days or so before picking them up (as Brian Benton, Chris Martenson and others have found) from those primary dealers who do bid at auction, rather than out-and-out monetizing the debt for all to see with its newly created cash.

And sure, private-sector demand for Treasuries continues to look so strong right now – what with overnight rates at 0%, plus the ongoing collapse of house prices, world trade and jobs creation – that the Fed says it will stop financing Uncle Sam’s spending in, umm, October rather than in September as previously stated.

But hoarding gold looked rather more sensible amidst the violence and misery of the mid-20th century, and no one at the Fed or Treasury guessed two years ago that they’d be offering leverage incentives to try and revive the market in mortgage-backed derivatives. When the global economy gets off the floor…or risk assets become more attractive to private investment…or China and Japan find they really don’t have any space left for US debt in their central-bank vaults, the market into which the Fed will want to sell its Treasury hoard will look very different to the market from which it’s currently buying.

Whether a decade from now, in 2010, or perhaps this fall – when the $300 billion of quantitative easing ear-marked for Treasuries is spent – trying to quit the Fed’s newest “legacy asset” could prove tougher even than finding ready buyers for today’s toxic junk. And given the soaring interest rates and potential US bankruptcy that in turn might trigger, spurred by whatever’s added to the Treasury’s $11.7 trillion of debt between now and then, perhaps buying gold will look a smart move to the Western world’s central bankers once more.

Regards,
Adrian Ash
BullionVault

August 18, 2009

Gold Will No Longer Be a Toxic Derivative to Central Banks was originally featured on Whiskey and Gunpowder

There is, however, a “Bankruptcy Clause” in the U.S. Constitution (Article I, Section 8, Clause 4). I’ve written before about bankruptcy in Whiskey & Gunpowder. See “National Bankruptcy,” and “A Suggestion of Bankruptcy,” Part I and Part II.

The key point is that the framers of the U.S. Constitution specifically anticipated that the nation would encounter economic troubles from time to time. So they gave Congress the power to enact bankruptcy laws, as opposed to “bailout” laws. And throughout U.S. history, the various economic “Panics” — which occurred every couple of decades — always led to one direction or another in the evolution of state and federal bankruptcy laws. Hey, bankruptcy works. (Full disclosure — I used to practice bankruptcy law.)

At some times in U.S. history, the bankruptcy laws favored the creditor class. During other times, the bankruptcy laws favored debtors. The point is that the economic hardships were eventually manifested in bankruptcy proceedings.

Just as all rivers flow to the sea, bad debt must find its way to discharge. So bankruptcy court was where judges and attorneys and other financial experts (like accountants and actuaries) could deal with each case on the merits. The problems could come to some sort of resolution. Some people came out OK. Other people lost everything. But capital flowed from weak hands to strong hands, and the economy moved along.

Why Not Bankruptcy Process?

But not today. Indeed, according to the New York Times many law firms — including firms that focus on bankruptcy work — are actually scaling back and laying off staff. Why is that? Why are the politicians so eager to avoid seeing companies go into bankruptcy? The government is trying to solve the problems of gargantuan levels of debt — along with chronic insolvency and illiquidity within the economy — without resorting to the constitutional-based legal mechanisms and tools that have served the nation well for over 200 years.

Consider the problems of derivatives. Few understand them. Many so-called derivative “contracts” are little more than mathematical formulae based on a series of futuristic occurrences that are entirely speculative. Their initial value in the best of times was entirely somebody’s guess. So is it any surprise that it is all but impossible to place a value on such things during the throes of a recession? Yet derivatives are some of the “troubled assets” that the Treasury is attempting to bail out. This is ridiculous!

Why is the Treasury allowing even one dollar of taxpayer money to get near a derivative? Why not use the bankruptcy process in this kind of situation? The companies that hold unsalable derivatives should have to go into a Chapter 11 proceeding and let a bankruptcy court sort it out. If the derivatives have value, let someone say so — under oath — in front of a federal judge. If the derivatives are worthless, let the judges do what we pay them to do — void the instruments and allocate the losses.

Sure, bankruptcy cases take time to roll through the courts. But could Chapter 11 bankruptcy be any worse than the current drip-drip-drip, hemorrhage of funds into the black hole of the likes of AIG? And at least some bankruptcy judge might just put a stop to the AIG exploits of taking nice vacations to exotic resort locales.

Or what about the U.S. automobile industry? Now the domestic carmakers want some of that TARP money too. Or else what? They’ll have to file for Chapter 11? Yeah? And then?

Well on the day that the automakers file for bankruptcy, the automobile factories will still be there. The patents and designs aren’t going anywhere. The workers and design teams will stick around for a while — it’s not like there are a whole lot of other jobs out there, except maybe raking leaves in leafy suburbs.

