by Stephen R. Ganns on January 14th, 2010

The Harvard Law School Forum on Corporate Governance and Financial Regulation

Posting: Financial Crisis Inquiry Commission to Begin Investigations

http://blogs.law.harvard.edu/corpgov/2009/09/22/financial-crisis-inquiry-commission-to-begin-investigations/#comment-440323

“The hope of the twentieth century rests on its recognition that war and depression are man-made, and needless.” Tragedy & Hope, Dr. Carroll Quigley, Georgetown University 1966

Whether or not the commission has the special authority of referral seems less important, as I would imagine that ability is implicit.

Briefly the purpose and charge of the commission might be more important than meets the eye. The regulatory framework that exists between the Executive and Legislative branches speaks to a system which has been quite confused and dysfunctional. The charge of this commission is of paramount importance for several reasons. Not the least of which is contained in the quote above – it is man-made.

The commission, if it diligently pursues the true causes of the financial crisis, may be the only body that can provide a framework to dispassionately map out the architecture of the crisis and make strong recommendations to be able to:

1) Assuage the effects of the turmoil or crisis, and
2) Recommend policy and regulatory reform to create a playing field in which similar events will not occur.

There are several areas or categories which the commission has the capability, with the expertise of its members, to review. The restoration of confidence in the system would embrace very determined and decisive action – a sort of political will which has not been demonstrated as of yet. These are serious matters, which have not had to be dealt with in several decades, and some would argue several centuries. Civilizations throughout history have been plagued with economic crises – there was even a residential housing bubble in ancient times. Too often in today’s modern society, complicated and daunting issues are generally found to be viewed with the attitude “it’s not important how we got here but what we do about it.”

However, it is important to understand the evolution, peg the causal events at the core, and recommend policy to prevent its occurrence in the future. The stakes are high: “From these studies it would seem that civilizations pass through a process of evolution…Racked by internal struggles of a social and constitutional character, weakened by loss of faith in its older ideologies and by the challenge of new ideas incompatible with its past nature, the civilization grows steadily weaker until it is submerged…, and eventually disappears.” Ibid.

Members of the Commission are:

1. Phil Angelides

2. Hon. Bill Thomas

3. Brooksley Born

4. Byron S. Georgiou

5. Senator Bob Graham

6. Keith Hennessey

7. Douglas Holtz-Eakin

8. Heather H. Murren, CFA

9.  John W. Thompson

10. Peter J. Wallison

Stephen R. Ganns has more than 30 years of real estate experience in acquisition, management, restructure/workout and financing.

by Stephen R. Ganns on May 13th, 2010

Questions relating to elements of the Financial Turmoil:

Recently, I’ve been asked some similar questions having to do with specific topics related to actions taken and elements which existed or still exist, that are part the macro financial picture.  I’ve chosen two of them to mention in this post: 

1. The Federal Reserve ended its currency swap lines in February of this year.  How do these “swaps” relate to the dollar, and could this affect the value of the currency? 

The Fed “Swap Line” is essentially using a different definition of “swap”–which is also used to denote certain classes of  “Over the Counter” ( or unregulated and non exchange traded) options style contracts such as Credit Default,  Foreign Exchange/Currency or Interest Rate Swaps –which make up the vast majority of these unregulated or OTC derivatives. 

This definition (Fed Line) is literally swapping or trading dollars with other central banks.  These are mainly used to settle contracts that are denominated in U.S. dollars when there is a shortage of dollars held by foreign commercial banks–primarily to facilitate international trade or various cross border transactions.  It relates generally to a country’s “current accounts”–which appears in the public press as trade deficits or surpluses, etc.   When the Fed set the swap line up, there was a shortage of dollars available to settle foreign exchange contracts and this line allowed stability in the price of dollars for other countries to be able to settle trade contracts.  The effect of its “ending” could be volatility in the price of dollars if a shortage is perceived.  I’m including a title from the WSJ A Primer on the Fed’ Swap Lines with Europe* about this swap line for your convenience.  

