A couple of months ago, Nassim Taleb spoke out in Bloomberg about the “reforms” taking place in the financial system under the Obama and Geithner plans. He expressed his disgust and disappointment that not only are governments bailing out failed institutions but the new accounting standards being proposed after the crisis allow for even less transparency in reporting of gains and losses.

Towards the latter part of his interview Taleb briefly touched on a two-tier concept for the financial system: one side solely for utilitarian purposes but very low risk (banks), the other side solely for risk taking (hedge funds). The key to making this system work is that governments will be very protective of the banks for as long as they are not allowed to freely take risk, whilst the hedge funds can take on as much speculation as they wish, but are not subject to bailout. This would reduce moral hazard and would provide a more robust financial system. In a speaking engagement in Germany, Taleb specifically describes this two-tiered idea.

Former derivatives trader turned skeptical philosopher, Nassim Taleb, vents his frustration at the world financial system for allowing hindsight bias to fool them into a false sense of security which has now led to the worldwide financial crisis and recession.

Taleb criticizes economists for relying on theoretical models that have little bearing on the real-world appreciation of risk, and blames banks for throwing large amounts of capital on academics and PhDs whose economic theories were widely off the mark in anticipating the global crash.

(It’s just too bad the journalist couldn’t formulate better questions to appreciate the thinking of this guy. (Next to economists and academics, Taleb despises journalists too.)

We discussed some of Taleb’s ideas here before, notably the Platonic fallacy and fallacy of history, which are dangerous human tendencies that can lead to a grave misunderstanding of events which is exactly how he describes the current financial crisis.

Taleb is a skeptical empiricist: or one who considers historical evidence only as a PARTIAL indicator of probabilities, as opposed to naive empiricists who consider historical evidence as the complete basis for predicting future events. Skeptical empiricists like Taleb never admit to knowing the truth fully, and only fully consider evidence that DISPUTES a claim, while evidence that SUPPORTS a claim can never be fully accepted.

He was inspired by skeptical thinkers like Karl Popper whose theory of falsification we feature in this website. Popper also inspired the investment styles of other investors such as George Soros and Jim Rogers.

Aurelio “Gigi” Montinola III is the president of the Bank of the Philippine Islands, and one of the most respected bankers in the Philippines. He wrote the following messages, which I find as the most sober and forthright thoughts in this financial crisis.

Fellow Unibankers,

Attached please find a piece that I was supposed to write for an outside publication – unfortunately, I cannot submit it as the ending is perpetually changing.

What I thought to be a gathering storm to hit in the first quarter of 2009 has hit our beaches yesterday – the Philippine Stock Exchange had its highest (12. 27 %) drop in history a single day, and the Peso Dollar exchange rate is creeping back from around P 41: $ 1 to almost P 50 : $1. Like other markets in the region, the PSEI has dropped 50% ytd, and people are getting nervous.

It has now become a Fundamentals versus Emotion issue – Philippine economic fundamentals relative to the world and even Asia are good, and the banking system is stable, but Bloomberg 24×7 Television, local media reports, and cocktail party talk make people fear the worst, and then expect the worst.

We know however from experience that Filipinos are resilient and have survived the economic crises of the foreign debt moratorium in the 1980s and the Asian Crisis in the 1990s.

BPI remains well capitalized, strong, and prudent – and both our customers and the market analysts appreciate this. 2008 will show lower earnings than our banner year in 2007, and we must now worry about what 2009 will bring.

As in the past, this negative cycle will eventually pass, but in the meantime, we will have to prepare for the typhoon.

Let us all work together to take care of our customers, and in the process, keep BPI strong and our employees safe and secure in their jobs.

All the best,

Gigi Montinola

His message follows:

FINANCIAL TSUNAMI 2008

On Sept 15 2008, the unthinkable happened. Lehman Brothers, a Triple A credit rated, 4th largest, and 158 year old US investment bank, filed for bankruptcy. Merrill Lynch was rescued and sold to Bank of America, and one day later, AIG, the world’s largest insurer, announced its effective nationalization. This set off a chain of notorious “firsts” – a $ 700 billion bailout of the US banking system that almost did not pass, a country (Iceland) almost going bankrupt, and the largest UK banks in trouble.

