Tuesday, June 04, 2013 - Systemically Dangerous

Systemically Dangerous

by Sinclair Noe

DOW – 76 = 15,177
SPX – 9 = 1631
NAS – 20 = 3445
10 YR YLD un = 2.13%
OIL + .38 = 93.83
GOLD – 11.20 = 1401.00
SILV - .20 = 22.65

Tuesday?? What happened? For 20 consecutive weeks, Tuesday was an up day on Wall Street; going back to January, every Tuesday was a winner. I don't know why. Maybe there was something going on in the shadows and dark corners of Wall Street, maybe it was just a fluke of nature; maybe it was a trend that started and continued as the algorithmic traders took notice.

The first rule of trends is that a trend in place is more likely to continue than it is to reverse, until it reverses. That sounds simple, but it isn't. Behind that concept is the idea that you follow the market rather than trying to impose your will, or your pre-conceived notions, or your bias on the market. Today, the trend reversed.

Federal regulators have proposed a group of firms that aren't banks to be deemed potential threats to the financial system that need stricter government oversight. The Financial Stability Oversight Council, which includes Treasury Secretary Jacob Lew and Federal Reserve Chairman Ben Bernanke, was created to help prevent another meltdown.

Nonbank financial firms include insurers, hedge funds, mutual fund companies and private equity firms. Those deemed "systemically important" would have to increase their cushion against losses, limit their use of borrowed money and submit to inspections by Fed examiners. These firms would have 30 days to notify the council that they're contesting the designation. The council would have to vote again to finalize each designation. The regulators didn't name the firms or say how many it wants to designate as so big and interconnected that their potential troubles could imperil the financial system.

Some of the usual suspects include the insurance firms, AIG and Prudential, they might include names like Pimco; we'll get to them in a moment. I'm not sure how much credence we lend to the regulators, especially considering they haven't been able to regulate the systemically dangerous banks. If they want to be taken seriously, the first step is to reinstate Glass-Steagall.

We don't know the firms on the list of nonbank, potentially dangerous financial firms, but it would seem that Pimco is pretty big – about $2 trillion, and before they could be labeled dangerous, bond guru Bill Gross has taken aim at the Federal Reserve and Ben Bernanke, charging that the Fed's super-easy monetary policies are dangerous to an economic recovery.

Gross is the founder and co-chief investment officer of Pimco and he writes a regular letter to investors which he posts on the firm's website. The latest letter is entitled “Wounded Heart” and he warns investors to reduce risk assets as a result of the weak rewards to be gained. Gross characterized the Fed's zero interest rate policy and quantitative easing as distorting markets by keeping interest rates artificially low and creating an insatiable demand for riskier, higher yielding assets.

Gross wrote: "Our global financial system at the zero-bound is beginning to resemble a leukemia patient with New Age chemotherapy, desperately attempting to cure an economy that requires structural as opposed to monetary solutions.”

Gross also wrote: “Central banks — including today’s superquant, Kuroda, leading the Bank of Japan — seem to believe that higher and higher asset prices produced necessarily by more and more QE check writing will inevitably stimulate real economic growth via the spillover wealth effect into consumption and real investment. That theory requires challenge if only because it doesn’t seem to be working very well.”

The quick version of Gross' thesis is that financial markets require “carry” to pump oxygen to the real economy; “Carry” is compressed – yields, spreads and volatility are near or at historical lows; the Fed's QE plan assumes higher asset prices will reinvigorate growth; it doesn't seem to be working; therefore reduce risk/carry related assets.

Gross may have a point, but then he missed his mark claiming that low rates create less incentive to take risk; and while that may be true, it is the wrong answer. Gross seems stuck in his supply-side world. The answer is not creating more credit, but creating more demand. Short-term the Fed has been able to re-inflate the stock market, and Bernanke makes no bones about that, but it is a dangerous game to inflate asset bubbles, and it doesn't really do much to create jobs. If the Fed really wants to lower the unemployment rate, they will have to change their tactics, and that seems to be what the Fed is priming the markets for right now.

