Breakingviews

Lehman sideshow underscores regulatory gaps

By Reynolds Holding The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

A case that’s a mere sideshow to the Lehman Brothers spectacle underscores serious regulatory gaps. Unable to bag Dick Fuld & Co, the U.S. Securities and Exchange Commission has spent three years suing a money market fund for its exposure to the collapsed bank. But while Lehman wreaked havoc on markets, the Reserve Primary Fund made investors essentially whole. The folly is a reminder of the watchdog’s flaws.

Reserve Primary was only the second money market fund to break the buck, falling below the touchstone $1 a share after getting caught with $785 million of Lehman paper when the bank failed and sparking a broader run. Investors pulled $140 billion from the $3.5 trillion industry in a single day, and the U.S. government was forced to guarantee all funds.

It remains unclear, however, what Reserve Primary did wrong. The SEC alleges that fund founders delayed disclosing the true value of its Lehman holdings and the rate of investor redemptions while falsely promising financial support. The founders, on the other hand, claim they shared information as quickly as possible amid confusing, fast-moving events.

Either way, investors suffered little harm. They got out with more than 99 percent of their money after the fund closed in 2008. Yet the SEC is forcing a costly trial, seeking penalties and any ill-gotten gains.

Meanwhile, the regulator has been flummoxed by Lehman itself. A mere five days before declaring bankruptcy, the bank assured Reserve Primary and other investors of its health. Yet it was papering over serious problems with dodgy accounting that temporarily shifted assets off the balance sheet. Though a court investigator concluded senior Lehman executives could be liable for fraud, they haven’t been charged.

Such cases are tough to win, requiring proof of intentional or reckless wrongdoing. Despite the investigator’s findings, evidence against the likes of Fuld may be thin. And though negligence claims are easier to prove, they’re also harder when the company involved is gone.

Japan’s retiree raid augurs political paralysis

By Wayne Arnold

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Japanese Prime Minister Yoshihiko Noda has wrangled a deal with the opposition to double the consumption tax and whittle down government debt, which is already double GDP. On paper, it’s a good start. In Japan’s toxic political environment, though, it’s a big risk. Because the tax hike will hit the country’s growing population of retired voters, the bill’s passage – or indeed failure – could wind up costing Noda his job. That would derail other reforms needed to avoid a sovereign debt crisis.

Japan has two big concurrent problems: its debt is growing while its population is shrinking. The government’s 959.9 trillion yen ($12 trillion) of debt has doubled in the past 15 years, and, net of Japan’s overseas lending, now amounts to around 125 percent of GDP. Thanks to longer life spans and falling birthrates, its population is aging – nearly 1 in 4 Japanese are 65 or older – and shrinking. The number of Japanese declined by 0.2 percent last year and is on course to shrink a third by 2060. It could face a Greek-style fiscal crisis much sooner, when more retirees begin drawing down on their savings, which today finance the country’s borrowing.

Raising income taxes isn’t likely to be particularly effective in a country where a large and rising segment of the population no longer works.

Doubling the sales tax could cut net debt by 2.5 percent of GDP by 2020, the IMF estimates. But that’s not enough to keep it from rising. For that, Japan needs to raise the consumption tax rate to as high as 15 percent as well as cut corporate taxes, increase the retirement age and reduce tax and pension exemptions for housewives.

None of these options will appeal to aging or already-retired voters. Opposition politicians appear to have won a promise from Noda’s party for snap elections in return for their support. But rebel party members on both sides of the aisle may scuttle the deal, forcing Noda to call elections. Either way, the read for markets is bleak: no Japanese government looks capable of staving off the country’s coming fiscal nightmare anytime soon.