It seems to me that General Motors, Ford or Chrysler — without the legacy costs of pensions and health care and featherbed contracts for non-working union members — would actually be a decent investment for a Debtor-in-Possession (DIP) form of financing. Any DIP-lender worth its salt would certainly go into the management suites to take names, kick ass and get rid of the deadwood. And over the long term, if U.S. automakers actually paid more for steel than they have to pay for retiree health care, then we might actually see a revival of that industry.

Meanwhile, We’re Losing Time

Meanwhile, we are losing time. “Ask me for anything,” said Napoleon to his lieutenant. “Anything but time.”

What Napoleon was saying to his subordinate was that in the context of war, there are always setbacks. Terrain, for example, is sometimes captured and lost to the enemy. But lost terrain can be regained. And troops are lost in combat, but the armed forces can be rebuilt and reconstituted from the strategic reserve. Lost time, however? Once it has passed, time is gone forever. You will never get it back, and no general — however great — can win it back on any field of battle.

It is the same thing with the declining U.S. and world economy. The world’s central bankers and treasury ministers dither, and squander capital into bottomless pits of a deflationary recession.

But the great villain in all of this is debt, pure and simple. And much debt is just a collection of bizarre debt instruments, exotic forms of speculative contracts, and obligations so massive that they will never be repaid. So why prolong the agony? Liquidate it now. Let the bankruptcy courts do what the framers intended.

That’s all for now.

Until we meet again…
Byron W. King
November 19, 2008

Bankruptcy, Not Bailouts was originally featured on Whiskey and Gunpowder

Proxmire made it plain he expected Greenspan would encourage these tendencies. And while the chairman’s statements and questions were directed to Greenspan, he spoke with the frustration of a man who sees danger ahead, but finds little acknowledgment among his fellow legislators.

Greenspan’s confirmation hearing was in July 1987. This was during the great deregulation of banking. Initiatives included the emancipation of the savings and loan industry and the authorization for commercial banks to cross state lines, offer home mortgages, enter the brokerage business, underwrite securities and change themselves into conglomerates offering all of the above services and more.

Toward the end of the hearing, Proxmire declaimed the trend: “It seems to me that banking in this country, and finance in this country, is likely to move very sharply…in the direction of concentration…I think most senators, if they thought very long about it, might be very concerned too. And I think the American people would be concerned too.”

A coincidental development was the socialization of risk, unwritten (at least in legislation), but gradually understood by all: the “too big to fail” doctrine. The government bailout of Continental Illinois in 1984 made it plain that the federal government would not allow one of the largest banks in the country to suffer insolvency.

In the same year that Continental Illinois was born again, 1986, Henry Kaufman, then the managing director and chief economist at Salomon Brothers, wrote an important book, Interest Rates, the Markets, & the New Financial World. As is often the case with books published well ahead of their time, nobody read it. Kaufman saw that banks would augment their balance sheets and profits by securitizing mortgages, consumer credit and commercial property. Financial derivatives were young. He expected these markets to explode.

Proxmire tutored Greenspan on the beauty of markets. He explained that the chairman of the Federal Reserve is the county’s leading bank regulator. Proxmire was concerned that Greenspan was taking this job at a time when bank concentration was looming. Just weeks before, the second and third largest banks in Wisconsin announced their intention to merge and form a bank that would be much larger than its nearest competition throughout the state.

Greenspan’s term was marked by government distortion of asset markets and the economy by consistently setting the short-term interest rate at a level that encouraged speculation, borrowing and bubbles, at the expense of long-term capital investment. It requires courage for a Fed chairman to resist the temptation of low interest rates.

Proxmire questioned the candidate’s resolve. Could Greenspan be able to say no to a Congress and president that would certainly love to claim credit for an expansive low-interest rate policy?

Proxmire continued to address financial concentration. Worried by Greenspan’s record, the senator questioned whether Greenspan would be able to disapprove of massive bank mergers that promote financial concentration. Proxmire believed that no regulator could do the job that competition can when it comes to the stability of the banking system.

Proxmire was looking in the wrong place for conviction. He probably knew this, since he described Greenspan elsewhere as a “get along, go along” guy. Over the course of Greenspan’s term at the Fed, banks merged and expanded until they were no longer banks. Now they take deposits, make loans, trade for their own accounts, manage hedge funds, serve as brokers for competing hedge funds, offer mortgages, securitize mortgages, sell securitized mortgages, (e.g., CDOs, CBOs, CMBS) and then sell credit derivatives to protect the buyer against bankruptcy of the securitized mortgage.

Kaufman foresaw the abstraction of matter. Derivatives grew fancier and more profitable and detached themselves from economic purpose: In a world that produces a $50 trillion gross domestic product, derivatives, mostly created from within the banking system, now top $500 trillion. Financing exceeds economic output by at least a factor of 10 — for what purpose?

The financial system serves an economic function of its own: Additional finance is needed to grow the real economy (e.g., that of manufacturing automobiles and selling flowers). Credit expanded faster than production. This impaired the ability of those living in the real economy to service debt (most obvious now in California, where, at the peak, the median house price exceeded $500,000, with a median income of $60,000).