2. There are some 1.4 quadrillion dollars of derivatives floating around.  Interest rate swaps and currency/exchange rate swaps are most worrisome. I haven’t seen a breakdown of these anywhere but I assume a lot of them are valued in dollars. If they were to cascade into a default what effect could this have on the dollar? 

The back story of this question is really tantamount to asking “What happened anyway?”  

It’s really a longer study but briefly: 

The “notional” aggregate amount of Quadrillions, is just that–notional or imaginary–probably better defined as the face amount of the outer limit of all liabilities real and contingent contained within this economic class of instruments.  As assets or rates decline or increase, it forces settlement of these contracts–which could be a small portion of the notional amount or all of it, a moving target which is impossible to accurately quantify.  That is a real problem.  

These “derivatives” are pretty evenly divided between Exchange Traded (regulated with rules, settlement protocols, reserves against future liabilities, margin calls, etc.) by various regulatory bodies such as CFTC, Chicago Mercantile Exchange, etc. and non-exchange traded or Over the Counter (OTC).  There is a lot of regulatory and legislative history related to all this.  The OTC market literally has no “real” rules or regulation (except made up on a sort of ad hoc basis by the dealers in these contracts) which unfortunately are primarily the large money center banks and investment banks.  You’ll recall that the original plan by the U.S. in ‘08 was to purchase the “toxic assets” from banks through the TARP program. The idea was: this plan would un-freeze the capital markets and let the economy re-set and move forward–sort of back to normal.  Why did they suddenly change the plan to “recapitalizing” the banks rather than just purchasing the bad assets–as was done many times in past anomalies–such as the savings and loan crisis in the 1980’s? 

This brings us back to the derivatives.  The banks losses or liabilities were magnified by the OTC derivatives (CDS, Interest Rate and Foreign Exchange) in a parabolic fashion– like a particle accelerator in a nuclear reactor.  The correct action at the time would have been to suspend all trading in these OTC contracts (as the Chinese allowed their private corporations to do) as a matter of National Security and then to create a bad bank to liquidate the assets–have treasury or the fed pay the difference which at the time was only around a trillion dollars, and just move on down the road.  This bad bank had been the usual “workable” solution used in past anomalies–not ideal but at least a better solution. 

So instead, we get a “suspended animation” of real economies–hoping that banking capital will increase sufficiently to be able to then take the “losses” into account and then re-set.  Problem is that this is a slow painful process–the fragility of which cannot handle another major anomaly. 

So, simple answer to the question is that: it’s the erosion of banking capital that is at risk–which would have tangential effects on the value of the dollar, such as continued freezing of credit, more bailout, more fiscal deficits, more loss of confidence, geo-political implications, etc.  

As a note, there could be currency manipulation as well, but at this point, the Fed and Treasury would step in to handle that–so I don’t see it as very deleterious to the overall situation. 

____

 Stephen R. Ganns has more than 30 years of real estate experience in acquisition, management, restructure/workout and financing.

by Stephen R. Ganns on August 17th, 2010

Published 10 August 2010: BNA Real Esatae Law and Industry Report

Economic History

By Stephen Ganns

Houston, TX, 10 August 2010

__________________________

“The hope of the twentieth century rests on its recognition that war and depression are man-made, and needless.”  _{Tragedy & Hope, Dr. Carroll Quigley, Georgetown University 1966}

I. The  Art and Science of Certainty

In October of 2008, I read an article by Krassimir Petrov, Professor of Economics at Prince Sultan University in Saudi Arabia, which stated that the current economic turmoil had no real historical precedent.  I commented to him something to the effect that that may be true, save 476 A.D., where we find the last vestiges of Roman civilization; to which he replied: “yes, it’s the end of empire”.

