An Elegant Solution

The heads of the global banking cartel are currently gathered for their annual meeting in Davos, Switzerland. They have received enormous subsidies and bailouts at the expense of taxpayers in many nations all around the world. Those nations that possess representative governments are now beginning to respond to the outrage of their citizens at this gross injustice. In Britain, this has taken the form of a proposal to tax financial transactions. In the US, President Obama recently proposed regulations to limit the risk-taking activities of banks and to force the "too big to fail" institutions to shrink. The bankers' response is a proposal to take regulatory power away from national governments according to a British Press outlet.

This of course would be precisely the WRONG action. National governments in representative systems are forced to respond to the concerns of their citizens. The bankers' proposal would push the power even further away from the people and vest it in unaccountable supra-national bureaucracies. Our response should be precisely the opposite - devolve regulatory power over the banks back from the Federal government back to the state level. This should be particularly true for commercial banking. First, power should be as close to the citizens as reasonably practical so that the exercise of government power will be as responsive as possible to the average citizen. Second, power should be decentralized so as to reduce the incentive to abuse it and to minimize the damage when such abuse does occur.

One very positive effect would be to create a framework that automatically penalizes large organizations. Giant banks constantly lobbied to reduce the role of the states in banking regulation in the name of "efficiency" starting in the 1970s. One of the chief claims advanced during that period was that US banks would be unable to compete with foreign (especially Japanese) banks without consolidation. That turned out to be correct as the US banks produced a bubble very comparable to the one that has led to a 20 year depression in Japan.

The collapse of the states' role led directly to the creation of corrupt TBTF mega-banks by reducing the cost of geographic consolidation, just as the weakening and then repeal of Glass-Steagall enabled the growth of financial conglomerates via acquisition across business lines. President Obama has called for limiting the ability of banks to take risk and also breaking up the TBTF banks. We agree and call upon the president to immediately re-implement Glass-Steagall in order to confirm the seriousness of his words via corresponding action. In addition, we call upon him to remove all federal roadblocks to state banking regulation.

The mega-banks object to state regulations because it would increase their cost of compliance. We agree that it would increase such costs and further state that such an outcome would be a GOOD thing. It would create an automatic systemic incentive not to expand. It would be far better for the banks to decide to break themselves up rather than to mandate such an outcome. The legal and regulatory environment can provide the proper incentives and then leave the implementation to the individual players when they find such actions to be in their self-interest. The explicit repudiation of the "too big to fail" doctrine should be sufficient as the only reason to create such behemoths was to become large enough to hold the US economy and financial system hostage. But it never hurts to create the right incentives - all that Washington DC needs to do is stop interfering with the states' ability to regulate.

This seems to be an elegant solution.

Leverage and Its Uses

During the Universal Debt Bubble (UDB), corporations borrowed a lot of money, so where did it go? Quite a bit of it went into buying other companies as worldwide buyouts reached a record $4.06 trillion in 2006, with about 40% of that in the USA. That was well above the previous record $3.3 trillion in 2000. The difference was that the M&A boom in 2000 was done largely with stock; this one is funded with debt. When things went bad in 2000, the equity didn't have to be paid back, but the debt from the current frenzy will.


While a lot of money went to buy other companies' stock, another big chunk funded companies who bought back their own stock. Naturally, all of this debt-funded stock buying has served to prop up equity prices. Many shareholders came to believe that they were in a no-lose position because of continuous demand from buybacks. And if anything went wrong, someone else would swoop in and buy the whole company as part of the M&A wave. That sort of overconfidence is usually a setup for a big fall - which looks to be starting now.


Until very recently, we were on pace for takeovers to be even higher in 2007 than last year. Then someone apparently had a blow to the head that restored rational thought processes. The interest payments on many of these deals could barely be supported in the current good times. What might happen in bad times is something I don't like to think about. Apparently, many market participants agreed and collectively decided not to think about it - until forced to as buyout deals started to go sour. There are apparently some $300 billion worth of deals that still need funding and can't get it.
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"Investment banks including JPMorgan Chase & Co. and Citigroup Inc. have promised to sell about $300 billion in bonds and loans to fund takeovers of companies including TXU Corp. and First Data Corp. Investors have balked at buying much of the debt offered so far"

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aK_K.Nq65USQ



The banks have stuck their necks way out there and are not anxious to increase their exposure further. In fact, they are trying hard to get out of the deals they've already committed to doing. There will be little M&A activity for the foreseeable future. To a significant extent, company stock buybacks are also dependent on debt. The clearest case of this was Expedia, which was forced to cancel 80% of its buyback when their borrowing fell through.
http://www.reuters.com/article/marketsNews/idUKN2333911620070723?rpc=44

With the takeover wave in full retreat and much of the fuel for stock buybacks being choked off, the two key pillars supporting the stock market are looking very shaky. For now, that should be more than sufficient the keep stocks weak.

Once we go out a few months, the far larger fundamental problems will start to become apparent. First, is the large number of companies that should already be bankrupt but have been kept on life support by cheap debt.

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"The persistently large volume of 'CCC - C' rated bonds in combination with a historically low default rate suggests that liquidity more than fundamentals kept defaults in check."

"'CCC - C' issuers are generally only able to service their significant debt burdens by tapping external funding and have no cushion to sustain them if business or borrowing conditions soften. "

http://www.thefreelibrary.com/Fitch%3a+U.S.+Deep+Speculative+Grade+Issuers+Living+on+Borrowed+Money%2c...-a0157197082

Well, borrowing conditions have already softened and these companies can no longer borrow more money to pay off the interest like they've been doing. In addition, we have just over 2 months until the reports for the 3rd quarter start to come in. That will be when many financial firms are going be forced to report just how much the end of the UDB has cost them. It could get ugly, but that's another topic.