State meddling won’t solve UK bubble-pricking bind

By Peter Thal Larsen

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

George Osborne is exerting his influence on the Bank of England. Britain’s Chancellor of the Exchequer has decided that the central bank’s new Financial Policy Committee must support government policy. That raises questions about the FPC’s ability to bust financial bubbles. But it won’t change the committee’s current dilemma: how to combat excessive risk-aversion. Before the crisis, the British central bank obsessed about controlling inflation, while bank supervisors worried about individual lenders. Neither was able – nor willing – to tackle the huge credit bubble that eventually caused a severe recession. In response, the authorities created the FPC to take charge of “macro-prudential” policy. Right now, financial bubbles are hardly the leading threat in the UK’s financial sector. Banks and the economy are suffering from excess caution, not exuberance. Regulators are unsure what to do. As Donald Kohn, the former Federal Reserve governor who sits on the FPC has pointed out; it’s easier to take the punch bowl away from a party that is getting out of hand than to spike the punch to get the party going. The tension is clear in the almost contradictory stance of the FPC towards bank capital and liquidity buffers. It has both urged banks to rebuild them and suggested they could be run down to counter economic weakness. Enter the UK government. Osborne announced last week that the FPC would be given a secondary objective of supporting government policy. That has set alarm bells ringing: could the FPC act to rein in a future housing bubble if, say, the government had an explicit policy of promoting home ownership? These fears may be overblown: the Monetary Policy Committee, which sets interest rates, is already required to support government policies, provided they do not conflict with the goal of maintaining stable prices. And Osborne is right that policies which maintained financial stability but choked off economic growth would be perverse. However, the debate over state influence misses the FPC’s more immediate problem, its shortage of effective tools for addressing the current slump. That is a problem that no amount of ministerial meddling will solve.

Spain won’t be saved without grand master plan

By Pierre Briançon

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Avoiding the great Greek scare hasn’t allowed the euro zone to breathe a sigh of relief on Spain. Yields on the country’s 10-year bonds are now reaching 7.2 percent. The Spanish government has already done a lot. The extra steps it could take are of marginal importance in the current context.

Markets aren’t listening to Madrid. What matters is that the euro leaders come up with a credible road map to overhaul monetary union at their end-of-month summit.

It’s time to end the alphabet soup – plan A, plan B etc – and come up with a grand plan. The euro leaders’ collective fault is to have let markets even imagine that Spain could be bailed out – or even that it could possibly leave the euro. If they don’t want either to happen, they must act fast.

What is needed is a powerful message that the euro zone is integrating, not disintegrating. It may start with the launch of a fully-fledged banking union, as Mario Draghi and French President François Hollande advocate. It will not happen overnight. Angela Merkel doesn’t think it is possible without a fiscal and even a political union: this should be a good incentive for the French president to accept the type of sovereignty transfers that France has historically refused – even if the price is that some structural reforms might be forced on his government.

The second challenge euro zone leaders must tackle is the consequence of austerity on the region’s economy. Greece, Ireland, Portugal and Spain are bleeding. No one advocates that their governments should stop cleaning up their budgets. But indiscriminate spending cuts hurt demand, and income tax hikes hurt competitiveness. More time will be needed to reach the fiscal targets agreed. There is no avoiding that basic fact. And the ECB may want to confirm its hints that it is ready to lower its key interest rates next month.

Five ways to hedge against a China slowdown

By Wayne Arnold

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

It’s no surprise Hu Jintao, China’s president, wants to talk up his economy. He spoke about continuing robust growth over the weekend as he headed for the G20 summit in Mexico. But the latest data showing city house prices down 1.5 percent, along with tumbling industrial production, suggest a slowdown.

Few doubt the world’s second-largest economy will keep growing. The question is how fast. Cautious investors have already punished stocks that rely on China growing rapidly, like Australian copper miner PanAust, which has fallen 19 percent in the past four months, and South Korean construction equipment maker Doosan Infracore, which has lost 23 percent since March 13. But there are still trades that offer protection for investors who don’t buy the party line.

First come put options on the Australian dollar. The currency is a proxy for China’s growing appetite for resources, and puts could pay big if that demand softens. Morgan Stanley estimates the Aussie could drop as much as 15 percent if China’s economic growth slips below 5 percent a year.

A similar logic applies to Taiwan dollar puts. This time the currency serves as a proxy for expanding investment and tourism in China, which would probably suffer if growth slows sharply.

Hedge number three is Korean credit default swaps. China is Korea’s largest export market, so the cost of insuring government bonds against default would rise if exports slowed, pressuring Korea’s current account balance and government finances.

