I was on a panel on Tranche Warfare last month in IMN’s 11th Annual US Real Estate Opportunity & Private Fund Investing Forum. It was a very well organized conference with a lot of people in attendance, and provided a great opportunity to exchange ideas with and listen to views of significant participants in the industry. The conference and views expressed have been reported earlier. Below are some of my thoughts on what I heard.

The most common thread in a lot of comments, both in the panels and in private conversations, was the lack of opportunities to invest. Investors, remembering how much money was made purchasing cheap assets from RTC sales during the last real estate downturn of early 1990s, have raised a lot of money in anticipation of a similar opportunity this time around. However, those fire sales have not materialized, causing some disappointment. Many do not seem to realize that the investors were not the only ones who learnt from the early 90s experience. The owners of the assets, and the regulators, learnt too - if the assets are sold at cheap fire sale type of prices, investors make a killing, but the owners of assets lose out. So, this time around, the owners of the assets are trying to hold out as long as they can and it makes sense. Regulators, having learnt from the experience too, seem to be doing everything they prudently can, to give latitude to owners to avoid fire sales. Somehow, many seem to be disappointed at things not having played out the same way as they did in 90s! Seems logical that they should not, still many are surprised.

The good news from many was that the opportunities, though not as plentiful, are there. And people are doing deals. They take a little more searching, a little more digging into the things that are out there to separate the good ones from the bad, and they are often a little smaller than ideally desired, but they are there. On the easy ones, there is competition, and sometimes those assets get overbid. So, discipline in the process is as important as ever.

Another lesson that I came back with was that those GPs who gave themselves (or were able to get) more flexibility when raising funds in terms of types of investments, timeframe, and returns are better placed to take advantage of opportunities as they come up than those who got narrower mandates from their LP investors.

The more I think about it, the more it seems to me that this time around, the process will be stretched out over a period of time. In commercial real estate, values are down – around 40% by some commonly used metrices, and there do not seem to be any immediate drivers that will quickly and significantly drive prices up. This is bound to result in transfer of assets from those owners who are overleveraged and do not have ability to put in more capital to refinance maturing loans in the new lower leverage environment. That will create opportunities for those with patient capital to invest. Just slowly. And they may not get fire sale prices, but they will be investing at today’s lower prices.

This forum served up the usual pundits’ assessments of the state of our industry, revealed strategies and tactics de jour to capitalize on current opportunities, and provided fabulous networking opportunities with key industry players.

Panel speakers opening the conference let all the usual ‘double-dip,’‘half-full glass’, ‘tale of two cities’, and baseball game inning estimate metaphors fly. It seemed the FUD factor (fear, uncertainty and doubt) that dominated last year’s event was subtly in play this year amidst the optimism.

I sized it all up as follows:

1) Signs of recovery in the economy and the market are clear. But are they real or just the result of performance enhancing government intervention? It’s too soon to tell.

2) Banks and financial institutions are hanging on for dear life to their book valued real estate. Consequently the deal flow remains 95% below ’07 levels. This has led to otherwise idle dealmakers throwing their un-deployed capital at scarce deals sometimes bidding beyond rational fundamentals, which is why many of the recent press releases touting dozens of bidders for sub 6 cap assets are seen more as a report of the continuing problem rather than of the emerging resolution.

3) Meanwhile, there is tremendous surplus of un-deployed private equity fund capital and oversupply of operators. These players are dividing their time between chasing rare deals and containing their legacy damage.

4) The above means that first time fund sponsors are facing the most difficult fund raising prospects in over 20 years. Some LP’s are recalling their un-deployed capital and refusing to invest in anything other than a specific deal subject to their full discretion. However, first time funds are being raised now when the sponsor offers a distinct and compelling strategy, a competent track record and excellent and honest investor service.

The main justification for the cost of a fund is to allow investors and sponsors to capture deal flow profits that they would otherwise forego by serially raising capital for each deal. Yet there is miniscule deal flow. This begged questions about the pertinence today of the real estate investment fund model that no one dared to ask.

State of the Industry

A common thread throughout the conference among GG’s and LP’s was that until deal flow returns, the deal sponsor is king. ‘Show me the deal and we will show you the money’ seemed to be on everyone’s lips.

As far the state of the fund manager compensation structure, as expected 1.5/15 is the new 2/20 along with full cavity search due diligence. I also sensed a lot of LP resistance to management fees on un-deployed funds, with higher pref’s, no catch ups and more of that show me the deal first attitude.