Professor Carol Quigley portrays the natural cycle of civilizations in his work, Tragedy and Hope:

“From these studies it would seem that civilizations pass through a process of evolution which can be analyzed briefly as follows: each civilization is born in some inexplicable fashion, and after a slow start, enters a period of vigorous expansion, increasing its size and power, both internally and at the expense of its neighbors, until gradually a crisis of organization appears.  When this crisis has passed and the civilization has been reorganized, it seems somewhat different.  Its vigor and morale have weakened.  It becomes stabilized and eventually stagnant.  After a Golden Age of peace and prosperity, internal crises again rise.  At this point there appears, for the first time, a moral and physical weakness which raises, also for the first time, questions about the civilization’s ability to defend itself against external enemies.  Racked by internal struggles of a social and constitutional character, weakened by loss of faith in its older ideologies and by the challenge of new ideas incompatible with its past nature, the civilization grows steadily weaker until it is submerged by outside enemies, and eventually disappears.”

Are these the elements we face today?  The thoughts are quite sobering.   However, they do establish a fact: that the stakes we are playing for are nothing short of pivotal.

So much new terminology has crept into our current lexicon; words such as “un-sustainability” or “accountability” or “responsibility”—all of which have become hackneyed and are randomly tossed about by too many public speakers.  The foremost throw away tagline, which has proliferated like a virus, seems to be “… the worse, crisis or turmoil or anomaly since the Great Depression”.  But, is that really the correct benchmark for comparison?  Of which “great depression” are we speaking?

Rapid understanding and problem solving affected earlier in 2008, could have possibly set-up an economic environment with regimes capable of causing the markets adequate space for clearing.   Having an economy generally in suspended animation is a slow and painful process.

So the questions which are posed today universally are: How bad is this financial crisis?  What are its true parallels in history?   How did we come to this dilemma?  What are the implications for future levels of survival?

The keynote of the existing economic phenomena is that, its uncertainty is pervasive.  The construction of this turmoil is un-paralleled in its scope.  If it were rendered in something analogous to a set of architectural plans, it would indeed look like the creation of a perfect financial and societal crisis —confusing and not easily confronted.   However, it need not be.  A full statement of its construction would tend to open up the door to resolution.

One interesting element of the uncertainty has been the various names and symbols attached to the turmoil—question marks and X’s, i.e. “…the 2007-20xx Crisis” or “…The Financial Turmoil of 2007-?”   So let’s give it a definite name: The Financial Crisis of 1987 to 2012.  

This set of circumstances might have passed muster, if it wasn’t for the fact that these crises have been occurring for thousands of years.     Is “it was worse than we thought” really an acceptable response?

II. Speculative Economics and the Stewards of the Economy

The field of western economics, in its basic form, is a science.  It has observable laws and axioms which can be applied.   Some of the basic and fundamental principles are described, for example, in Adam Smith’s 18^th century treatise The Wealth of Nations. However, this abbreviated version of the title omits an important element of the concept.  The full title is: An Inquiry into the Nature and Causes of the Wealth of Nations. Brilliant minds have carried on the tradition of the subject—although much of the field has been laced with random and theoretical studies of behavior and esoteric complications.  Its essence is a study in production, efficiency, employment and the creation of wealth.   All fields evolve, transmute and change, but there are basic laws and principles that remain constant.  The book is a blue print or schematic dealing with the fundamental subject.

A few quotes relevant to today, published circa 1776, are used here to illustrate the point:

a. “Any increase in the quantity of commodities annually circulated within the country, while that of the money which circulated them remained the same, would, on the contrary, produce many other important effects, besides that of raising the value of the money.  The capital of the country, though it might nominally be the same, would really be augmented.  It might continue to be expressed by the same quantity of money, but it would command a greater quantity of labour.  The quantity of productive labour which it could maintain and employ would be increased, and consequently the demand for that labour.”

b. “In countries where interest is permitted, the law in order to prevent the extortion of usury, generally fixes the highest rate which can be taken without incurring a penalty.  This rate ought always to be somewhat above the lowest market price, or the price which commonly paid for the use of money by those who can give the most undoubted security…     In a country such as Great Britain, where money is lent to government at three percent and to private people, upon good security, at four and four and a-half, the percent legal rate, five percent is perhaps as proper as any.”

c. “The tax which each individual is bound to pay, ought to be certain and not arbitrary.  The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor, and to every other person. ”

It is worthy of note that the concept of the “invisible hand” being the only governor of irrationality makes little sense and doesn’t take into account Professor Smith’s earlier work (again abbreviated title), The Theory of Moral Sentiments.   Or, An Essay Towards An Analysis of the Principles by which Men Naturally Judge Concerning the Conduct and Character, First of their Neighbours, and Afterward of Themselves.  The two books in tandem were recently (and only) discussed by Wen, Jiaboa, ironically, the Premier of the State Council of the People’s Republic of China.