Why it’s hard to shut down a Spanish bank

By Fiona Maharg-Bravo

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Joaquin Almunia, the vice-president of the European Commission, has prematurely weighed into the debate on possible conditions attached to the country’s 100 billion euro bank bailout. Before the rescue operation even began, he opined that liquidating a bank could make sense if the costs of keeping it alive with public money exceed the costs of shutting it down. This sounds sensible in theory. But in Spain, it’s not that simple.

Spain does not have a specific bank resolution scheme to deal with bank liquidation. The central bank’s preferred route has always been to intervene, clean it up, and then sell the troubled lender to a third party. However, it is technically possible for a bank to declare bankruptcy. The last to so this was the tiny Eurobank, nearly nine years ago.

Shutting down a bank in Spain would raise three problems. Shareholders are the first to suffer losses, followed by holders of preferred equity and subordinated debt. A large chunk of these subordinated instruments – 62 percent – is in the hands of depositors, according to Barclays estimates. In most cases they are the bank’s best clients, some of whom complain that the risks of these instruments weren’t properly explained. Wiping out retail holders risks triggering the deposit flight.

There may still be some ways of imposing pain. Some weak banks have stopped paying the coupon. Some others have been more creative. Holders of preference shares in bailed-out CAM, later bought by Sabadell, have been offered an exchange of Sabadell shares – at a 39 percent premium to the current share price – plus a cash bonus to be paid over four years.

The second problem is that imposing losses on senior debt holders without hitting depositors as well isn’t easy either. Senior debt holders in Spain, like elsewhere in the European Union, currently rank on a par with depositors.

BoE can’t blame Europe for its monetary U-turn

By Peter Thal Larsen

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Reality is catching up with Mervyn King once again. After months of resistance, the governor of the Bank of England has announced plans to channel subsidised loans to British borrowers and pump extra liquidity into banks. The overt justification for the U-turn is to pre-empt a storm from Europe. But King can’t lay all the blame on the euro zone: many of Britain’s woes are self-inflicted.

The central bank has slashed interest rates and pumped 325 billion pounds into the economy through quantitative easing. Yet bank funding costs remain high and credit tight. This is particularly painful for consumers and small businesses, which have few alternatives to bank finance.

So the BoE is to offer banks up to 80 billion pounds in multi-year loans at below-market rates, secured against loans to the British economy. Not for the first time, the government will indemnify the central bank against subsequent losses. The BoE will also conduct monthly auctions of six-month liquidity to ease funding strains.

Without the hard details, it’s hard to say whether the “funding-for-lending” initiative will work. But it will test the view of many bank executives that falling lending reflects a shortage of demand, not a lack of supply. Extra liquidity is of course welcome, even though the size and duration of the BoE’s programme falls well short of the European Central Bank’s operations.

King is wrong to blame problems entirely on the euro zone. Though turmoil on the continent has undermined economic confidence and rattled markets, government austerity and the UK’s still-large private debt burden are an added drag. Regulation hasn’t helped either: King’s plan for taxpayer-subsidised loans coincided with the government publishing new rules designed to limit future bailouts. Though the reforms make long-term sense, they will hardly make bank credit cheaper.

Investors fussing too much over Greek election

By Edward Hadas The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The tension over Sunday’s Greek election is almost palpable. The financial world is watching Athens as if this vote, the second in two months, will change history dramatically for the worse. It just might, but probably won’t. But either way, the world economy will remain troubled for years.

The bad news story goes like this. The Greeks elect a government which acts so badly that the other euro zone members force it out of the single currency. The candidate whose victory is widely seen as increasing that risk is leftist Alexis Tsipras, although he says he wants to keep the single currency. But conservative rival Antonis Samaras, or a coalition, would not have an easy time working with the EU either.

In the doomsday narrative, the shock of Greek departure leads to financial panic in other weak members of the euro zone. Discord replaces precarious political harmony, and the European Central Bank goes into lockdown. The single currency breaks up, bringing a global financial panic, a mega-recession and, for serious pessimists, military conflict. The mere possibility is enough to frighten many investors. Their flight to safety has increased the risks. For example, the reluctance to hold Spanish government debt has made it harder for Spain to borrow.