On the operator side, track record is king with possible muligans on selected well explained failed legacy projects. Some operators are being asked to invest more than just token point or two or equity. Here too, you get the rubber glove treatment!

When they could get deal flow and profits, GP’s most alluded to core and core plus in A/major US markets. Multifamily seemed to be the first choice from risk adjusted return view point. However, the fed’s continued life support of agency financing has been blamed for otherwise inexplicable cap rate compression. The other major food groups; office, retail and industrial all received their share of panel speakers’ polarized picking and panning. One man’s feast seemed to be another man’s poison.

There was some talk of big killing made by sellers of finished lots that were purchased in ‘07-’08. It seems builders are back to hoarding finished lots and land with their big loss carry back tax refunds. A bright spot was that when asked about required returns most speakers quoted sub-20 IRR’s, with mid-teens as a median bid. Overall, indomitable optimism won a narrow majority. Most panel speakers seemed confident that the worst was over and they are ready to pounce on the good deals as soon as banks balance sheets get well enough to take the losses.

Overall, the conference was an insightful snapshot of the pulse of the market, and some useful color about new opportunities and how to seize them. Yet what I valued most was the concentration of intellectual capital a handshake away, and the dozens of powerful contacts I made and followed up with.

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To contact Carlos Vigon, please email cvigon@newoakcapital.com

Tags: Real Estate Opportunity, Real Estate Outlook

The most important and the most basic issue related to ratings and rating agencies has not been recognized or addressed in reforms announced so far. Here’s a new idea on a practical solution to address this most fundamental issue, which also addresses the conflict of interest issue that has received the most attention so far.

The Reforms

Ratings agencies have been criticized heavily by many for their role in the U.S. financial crisis, in particular over conflicts of interest and their failure to recognize the high risks inherent in complex structured products. They have also been blamed for throwing fuel onto the fire of crises by belatedly and aggressively ratcheting down ratings. Numerous proposals have been put forward to reform the rating process to avoid these issues.

The US Congress, after resolving the differences between the House and Senate versions last week, is on the path to pass a sweeping financial regulatory reform bill aimed at increasing oversight and regulation of the US financial system. Among the issues addressed is reform of credit rating agencies. However, the compromise bill avoids most of the stronger proposals. The bill directs SEC to conduct a two-year study to determine if a board overseen by SEC should be setup to help pick which firms rate asset backed securities (the Senate version of the bill had required such a regulatory board). The bill also adopted a softer version of proposed liability provision than was in the house version of the bill (investors must show a company “knowingly or recklessly” failed to conduct a “reasonable” investigation before issuing a rating). The compromises are better than the extreme versions of proposals even though it means that the proposed regulations may not do much to change how the agencies operate.

Earlier, in mid April, SEC made some changes. In the update of Regulation AB, it eliminated the involvement of rating agencies in the shelf registration process by removing the requirement that the ABS be rated investment grade. This clearly has no impact on the rating process.

SEC also promulgated the Rule 17g-5, which went into effect on June 2, to address perceived conflicts of interest with issuer-paid ratings provided by nationally recognized statistical rating organizations (“NRSROs”). The rule aims to increase the number of ratings and promote unsolicited ratings for structured finance products. To achieve this goal, the rule requires issuers and hired rating agencies to maintain password-protected websites to share rating information with non-hired rating agencies. The concept is good, but if implementation means rating agencies will have to share all information with other agencies, they may have less incentive to dig deeper and find more data.

None of these changes are radical overhauls or even proportionate to the amount of Calpers has sued the three major bond rating agencies for $1 billion in losses it said were caused by Markets reacted violently to the cuts as investors worried about the safety of the debt of these countries, and contagion spread from Greece to other countries. Stock markets tumbled worldwide, and bond and currency markets had big moves and became very volatile.

Another way ratings impact markets is via the feedback loop between the markets and ratings through portfolios tied to indexes mandating certain holdings of particular debt. For example, the Barclays Euro Government Bond Index includes Greek debt as 4% of index, but only if the bonds maintain a certain credit quality based on lower of the rating from S&P and Moody’s. Greece had been 4% of that index but was excluded starting May 1, due to S&P’s downgrade. That in turn likely forced selling from investors tracking that index.