By the IMF meeting on Oct 13, two additional unthinkables were unfolding. Global stock markets had fallen 20% in a week, the entire global banking system had almost collapsed, and it took the collective resolve of 27 European governments and the US to institute forceful emergency circuitbreaker measures to temporarily calm the world and prevent a catastrophic breakdown of financial markets worldwide. However, in the most free market oriented countries of the developed world, the US and the UK had effectively partially nationalized the largest banks without a public outcry.

How did this happen, and what is the effect on the Philippines, and the Pinoy citizen?

Act 1 – 2007 Housing Collapse

Home ownership ($ 20 trillion) and equities ownership ($ 20 trillion) are central to the American middle class dream of becoming wealthy. Borrowing money is equally ingrained – the US household debt today is larger than what the US can produce through its GDP (Gross Domestic Product). America became the world’s largest consumer of cheap imported goods, and China became the world’s largest producer.

Through a confluence of events, a deadly cocktail was being concocted.

First was increased home ownership demand in a boom time. Next was easy credit (1% US Fed Funds rate), and commercial banks relaxing credit standards (zero down payment) to lend to subprime borrowers (with minimal income) due to the belief that home prices would forever rise and therefore this would protect the loan from default. Third were investment banks securitizing or packaging a pool of these loans (“mortgage backed securities” ) backed up by credit agencies rating the top slices as Triple A credits. Finally, there were commercial banks and hedge funds with sophisticated risk models who greedily bought into these instruments as a means of increasing the yields on their books.

Initially, home prices soared 20% as the bubble grew with triple leverage (housing loan, investment bank securitization, and hedge funds buying). What was not apparent was that due to lax US regulations, investment banks had leverage (debt to equity ) ratios of
35 to 1, and unregulated Hedge funds had a 30:1 debt to equity ratio. Going up (2002 to 2007), everyone made money.

Suddenly, in 2007, some subprime borrowers defaulted, homes were foreclosed, and home prices fell. Countryside Financial, a US institution, almost failed, while Northern Rock, a UK institution, failed due to bad loans and falling house prices. The housing bubble had burst, and attention shifted to major commercial and investment banks with exposure to the housing sector.

Act 2 – 2008 Financial Markets Meltdown

First to go were the investment banks and AIG.

By regulatory fiat after the Great Depression, investment banks were separated from commercial banks. By anti regulatory bias in the past decade, Alan Greenspan, the US free market “maestro” of financial policy, and the Federal Reserve Bank took away a 12:1 debt to equity regulatory ceiling, and allowed investment banks to use “sophisticated” risk models to justify 35:1 debt to equity levels and help sell billions of dollars of CDOs (“collateralized debt obligations”) that eventually peaked at $ 55 trillion, which is the size of the world’s GDP! Worse, AIG sold $ 400 billion CDSs (“Credit Default Swaps”) insuring against the default of housing related securities.

The result should have been obvious. Normal leverage is 2:1 for a manufacturing company, 3:1 for a trading company, and 12:1 for a commercial bank. At 35:1, an investment bank happily made a 35% return on its capital if its position income only rose 1%; however, if the position dropped 10%, it would lose 350% of its position, and severely erode its capital.

Banks operate on liquidity (free flow of funds), solvency (amount of capital to pay for obligations), and Trust (market confidence in normally operating institutions).

Once the market saw the falling home prices deteriorating into potentially illiquid asset prices, counterparties started holding back and stopped dealing with suspect investment banks. Bear Stearns was rescued by JP Morgan at fire sale prices. Lehman had $ 19 billion in cash the day it went bankrupt; not enough counterparties could be found to deal with them. Merill Lynch was rescued by Bank of America, and Morgan Stanley by Mitsubishi UFJ. Even the proud and mighty Goldman Sachs announced it would become a commercial bank with lower leverage.

Next to go were the global stock markets, which acted more in unison even if the events were initially US based., In the Great Depression, 90% of the stock market value was lost from 1929 – 1932. Today, $ 9 trillion and 40% has been lost since the 2007 peak, and RBS, the largest UK bank, lost 40% in a day! Bloomberg became the most watched 24×7 television show in the world, and fear and panic begun to spread. Most felt “poorer”.

Third to go were the commercial banks.