Still, a less flamboyant outcome is far more likely. Greece has no good place to go and the other euro zone members don’t really want to let it out. The current painful austerity, slow reform and inadequate progress on meeting unrealistic targets is undesirable. But the alternative is worse. In Greece, exit would be followed by inflation, bitter political recriminations and quite likely a huge drop in GDP. It would rock the rest of the world.

But suppose Greece does abandon the euro. After two years of rolling crisis and at least six months seriously considering the possibility, political and monetary players should be well prepared. The visible fallout is likely to strengthen the remainder of the EU, leading weak members to redouble their reform efforts, the ECB to provide more help, and the politicians to stop bickering for a while. Germany could perhaps tolerate a Greek exit, but might then be willing to open its coffers much wider to help Spain avoid the same fate.

The legalities and processes are complex. But the only thing that really matters for the whole EU project of “ever closer union” is whether politicians accept sharing the pain of troubled members. Up to now, they have. The EU doesn’t inspire much idealistic fervour, but for ruling parties and leading opposition groups across the region, it still beats the alternatives. As long as that remains true, the single currency will probably survive.

Looming US debt clash a safety check for investors

By Daniel Indiviglio The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Investors shouldn’t get too worried about the battle looming in Washington over the nation’s indebtedness. Sure, the extreme posturing that characterized last year’s fight about raising the debt ceiling almost ended in a debacle. But that’s the point: Congress may well indulge in scary-looking brinkmanship, but history shows its members always pull back from the brink.

Another acrimonious debate certainly looks likely. By the end of May America’s outstanding debt – or at least that subject to the limit – hit $15.7 trillion. That’s $700 billion shy of the amount the government is allowed to borrow. Treasury Secretary Timothy Geithner reckons the United States will hit the limit late this year.

Geithner does, though, have a few tricks up his sleeve to postpone doing so until early 2013. That should ensure the only role it plays in November’s elections is as a rhetorical device. And the delay should also mean that the lawmakers and presidential candidate who win at the ballot boxes will have to sort it out, rather than a lame duck Congress.

It may sound counterintuitive, especially after last year’s fiasco, but maintaining a split in the balance of power may be the better election outcome for the debt ceiling debate. It may well be quicker and easier if either side manages to win both the White House and Congress. But messy skirmishes like last year’s serve to put the topic of reducing the deficit in the spotlight.

It’s not comfortable, by any means: the mid-2011 spectacle wreaked havoc on already nervous markets and even contributed to Standard & Poor’s stripping the United States of its triple-A rating. But it also forced a polarized Congress into a public debate about the deficit and made them hammer out an acceptable compromise.

That’s a great check for investors on both unrestrained borrowing and overly harsh budget cuts. And it turns out Congress always comes through: in the 95 years the United States has lived under a debt ceiling, Congress has agreed to raise it over 100 times. The nation’s lawmakers might be dysfunctional – and exceptionally so in recent years – but they’re not psychotic.

Guide for the perplexed: What is a euro bond?

By Neil Unmack

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Euro bond proposals are proliferating. Euro zone politicians will chew over the multiple variations on the theme of debt mutualisation at this month’s summit. Here’s our guide to everything you always wanted to know about Eurobills, redemptions bonds, red/blue bonds, deficit bonds etc but never dared ask.    Eurobills

This is the easiest and least controversial proposal, because it requires a relatively small transfer of risk, and little surrender of sovereignty. The idea, proposed by two French academics – Christian Hellwig and Thomas Philippon – just covers short-term debt.

Countries would issue short-term debt guaranteed by each other and capped at a given percentage of national GDP, probably 10 percent. Potential losses would be low as short-term debt is rarely restructured; and countries that ran up excessive deficits could be kicked off the programme, reducing moral hazard. Moreover, countries would still have to issue long-term debt, exposing them to market discipline. One problem is that euro zone governments may shy away from kicking a country off the programme for fear of triggering default.

Eurobills could be quickly implemented and wouldn’t require a change to the European treaty that prohibits countries from assuming each other’s liabilities. But they can’t solve the crisis on their own, as they would cover only a small portion of a government’s debt and only the short-term borrowings. Think of them as a first step on the very long road to a real common bond.    Deficit bonds

A second proposal, deficit bonds, is to mutualise only new debt. The idea is being explored by a quartet of senior officials including the ECB’s President Mario Draghi, according to Der Spiegel.