The stewards of the world’s economies were appointed to what is tantamount to a sacred trust.  The execution and precision of their work is important to every member of society.    The turmoil is not necessarily complicated, but it is complex–based on its’ multi-faceted component parts.

In the U.S. alone there are a plethora of departments and agencies such as: the Federal Reserve, the Treasury, both Houses of Congress, FDIC, OCC, OTS, CFTC, SEC, BLS, etc.  Internationally, we have the Bank for International Settlements, the IMF, the World Bank, the G-20, the Financial Stability Board, to name just a few.

CBO when speaking of fiscal and structural deficits and their possible future remedies was asked if a GDP attribution analysis (what areas created the most growth potential) had been done.  It had not.  OCC was asked if there were data delineating a breakdown of OTC derivatives by type of securitized products or asset classes.  The reply was that their data was not that granular.

Central banks and sovereign treasuries, to be able to know and analyze macro consequences, must have access to accurate information and then the analyses are only as good as the data collected along with concomitant ability to analyze, understand and predict distributive results and outcomes.

What has been needed is an holistic coordination in gathering information and supervisory execution as well as really looking at the effects created and their consequences–both intended and un-intended. This coordination needs to be well thought out and pursued with precision.

All systems need essential policy guidance—rules causing behavior to function optimally.  The inclination toward deregulation in the mid 1980’s began various processes that although lofty, were never intended to supplant any ‘built in stabilizers’ or importantly prudential regulation (supervision) and monitoring.   Without regulatory schemes and mechanisms put into place for risk management, anomaly and turmoil are subject to a high probability of occurrence and with severity.

Perhaps J.M. Keynes’ most notable quote was: “Markets can remain irrational longer than you can remain solvent.”   That basically encapsulates what’s happening today.

Keynes’ work on the dynamics of money and employment during economic turmoil have been used and discussed for decades.   Today, and colloquially, the view is perceived to encompass interventions by the state, in an effort to cause increases of employment and production.  However, as economic crises have been with humanity for many millennia, and economic stimulus has a long history, it would be relevant to mention a couple of instances during Roman civilizations.

Quoting from esteemed historian Will Durant’s Heroes of History:

Gracchus  c. 130 B.C. “ His proposals to it aimed to win diverse classes to his support: the peasantry by renewing his brother’s program for redistribution of state lands; the middle classes by establishing new colonies… and developing these as thriving centers of trade; and the urban masses by his lex frumentaria, or corn law, which committed the government to distribute grain at half the market price to all who asked for it.  It was a measure shocking to old Roman ideas of self-reliance and was destined to play a vital role in Roman history.  It enriched contractors and reduced unemployment by a program of road-building in every part of Italy.  It was one of the most radical measures offered to Rome before Caesar.

Caesar c. 50 BC. “Within a decade after Sulla’s (predecessor) death his policy (Sulla) for restoring economic and political order had come to ruin.  He had dealt with the phenomena, not the causes, of Rome’s decay.”

“Continuing the work of Gracchus, he (Caesar) distributed lands to his veterans and the poor.  He relieved the pressure of a growing population by sending 80,000 citizens to colonize Carthage, Corinth, and other centers thinned by war.  To provide work for the unemployed, he allotted substantial sums to building programs in many cities in Italy, Spain, Gaul, and Greece.  To reduce the leakage of funds in administering welfare to the poor, he required a means test for eligibility to the state dole of grain; soon the number of applicants fell from 320,000 to 150,000. He scaled down debts, enacted several laws against excessive rates of interest, and relieved extreme cases of insolvency by establishing the laws of bankruptcy – essentially as they stand today.”