Regulators, analysts, and banks themselves started becoming suspicious that other commercial banks held more “toxic” (illiquid or low priced) assets that they admitted, and that potential solvency issues lurked if asset positions in a suspect bank wiped out capital. Recent “Fair Value ” accounting practices amplified reporting earnings volatility, as once any item (housing prices) dropped, the industry was compelled to “Mark to Market” these items to the new low level. If Lehman could go, so could a commercial bank.

Since 2007, banks have reported $ 633 billion in losses, but have raised only $ 418 billion in new capital. If things got worse, who would they raise additional capital from?

In simple terms, Trust, as expressed in interbank (banks lending to each other) lending availability and price, is the Oxygen of the financial system. When it slows to a crawl, the whole system is prone to massive cardiac arrest. Most businesses and consumers operate on a certain assumed debt level, and once this breaks down, prices rise astronomically if funding disappears.

Suddenly, from easily accessible global financial markets fuelled by cheap and available money worldwide, an “Ice Age” of banking started. Banks with high loan to deposit ratios requiring them to borrow from the previously free capital markets were hit badly. Neither a US $ 700 billion troubled asset purchase program (“TARP”), or piecemeal European home country deposit guarantees initially helped.

Washington Mutual was bought by JP Morgan, and Wachovia by Wells Fargo in the US. The European solution was government based, as the UK, Dutch, and French governments offered massive government capital to save and strengthen household names like RBS and ING.

Effectively, 27 European governments voted together for 3 measures – partially nationalizing large “significant” banks, partially guaranteeing retail deposits, and guaranteeing interbank lending. The US followed by offering funding and partial nationalization to 9 banks, and direct lending to US corporations through the commercial paper market. The IMF put a brave front announcing the measures, but many wondered why the IMF was not more active in the process.

Act 3 – 2008 Countries in Crisis

Even countries started running into trouble – as of press date, Korea, Pakistan, and Argentina were in various forms of funding problems, and the latter two were rumored to have to go to the IMF. Iceland became the first Western country in 40 years to seek IMF help.

Act 4 – 2009 Real Economy Recession

Clearly, the next wave would be a real economy US and European recession, which would then overflow to the emerging market countries.

In the US, massive deleveraging has started, and unemployment has risen. The consumer spends 75% of a $ 14 trillion economy, and financial sector debt is 115 % of the GDP. Working capital bank lines are cut, while people strive to pay back credit card debt. Businesses are closing, and consumer related industries will suffer the most.

In Europe, the housing collapse in Spain and Ireland has spread to the financial services layoffs in the UK to overall demand cut everywhere.

A year ago, Asia hoped to “decouple” from the US; today, this is fantasy. Once the world’s largest buyer (the US) stopped buying, the world’s largest producer (China) would have growth cutbacks, with corresponding effects on the rest of Asia. GDP in the US and Europe could fall to zero or negative, but in Asia it would be lower growth, but still positive.

The Philippines – A Gathering Storm

Fortunately, the Philippines is small, far away, and of less marketing interest to sophisticated financiers. Also, its banking and insurance industries are more heavily regulated. In addition, the painful 1997 Asian crisis has left Filipino businessmen and bankers more cautious and more resilient than their Western (former) idols.

Given this, the Philippines dodged the Housing Subprime bullet, and was only minimally affected by the US investment bank and UK commercial bank crisis.

Philippine local currency banking operates normally, as Sept yoy lending growth remains close to 20%, while the deposit market remains fairly liquid.

We will go through dollar funding strain just like all other emerging market countries, but hopefully this storm will pass.

Banking is all about Growth and Earnings in good years, and about Liquidity, Solvency, and Trust in bad years. While growth and earnings will be significantly lower in 2008 and 2009, hopefully they will still be positive. Liquidity and Solvency should be manageable for as long as Filipinos continue to Trust the banking system to function normally.

However, we will be hit hard in 2009 – the first wave will probably be trade related, as the US cuts back on imports from the Philippines and China (which imports from the Philippines).

The second wave could be more fearful – a significant drop in OFW remittances as some lose their jobs or need more for their overseas needs. Today, we contend that we are more insulated due to global OFW diversification and higher level jobs, but in a global recession, we will not be spared.

What to Do

Just as we prepare for a typhoon, we have to prepare for potentially rainy days in 2009.

For businesses, your balance sheet will become critical. You must reduce your debt to acceptable levels, and you must think through your business model in a low growth economy. Fro example, can a 20% drop in revenue cover your overhead? If not, some serious cost cutting is needed.