Critics assailed rating firms for fueling woe in Europe and Europeans criticized debt-rating agencies, accusing them of spooking the markets and worsening the plight of financially stretched governments such as Greece, struggling with heavy debt loads.

There are several other examples where a company needing to raise more debt in capital markets finds it cannot do so, or not at a reasonable cost, once it has been downgraded even while it was attempting to raise capital to improve its financial situation. The downgrade increases cost of financing as investors demand more yield reflecting lower rating. The downgrade may also result in existing investors having to sell holdings, further increasing the yields in the market. It can become a vicious circle increasing the likelihood of default. The downgrade reflects rating agency’s opinion of the outcome, but it also becomes a causal factor in determining that outcome. The rating agencies in effect become the judge, jury, and the hangman for the company.

The Real Problem That Has Not Been Recognized

In the current system, the rating agencies’ opinion can become a causal factor in making that opinion become reality. Time and again, in structured products and otherwise, it has been clear that the rating agencies are not infallible in their judgment, and do not have any special powers of predicting future. Their failures in predicting subprime mortgage performance have been appalling. But even if you look at the forecasts of defaults in corporate bonds, the predictions do not match the actual outcome, and the predictions themselves change over time, as they should.

So, if ratings are heavily embedded in the system and are needed, and yet rating agencies are not smarter than everybody else, and if they do not have special predictive powers about the future, how do we avoid giving their subjective opinions so much importance and extraordinary power?

The answer lies in recognizing the real problem – one that has not been addressed in any of the proposals so far. The real problem is that the rating agencies are combining two roles into one. First role is to provide a rating based on statistical analysis and past performance of the assets – remember that SR in NRSROs stands for Statistical Ratings. The second role is that of a research analyst to provide an opinion on what might happen in the future. Currently, rating agencies combine the two. The ratings are a mix of statistical analysis and somewhat subjective opinion on the future. This allows rating agencies to downgrade companies or countries even while they are in the process of attempting to improve their financial condition. At the same time, it leaves rating agencies open to criticism if they do not act and the feared worse outcome becomes reality before their downgrade. This also allows subjectivity and flexibility in ratings process that creates perceived conflicts of interest in issuer paid ratings.

The Solution

The logical solution is to separate the two roles. NRSROs should be doing Statistical Ratings – based on past performance of assets, known facts, events that have already taken place, and statistical models and methods that are well disclosed. They can put bonds on watch for upgrade or downgrade if a financial event is in progress or expected, but cannot downgrade or upgrade till the event actually happens. So they will not be precipitating events, and cannot be blamed for not downgrading sooner. This role will be limited to those approved as NRSROs.

The second role of providing credit ratings in the form of opinion on future performance should be separated from the NRSRO role, and should be open to any research provider, including NRSROs. These credit ratings could be designated as Informational Ratings without any legal or official role impacting investor charters, debt covenants, etc, which will only use the ratings designated as NRSRO Ratings. This will take the non-NRSRO rating agencies back to sort of where rating agencies started - as market researchers, selling assessments of corporate debt to people considering whether to buy that debt.

The information provided to NRSROs should be made available to all NRSROs and other non-NRSRO rating agencies, in a manner similar to password-protected website required under SEC Rule 17g-5. However, to promote competition and improve quality, the other rating agencies should be free to gather more information and not have to share it with others.

The conflict of issuer paid rating could be avoided if issuers were required to pay a fixed fee based on deal type (maybe to a group set up by the SEC or an industry association for that purpose) which would be divided between all NRSRO raters informing issuers of their decision to rate the deal after the issuers post the information on the password-protected website for credit raters. This will avoid ratings-shopping by issuers even though the agencies will be indirectly paid by the issuers. The NRSRO Rating will be provided to investors without any charge. The NRSROs will only provide the current rating, along with disclosing their rating methodology to investors. They will not provide any opinions or qualitative information.

For more qualitative information and opinions, investors will look to the Informational Ratings and more details from research providers (including NRSROs and non-NRSROs). This will be paid for by the investors looking for enhanced information and research. This will be the main source of income for credit raters and will incentivize them to compete with others for investor subscriptions and produce quality results.

Separating the two roles avoids the issues of rating agencies precipitating events if they act or facing criticism if they do not. It avoids the perception of conflict from issuer-paid ratings, by allocating costs between the issuer and the investors. It also preserves the role of rating agencies where its needed, while encouraging the investors to do more work on their own and look for third party unbiased research and opinion.