It is noteworthy that the “scaling down of debt” at that time,  included those related to a severe housing bubble—re-categorizing interest paid to principal reduction bringing loan-to- value ratios back into equilibrium.

The significance of any of these periods only has importance to illustrate that much data and history exist to draw from their causes and effects and formulate conclusions rather than deal in speculation.

III.  Analysis Program  Concerning the Turmoil

There is inherent value in being a student of history applying heuristic (practical) and analytic methods to the research of core phenomena in pursuit of solutions which have the highest probability of success.  Below, is a program which importantly, contemplates reviewing a hierarchy of causes of the current financial turmoil to determine which were most contributive. This would be inclusive of recommendations toward resolution for the chief ones identified done from both an understanding of the historical events of the past 25 years coupled with a pragmatic understanding of what occurs in the daily world of this strata of various financial transactions.

The current financial turmoil or upheaval that is with us today and will continue for an indeterminate amount of time – needs to truly be understood.  However, re-tracing specific events leading up to a complex series of problems is especially important in fully grasping the situation before embarking on devising a strategy toward a comprehensive vanishment or resolution.

Confidence, to be restored, would embrace very determined and decisive action.  Moving to the beginning of these evolutionary processes one might consider, ‘What policy actions could have been instituted that might have created systemic regulatory and prudential (supervisory) framework control?’    These regulatory frameworks are still capable of acting positively today.  The categories contained in the frameworks could be carefully defined and enumerated.

Embracing these concepts, the program would contain the following attributes and components:

1. A concise historical timeline of causal events which led up to this severe economic crisis in the United States and globally inclusive of the dismantling of earlier safeguards that had been put into place.
2. An analysis of capitalism by breaking it down to its component parts viz., a) free market theory and b) “financial capitalism” (banking and financial services).  These two concepts although complementary, in the main have some mutual exclusivity and need not necessarily be synthesized as one theory.  Too often, “capitalism” and “free enterprise” are used interchangeably although they refer to different concepts.   One element to be reviewed could be the growth of the financial services sector from 15% to 35% of GDP and its effect on employment.
3. Regulatory anomalies which have occurred over the past 25 years or so which portray a confusing system of financial regulatory frameworks and legislation which have garnered an array of unintended consequences through lack of coordination.  Included would be legislation of the late 1990’s.
4. A review of derivatives, especially the unregulated swaps or OTC markets, and how their existence and use has acted to magnify the bursting of an otherwise severe but manageable series of “asset bubbles” into a complexity at a higher “order of magnitude” than has been contemplated in modern times—which has virtually frozen the capital markets.  As a note, these instruments are termed by some as “welfare enhancing” credit risk transfer instruments — which create diversification and liquidity.  However, the speculative nature and volume of these unregulated instruments have been daunting to the international financial system and hard on real economies.
5. The adverse effects of unplanned international support systems in terms of credit, interest rate and foreign currency derivatives and the roles played by various dealers and other participants.
6. A view of the inherent flaws of the Credit Rating Agency system.
7. The concept of “super anti-efficient” or shadow markets and the evolution Special Purpose Entities as they relate to the current dilemma’s off balance sheet transactions and their effects.
8. Overview of the existing inventory and potential default severity of credit instruments (by asset class) still held by financial institutions (especially residential housing) along with relevant FASB accounting procedures as well as an analysis of derivative products which are attached.
9. Recommendations for applied remedial actions in an effort to assuage the current turmoil at its core, and restore a sense of normalcy to the United States economy, and to the global markets.

Obviously, there are other elements which would need to be analyzed and solved for, such as residential and commercial real estate valuation and their financings.  But the keynote of any program would have one overarching purpose: to allow the markets to clear, reset and move forward.  Reinstatement or the creation of new frameworks would act to provide boundaries to keep the economy on a smooth road.