Today,  Esther George, president and CEO of the Federal Reserve Bank of Kansas City and a member of the Federal Open Market Committee, which determines central bank monetary policy gave a speech and she said she is in support of "slowing the pace of asset purchases as an appropriate next step for monetary policy." While she acknowledged her views are not shared by the "majority" of the voting members of the FOMC, it created fresh uncertainty about when the Fed will start dialing down its stimulus. This is the dangerous gamble part of the Fed's asset bubble policy

George went on to say: "History suggests that waiting too long to acknowledge the economy's progress and prepare markets for more normal policy settings carries no less risk than tightening too soon," and "A slowing in the pace of purchases could be viewed as applying less pressure to the gas pedal, rather than stepping on the brake. Adjustments today can take a measured pace as the economy's progress unfolds." It's not so much a matter of applying the brakes, as it is that the Fed is in the wrong vehicle.

Back to those systemically dangerous, too big to fail institutions. Back in 1999, then deputy US attorney general Eric Holder wrote a memo entitled  “Bringing Criminal Charges Against Corporations,”  in which he argued that government officials could take into account “collateral consequences" when prosecuting corporate crimes.

That memo has resurfaced at a time when Holder, now U.S. attorney general, faces increasing criticism for the Department of Justice's reluctance to bring charges against white-collar criminals. Although it brought only a modest change in the way prosecutors evaluate whether to bring criminal charges against corporations, Holder's memo laid the groundwork for subsequent policies that allowed for more leeway when going after large firms.

In 1999, Holder highlighted the possibility of deferred prosecution -- an arrangement now common in the wake of the financial crisis -- whereby prosecutors essentially give defendants amnesty in exchange for paying a fine, enacting reforms and cooperating with investigators. Later, officials published further memos, turning the option into more of a recommendation. The policy was strengthened in response to the Arthur Andersen scandal of the early 2000s. After the government brought criminal charges against the consulting firm, the company failed, causing 28,000 workers -- many of whom likely had no role in any wrongdoing -- to lose their jobs. A court later overturned the charges.

Holder told the Wall Street Journal in 2006 that he drafted the memo in response to complaints that there seemed to be no uniform rules for deciding whether to bring charges in corporate cases: "[I] didn’t expect these issues would become as big as they were," Holder told the WSJ at the time. Indeed, they've only grown larger in the seven years since that interview.

The government has yet to prosecute any big banks or major executives for their role in the meltdown, and critics have derided Holder and his Justice Department for using the collateral damage argument as an excuse for not doing enough to hold those institutions accountable. The DOJ came under fire last year after declining to prosecute HSBC for years of money laundering violations, saying that to do so would bring too much damage to the global economy.

The government just backed down. Maybe there were reasons in 2008 to say maybe we shouldn’t indict any bank we can because it will just add to the systemic risk. But we were in 2012 to 2013 with HSBC -- that risk wasn’t there and we weren’t dealing with something that was relating to the activities that produced the 2008 crisis.

And finally today, we have a follow-up to the London Whale. Bloomberg Markets will report in its July Issue that Bruno Iksil, a Frenchman who would soon become known as the London Whale because of the size of his trades, knew that the trades were going very badly. On March 23, 2012 he wrote a message to an assoicate saying, “We are dead I tell you.”

Iksil had lost $44 million on corporate-credit bets three days earlier and was down more than $500 million for the year. He and junior trader Julien Grout, under pressure from their manager, had tried to hide the extent of losses that would swell to more than $6.2 billion, the bank’s biggest trading blunder ever.

“They are going to destroy us,” Iksil wrote to Grout that Friday in one of hundreds of e-mails, instant messages, transcripts of recorded conversations and other documents released in March by the U.S. Senate’s Permanent Subcommittee on Investigations after a nine-month probe.

In a 301-page report and at a hearing, the panel accused the largest and most profitable U.S. bank of hiding losses, deceiving regulators and misinforming investors.

The report, the bank’s own 129-page account and interviews with traders and current and former executives offer evidence of a widening spiral of panic as the losses became known beyond a small circle of traders and the extent of the damage reached top management, including Chief Executive OfficerJamie Dimon.

What the documents show is that Dimon presided over a company whose traders amassed growing positions in complex derivatives and whose executives offered rosy forecasts, withheld information from regulators and ignored risk limits that were breached 330 times in the first four months of 2012.

The records reveal how little has changed to prevent even the best-managed banks from speculating their way into trouble five years after the collapse of Lehman Brothers and three years after passage of the Dodd-Frank Act.