NAIC Action, Less Noticed, But Good for Commercial Mortgages

“The National Association of Insurance Commissioners backed off from its proposal to increase the capital that insurance companies must set aside for commercial mortgage loans. That is a good thing for the commercial real estate market,” says Malay Bansal, head of Portfolio Management and Advisory for Commercial Real Estate & CMBS at NewOak Capital, an asset management, advisory, and capital markets firm in Manhattan. “The NAIC had proposed to increase the MEAF for insurers with average loss experience from 2.6 to 4.0, which would have been an increase of 53% in capital that insurance companies would require for holding commercial mortgages. That increase would have resulted in insurance companies reducing their mortgage holdings and would have made it difficult for them to originate new loans. NAIC opted to leave the MEAF for insurers with average loss experience at 2.6%, while increasing it to as high as 4.6% for those with greater than average losses.”

Will China’s Exchange-Rate Policy Reduce Pressures on European Sovereign Bond Crisis?

“Latest China’s exchange-rate policy should help reduce pressures on European sovereign bond crisis on the margin,” says Ron D’Vari, CEO and Co-founder of NewOak Capital, an integrated advisory, capital markets, and asset management firm based in New York. “Beijing knows well that in the long run maintaining a huge current account surplus is not sustainable but at the same time it desires to maintain its export competitiveness against a double dip in western economies. Announcing it just a week before G-20 meeting is clever and will reduce trade war tensions. A gradual appreciation of RMNB over the next 2-3 years should improve world trade and reduce the risk of US and Europe economies to fall back into a deep recession. This is masterfully timed and incredibly wise move on Chinese part despite studies showing RMB’s overvaluation having fallen from 40% to 25%.”

Community Banks in High Demand: Yet Can New Owners Satisfy Existing Customers?

“The failed bank count thus far in 2010 currently stands at slightly over 80 and demand from private equity firms for banks in general remains strong” says James Frischling, President & Co-Founder at NewOak Capital. “The general view is that what goes down, must eventually go up. With so many banks in need of capital and trading at discount to their historical levels, from chaos comes opportunity and the investors are ready to pounce.”

However, the demand for deploying capital into the weakened banking space, while a much needed solution for preventing further damage to the financial system, doesn’t necessarily meet all the demands of the FDIC or the customers that these community banks serve. ‘Community continuity’ has become an important part of the approval process and protecting the customer base that was once served by these institutions is something suitors and potential acquirers need to pay closer attention to. Like any investment, proper and thorough due diligence is required, but beyond the acquisition target’s balance sheet or the capabilities of management, the target bank’s place in the community and its ability to retain its customers under new ownership will go a long way in making the investment a profitable one. ”

Tags: Community Banks, CRE, NAIC, Soverign Bonds

The SALT Conference 2010 held last week in Las Vegas was a confluence of 1,500 participants’ thoughts, opinions, and often pure speculations as to the direction of the Global economy and its markets. Much like the market’s recent spike in volatility, the tone of the conference reflected an increasing concern that the rapid “V” shape recovery in liquid asset prices was not reflective of the weak economic strength of the Global economy; primarily in Europe and to a lesser degree North America. If anything, we may be heading back in through the out door of the recession many thought we had left behind.

It was interesting to note that on the first day of the conference two of the conference’s guest speakers were convicted felons; Michael Milken and Frank Abagnale. Their very insightful speeches were followed later that evening by a keynote address from former President Bill Clinton who was impeached by the House of Representatives. While seemingly not intended as the theme of the conference, these individuals seemed to provide an ironic backdrop to the conference. To varying degrees these distinguished individuals were accused of their own distinct “excesses” at some point in time. Today, they are prominent and significant contributors to numerous Global causes while building tremendous legacies.

As I listened intently to their collective words, I could not help but think of the Global market’s own “excesses” of recent years and what legacy we will leave for future generations.
While the conference was self-contained in the Nevada dessert, the events in Greece and uncertainty in the Euro and the EU were reminders that what goes on in Vegas is still influenced by an ever increasing Global environment. Much of this thought process was on display during a macro-economic forum on the second day including notable market personalities Nouriel Roubini and Jeremy Siegel. Their respective doom versus recovery banter captured the essence of the conference – uncertainty.