Overindulgence is an age-old problem that rehabilitates itself in a recession, but the expedient route of faster financing beckoned. Too-low interest rates fueled the factories of finance with more energy than at Ford’s River Rouge, Mich. plant. The banks produced billion-dollar derivative instruments and sold them to hedge funds. Hedge funds produced more and sold them to banks. Generally, no capital was required to back these promises.

No money existed the moment before the transaction, yet the security was immediately integrated into the bouillabaisse of stocks, bonds and cash savings. Physical objects were turned into tradable currency — houses, powerboats, face-lifts, coffins and David Bowie. Finance was mimicking installation art; Alan Greenspan admitted to Congress he no longer knew what money was; money had grown more abstract than Greenspan’s syntax; if exhibited at the Whitney Museum Biennial, the chairman, stuffed and seated at the FOMC conference table, would win the blue ribbon for coherent symbolism.

The imprimatur of the Fed chairman went a long way to relieving concerns of derivative activity. Congress held hearings during the 1994 derivatives maelstrom. George Soros appeared before the House Banking Committee and stated: “There are so many [derivatives], and some of them are so esoteric that the risks involved may not be properly understood even by the most sophisticated of investors, and I’m supposed to be one of them.” After Congress completed its study, Alan Greenspan dismissed it as unnecessary. He described the risk of derivatives as “negligible.” Congress chose to believe the testimony of Greenspan and ignore Soros.

Whatever ran through Greenspan’s mind (it is not clear if Greenspan understood the consequences of his actions), the Federal Reserve, as the leading bank regulator, held an institutional bias toward expanding the derivatives markets: Commoditized and securitized loans relieved banks of default risk on their balance sheets.

The Fed chairman was ever vigilant in assuring all that derivatives reduced risk.

In May 2003: “Derivatives have permitted financial risks to be unbundled in ways that have facilitated both their measurement and their management… As a result, not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.”

In April 2005: “Lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers… These improvements have led to rapid growth in subprime mortgage lending.”

In May 2005: “The use of a growing array of derivatives and the related application of more sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions.”

Henry Kaufman viewed the development differently: “Institutions with aggressive [derivative] models will get the business and garner the profits. Senior managers will find it more difficult to resist increasing pressures to compete using riskier models, especially if doing so would cause the earnings and stock process to lag behind those of institutions deploying riskier models. Ongoing financial intermediation and balance sheet leveraging also will continue to support riskier modeling on the near horizon.”

In March 2007, before all hell broke loose, Kaufman viewed the preferable solution as impractical.

“One [solution] is to let competitive forces discipline market participants,” Kaufman said. “In this scenario, the managers who perform well will prosper, while those who do not will fail. [But] the failure of behemoth financial conglomerates not only exacts enormous social costs, but also poses systemic risks for markets around the world.”

During Greenspan’s recent book tour promotion, the most enterprising interviewer was Jon Stewart on Comedy Central. Stewart, unencumbered with presumptions of how he should think and what he should not say, spoke much as the boy who asked why the emperor wore no clothes:

STEWART: “Many people are free market capitalists, and they always ask about free market capitalism, and that is our economic theory. So why do we have a Fed?… Wouldn’t the market take care of interest rates and all that? Why do we have someone adjusting rates if we are in a free market society?”

GREENSPAN: “You’re asking a very fundamental question.”

STEWART: “I am? Should I leave?”

Greenspan convinced his host to both stay and listen to an inaccurate Federal Reserve pep talk. (The former chairman seemed to think the Fed was founded in the 1930s.) Stewart was not satisfied with the mumbo jumbo

STEWART: “So we’re not in a free market, then.”

GREENSPAN: “No. No.”

STEWART: “There’s a…benevolent hand that touches us.”

GREENSPAN: “Absolutely. You’re quite correct.”

Proxmire, Kaufman and Stewart alerted their audiences to government interference in the market. (The Greenspan myth includes a commitment to laissez-faire economics, which is a wholly inaccurate characterization.) In the end, both Proxmire and Kaufman tacitly conceded defeat to the monster they saw so clearly and that may devour us all. Proxmire concluded: “This nomination should result in a slam-bang debate in committee and the floor. It won’t, and it is startling, given what you have told us.”

At the end of his 2007 speech, Kaufman noted that decisive changes in economic thought occur only after collapse: “In light of this pattern, it seems unlikely that a new economic philosopher will come forth with an integrated economic and financial approach anytime soon. Today’s most influential economists have strong vested interests in preserving the integrity and reputation of their views…especially for those who have reached a leadership role. A lifetime of research and writing is at stake.”

In other words, the former chairman of the Princeton economics department, Ben Bernanke, is unlikely to question the viability of his own institution. The comedian from Comedy Central at least planted the seeds for a new economic philosopher.

Regards,
Fred Sheehan
January 21, 2008

Greenspan’s Housing Bubble was originally featured on Whiskey and Gunpowder