IV.  Prognosis: The Full Faith and Credit

The United States is such an interesting place, with its Constitution, its freedoms, its magnitude and its capacity for that most holy of attributes, its production.  It houses approximately 4.5% of the world’s population and yet is responsible for 25% of the world’s production.

To add some perspective, let’s take a look at some of the IMF’s listing of global GDP and Population for 2009:

United States                        14.25 trillion         313 million

Japan                                        5.1 trillion            127 million

PR China                                                4.9 trillion             1.4   billion

Germany                                3.3 trillion              81 million

France                                    2.7 trillion               65 million

UK                                           2.2 trillion               62 million

Italy                                         2.1 trillion                60 million

Brazil                                      1.6 trillion              193 million

Spain                                      1.5 trillion                 47 million

Canada                                   1.3 trillion                 34 million

India                                       1.2 trillion                 1.2 billion

Russia                                     1.2 trillion               142 million

Saudi Arabia                          360 billion                 26 million

Iran                                         330 billion                 79 million

These numbers indicate that the U.S. and its citizenry have a very high capacity to monetize resources, both as hard assets and as human innovation, production and technology.    So the question becomes, what is the prognosis?

The balance sheet of the United States is not in the news very often.  However, in a fiat monetary system which we have, wouldn’t this be the central part of the “full faith and credit” that backs our currency?   The value of public and private assets is truly a staggering amount.  The public assets alone have an estimated value of some $500 trillion, including land holdings, mineral rights, real estate, equipment assets, etc.  So from one perspective, what we have as a country is a cash flow problem.   Assets could be monetized. Treasury and the Fed could get creative with the inter-play between assets and the national debt.  The structural deficits need re-thinking and good planning.  GDP and employment need attribution analyses to provide for immediate growth.  Regulation needs to be pursued in a logical manner.

It would certainly be auspicious for the stewards of the economy to create a point of control to analyze and coordinate actual solutions.  If this can be done in a timely manner, with creativity and certainty, the prognosis can still be good—and the civilization will be described as one that will endure.

by Stephen R. Ganns on January 14th, 2011

The Group of Thirty, or Consultative Group on International Economic and Monetary Affairs, Inc., is one of the most influential banking and global monetary policy think tanks which exists today. 

Their recent publications include:  Financial Reform: a framework for financial stability ( working group headed by Paul Volcker),  Enhancing Financial Stability and Resilience: macro-prudential policy tools and systems for the future (working group headed by Roger Ferguson, Jr.), Twelve Market  and Government Failures Leading to the 2008-09 Financial Crisis (Guillermo de la Dehesa), and other relevant concepts by members such as  the Per Jacobsson Lecture Series: Markets and Government before, during and after the 2007-20xx Crisis (Tommaso Padoa-Schioppa-in memoriam).  The organization’s papers, work products and reports are generally intellectually breathtaking, relevant and significant to the financial issues of our time.

The members of the the organization comprise “very senior representatives of the public and private sectors” with the mandate of exploring “the international repercussions of decisions taken in the public and private sectors and to examine the choices available to market practitioners and policy makers.”   This is an august international body of central bankers, commercial and investment bankers, academics and others who influence monetary and fiscal policy. 

Some of the membership includes:  Paul Volcker former Federal Reserve Chairman, Jacob Frenkel former Governor of the Bank of Israel, Jaime Caruana General Manager of the Bank for International Settlements, Mario Draghi Governor of the Bank of Italy and Chairman of the Financial Stability Board, Roger Ferguson CEO of TIAA-CREF and former Vice Chairman of the Federal Reserve, Jean-Claude Trichet President European Central Bank, Paul Krugman Professor of Economics at the Woodrow Wilson School at Princeton University, Mervyn King Governor of the Bank of England, Martin Feldstein Professor of Economics at Harvard University, E. Gerald Corrigan Managing Director Goldman Sachs & Company and David Walker former Chairman Morgan Stanley International–to name just a few.

We have provided a link to their website and highly recommend keeping up with their stellar work in the field of international finance.  The organization’s Executive Director is Stuart P. M. Mackintosh.

 www.Group30.org