As the US economy sits seemingly on a precipice, what are the answers and what are the solutions? I thought Michael Milken’s comments provided some directive. Paraphrasing, “an individual can secure non-recourse 30 year mortgage financing cheaper than Microsoft can obtain financing” is part of the structural problem. Consensus on the dais and within the audience is that these types of deficiencies abound and that significant corrective financial sacrifice must be made. There is no bailout for the US. The concept of “too big to fail” fails.

Reflecting on the conference during my flight home, I was drawn to the apparent paradox of how the aforementioned guest speakers were able to experience adverse personal events – their own recession - and emerge stronger. These cruel to be kind life lessons are not dissimilar from what the US and most of the developed World is experiencing. Either we learn from the abuses of our own fiscal excesses and prosper or we go in through the out door of the continuing recession and back into deeper uncertainty.

Tags: SALT conference 2010

The bold measures taken by the Eurozone countries, the IMF and the US are to be applauded only in that the plan buys time for the restructuring of the Eurozone. It provides adequate liquidity in the near-term, and from the European perspective, is unorthodox indeed. By allowing the European Central Bank to buy government bonds directly from the market or the governments themselves, they are hoping to mimic the success of the Fed’s measures to deal with the last US financial crisis.

The problem is the nature of the Eurozone crisis is quite different. It is a solvency problem if the governments of the periphery are forced into austerity measures that are unlikely to be accepted by their populations on any sustained basis, and if they remain in the Eurozone. However, it is a temporary liquidity problem if it is used to provide time for an exit strategy by these countries from the Eurozone. As I have discussed before, you cannot announce in advance that a country is leaving the Eurozone. It must be done swiftly and be done either overnight or preferably over a weekend.

I have read many commentators recently who have begun to realize the true nature of the problem. The one thing they keep missing is that such an exit doesn’t mean a government technically defaults on its debt. It has the legal right to redenominate its old debt into its new currency just as it had the right to redenominate its old currency government debt into euro-denominated debt. No one called that a default.

The real risk investors face is that if what is really needed is done and the periphery exits the zone, then investors bear an exchange rate/interest rate risk, since in the initial stages, the value of these bonds may decline compared to the euro, if history is any guide. However, depending on the time horizon, the exchange rate of some of these countries may improve significantly, especially as their external accounts turn around. Using Italy as a past indicator, we see that whenever the lira declined sharply, exports soared, imports declined, international spreads on foreign currency denominated debt usually narrowed and the economy began to grow. This made austerity more politically palatable.

If this occurs in the periphery countries and there is a modicum of austerity, not the kind of austerity which is required by the present system, then Western Europe’s exchange rates against the dollar on a trade weighted basis will improve. This is what the US needs.

US swap lines are helpful, and the US can probably get away without buying government bonds directly, because the ECB will be doing it “for them. ”It will represent a virtual increase in international reserves. The Fed probably went down this route because it doesn’t technically need Administration approval. It keeps the action less political and more below the radar screen, since only a small percent of the voting public understands the arcane nature of central banking.

Tags: Bailout Plan, ECB, eurozone, Exit Strategy, Periphery, Swap Lines

As each day passes, and I watch and read about events in Europe, I grow increasingly frustrated. The Eurozone as it exists today is doomed, and if it isn’t soon dismantled, it risks derailing the worldwide now underway. Watching the Greek parliament pass an austerity bill for me was analogous to watching the Soviet Parliament pass a new civil rights law. It won’t work.

If you look at the latest three quarters, you already see that the US current account deficit has started to grow, which is a drag on US growth. The collapsing euro, along with a number of other major currencies is now almost certainly going to slow US growth further.

The peripheral countries of the Eurozone need to exit ASAP. It should be done this weekend. Their debts in euros should be redenominated back into local currencies at one-to-one. This wouldn’t represent a default, since when these debts were all redenominated into euros when the fiasco plan started, no one called it a default – even when German bunds were redenominated into euros. A redenomination, as long as it is done at one-to-one, is merely an exchange rate adjustment.

Exchange rate changes have never been included in the list of things included in default risk.

The fact that Britain, a non-euro member, doesn’t have a stable majority in Parliament, puts worldwide growth at even higher risk. Are we about to repeat 1937?

The US, France, Germany, and China should demand that the peripheral countries leave the failed monetary union. Also, the IMF should stay out of the entire affair. It has nothing but a horrible history of making matters worse. Austerity is not what these countries need. What they need are more flexible prices, something that only a flexible exchange rate can provide. The difficulty we have here is that France, Germany and the Benelux will reap the rewards, while the periphery will go down the tubes in the name of austerity.

Also, if the peripheral countries have problems rolling over their local currency debt post-redenomination, they should simply ignore Maastricht and stop issuing short-term paper to their banks, but require their banks to hold reserves made up only of medium-term government paper with capitalized interest. Greece did this about 20 years ago. Almost no one outside the Greek banks even noticed. If such an arrangement occurs within a national banking system, once again, it is not a default, and since the local debt is issued under local law, and central banks can regulate their own banks as they wish, local courts can decide the issue and will likely side with the government. Pan-European courts can then spend the next few years debating its euro legality. By then the new system will have been working well for years.

Tempus fugit!

Tags: China, default, eurozone, France, Germany, greece, redenomination, US

I normally wouldn’t call for the US Government to intervene in foreign exchange markets, but I think we are posed with a difficult and unusual problem. Also, I don’t mean simple swap lines, but rather an increase in US international reserves is required. My personal view, as I have expressed on a number of occasions is that the peripheral countries of Europe should leave the Eurozone quickly. As the Greek problem has become worse, and as the contagion from it has become more pervasive, the euro has fallen significantly against the dollar.

My concern is that this decline in the euro may accelerate. Even if it doesn’t fall further, the significant depreciation that has already taken place against the dollar puts the US recovery at risk. A major source of the V-shaped recovery we are witnessing in the US is the restocking of depleted inventories and the restart of investment by firms which were negatively affected by the financial meltdown.

The US economy has benefitted from a significant turnaround in its trade balance, in part due to the economic slowdown, and in part due to the decline of the dollar, which made imports more expensive and exports cheaper. If the euro stays where it is, or falls further, it may become far riskier for US firms to restock from US sources. The fall in the euro is a boon for Germany and France. Their fiscal positions are in decent enough shape that despite the higher euro that had occurred prior to the recent crisis, they were surviving the worldwide downturn rather well – all things considered. On the other hand, the US recovery is somewhat more fragile and does not need a declining euro putting downward pressure on US growth, even if only on the margin.

To insure against that happening, the Treasury should significantly increase its holding of euros and other advanced industrial country currencies which are suffering from the contagion posed by Greece and the failure of the eurozone as a single currency unit. The risk to the US government is that it might suffer some minor fiscal losses if the euro or these other currencies decline further. However, if the intervention works and provides time and stability to the eurozone, then the Greek problem, along with the other structural problems posed by the poorly structured eurozone may be fixed at a more leisurely pace and contagion reduced.

Given that the US is not in danger of runaway inflation anytime soon, and its ability to sterilize much of the inflow, it looks like a no-brainer to me. The Fed should immediately start purchasing euros and other appropriate currencies on behalf of the Treasury. For once the US government should put Americans and American jobs first. At the same time, the windfall gains France and Germany will attain will be reduced and redistributed to US-based industries and workers.

Tags: Dollar, euro, eurozone, Foreign Currency Intervention, France, Germany, greece

For more than a year I have been arguing that the peripheral countries of Europe should leave the Eurozone. It was a political creation, without the wherewithal to adapt to the various and changing needs of the peripheral members. We are finally seeing that come to fruition with a vengeance. From my point of view the only question is how do you handle the dismantling of the Eurozone.

All of them will be better off in the long-run not being tied to France, Germany and the Benelux countries. Since social cohesion is lacking in a number of these peripheral countries. The only way these countries historically dealt with crises was to use the exchange rate and interest rates, something even the least-educated peasant understands.

I would argue that these governments should just do it by decree overnight. The longer they wait, the worse the problem will get and the more costly will be the solution.

Most people don’t know it, but years ago, before Argentina defaulted, a major investment bank had put together a plan to avoid default, that in my opinion would have worked for quite a few years. What stopped the plan from being put in motion was political dithering on the part of the authorities. That’s what we have in Europe now. The countries which have tied their currencies to the euro should immediately free them up and let them freely float. The countries on the periphery should leave and recreate their own currencies in a blitzkrieg manner.

Italy and Spain will move to large current account surpluses. Small enterprises will compete with even the Chinese. Ireland will be the UK’s Cayman Islands. It’s quite simple. Simplicity, not Cartesian dreams of grandeur are usually best for the economy. We are getting Cartesians thinking too much and wasting time contemplating nature of the universe while Rome and Madrid literally burn.

Tags: exchange rates, greece, Ireland, Italy, Portugal, the Euro

There has been a lot of discussion in recent weeks about Senator Dodd’s proposed banking reform legislation, which differs in some ways from the House version. The key issue is, what does it mean? First, anyone who argues they understand all the ramifications of the bill are kidding you. His original bill was over 1100 pages long, with the revised version, taking into account some Republican and Conservative Democratic objections pushed the size of the bill to over 1300 pages. If that tells you anything, it’s that the bill is probably filled with many loopholes and outs that a tractor could probably drive through with little difficulty.

Nonetheless, there are two important provisions of the bill: 1) Changes to the regulatory environment; and, 2) Creation of a consumer protection agency. Some have argued that there are really three provisions, but I see their parsing as merely subsets of the regulatory environment.

FSOC

The bill contains a provision to create a new Financial Stability Oversight Council (FSOC) under the auspices of the Treasury, which is supposed to be on guard for systemic risks. If it finds there is a risk to the system, then it is to bring it to the attention of the Federal Reserve to resolve the matter. It is proposed that $50 billion be set aside for potential crises. Conservatives have labeled this a permanent TARP.

The reality is that the bill allows the Fed and Treasury to do what is needed when and if a systemic risk arises, which could easily resemble what happened during the last crisis. The hope is that such a watchdog council would see signs of a crisis brewing and therefore hope to avert it. It sounds good, but the reality, as even Senator Dodd admits, is that financial crises are always a possibility despite our best efforts. From my point of view, it is hard to oppose having a systemic watchdog council since an extra set of eyes might notice something missed by others.

Some argue that because the Council would tell the Fed to do something, in the end, the Fed will have more power because it is responsible for taking action. Frankly, I don’t think it makes much difference, since central banks can usually do pretty much what they want anyway, and thank goodness they can. If we had had to wait for Congress and the Administration to act in a timely manner, we would have had a full-blown depression on our hands, instead of a recession, which I should add ended by mid-2009.

The law leaves a great deal of discretion to the Fed, the FDIC and the Council in how they deal with troubled institutions. However, this discretion is what worries the rating agencies. If a large financial institution runs into trouble for idiosyncratic reasons, then it is not clear how the problem institution would be handled. The assumption has generally been that there are “too big to fail” banks. This will mean that there is a marginal increase in the risk of a large institution in the US being allowed to fail in a way that hurts creditors, especially non-depository creditors. I say “marginal” increase in risk, because if a financial institution is large enough, and gets in trouble, the last thing a regulator would want to do is to frighten investors or depositors. Therefore, although the risk may rise slightly, the bill may affect ratings because they are based on marginal changes in risk. However, the fundamental risk posed by large US banks in terms of default, I would argue, would remain extremely small. This proposed bill would do little to change that. Small banks are already allowed to fail with losses often shared by investors and depositors. This bill doesn’t change that.

On the purely regulatory front, the Fed is expected to regulate all financial institutions with over $50 billion in assets, including non-banks. State chartered institutions with assets below $50 billion would be regulated by the FDIC. The OCC (Office of the Comptroller of the Currency) would regulate nationally chartered financial institutions with assets below $50 billion. The Office of Thrift Supervision (OTS) would no longer play a regulatory role.

CFPB

The second important focus of the bill is the creation of a Consumer Financial Protection Bureau (CFPB). It would have jurisdiction over financial institutions with over $10 billion in assets. It is far from clear how this would work in practice. Senator Dodd’s bill proposes that the Bureau be housed within the Fed, but be completely independent from the Fed. He argues that this way the Bureau wouldn’t be subject to the vagaries of funding which have often decimated other regulatory bodies in the past. He also argues that it won’t cost taxpayer money because the Fed pays the bill. However, since Fed profits pass to the Treasury, it is an indirect way of taxpayer finance, since it raises Fed costs. That is an example of why dealing with banking and central banking, in particular, is so tricky.

In the end, it is likely that some form of this bill will pass, with most of the provisions remaining. If it is gutted, then we will know that bank lobbyists have regained clout lost during the last crisis. That would represent a paradigm shift.

Tags: Bank Reform, Bank Reform Legislation, CFPB, Consumer Financial Protection Bureau, FDIC, Fed, Federal Reserve, OCC, OTS, Senator Dodd, Treasury