For consumers, it will be time to reduce unnecessary expenses (electricity consumption, gasoline, impulse purchases) and to start saving even a small portion of your monthly income. Capital preservation is critical, so think through your KYC (“Know Your
Counterparty”), and your asset allocation. If you can, keep 25% in cash or bank placements, and 75% in fixed income instruments until you are brave enough to reenter the stock market.

If you want to spend anything, either ask yourself twice or postpone the decision for a day – you will be surprised how many items will feel less necessary or desirable the day after.

However, we Filipinos are resilient, and we will survive this crisis as we survived the bank moratorium in the 80s and the Asian Crisis in the 90s.

Good luck to us all!
AURELIO R. MONTINOLA, III
President
Bankers Association of the Philippines

President
Bank of the Philippine Islands

October 27, 2008

In a similar vein as films we have featured here before such as Money as Debt, Money Masters, and criticism posed by Zeitgeist Addendum, here is a documentary featuring personalities from the Mises Institute about the nature and flaws of the present monetary system. This is Money, Banking, and the Federal Reserve.

Latest news is that the US government has unveiled its intention to buy about USD250B worth of bank equity–to recapitalize their banking system. This in effect, nationalizes the US banking system, and after its absorption of Federal institutions Fannie Mae, Freddie Mac, Indymac, and recently AIG, puts the once proudly capitalistic country closer to its European counterparts: socialist.

Time notes that the US has become the United States of France:

Put it all together, and the America that emerges is a cartoonish version of the country most despised by red-meat red-state patriots: France. Only with worse food.

Admit it, mes amis, the rugged individualism and cutthroat capitalism that made America the land of unlimited opportunity has been shrink-wrapped by half a dozen short sellers in Greenwich, Conn., and FedExed to Washington, D.C., to be spoon-fed back to life by Fed Chairman Ben Bernanke and Treasury Secretary Hank Paulson. We’re now no different from any of those Western European semi-socialist welfare states that we love to deride. Italy? Sure, it’s had four governments since last Thursday, but none of them would have allowed this to go on; the Italians know how to rig an economy.

Some nitty gritty details. More from Marketwatch here:

Treasury Secretary Henry Paulson and Federal Reserve Board Chairman Ben Bernanke met with top chief executives of the largest banks and Wall Street firms Monday, and after the meeting details of the package began to leak out.

The Wall Street Journal reported that in addition to Treasury taking stakes in nine top banks, the Federal Deposit Insurance Corp. will insure new senior preferred debt for three years in order to get interbank lending restarted.

The Treasury plan would also raise deposit insurance for non-interest bearing accounts above $250,000.

The White House said that President Bush would meet on Tuesday with members of his working group on financial markets, which includes Paulson, Bernanke and the heads of the independent regulatory agencies.

The meeting would take place at 7:30 a.m. Eastern and Bush would make a statement at 8:05 a.m., the White House said.

That would be followed by statements from Paulson, Bernanke and Sheila Bair, the head of the Federal Deposit Insurance Corp.

I am not a Finance man, but the article below seems quite bad. Just fixing this seems to be a big problem, and other bankruptcies can occur anytime.

http://www.bloomberg.com/apps/news?pid=20601087&sid=ahwz_k5JvuB8&refer=worldwide

Sept. 29 (Bloomberg) — The Federal Reserve will pump an additional $630 billion into the global financial system, flooding banks with cash to alleviate the worst banking crisis since the Great Depression.

The Fed increased its existing currency swaps with foreign central banks by $330 billion to $620 billion to make more dollars available worldwide. The Term Auction Facility, the Fed’s emergency loan program, will expand by $300 billion to $450 billion. The European Central Bank, the Bank of England and the Bank of Japan are among the participating authorities.

The Fed’s expansion of liquidity, the biggest since credit markets seized up last year, came hours before the U.S. House of Representatives rejected a $700 billion bailout for the financial industry. The crisis is reverberating through the global economy, causing stocks to plunge and forcing European governments to rescue four banks over the past two days alone.

“Today’s blast of term liquidity will settle the funding markets down, and allow trust to slowly be restored between borrowers and lenders,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. On the other hand, “the Fed’s balance sheet is about to explode.”

The MSCI World Index of stocks in 23 developed markets sank 6 percent, the most since its creation in 1970. Credit markets deteriorated further as authorities tried to save more financial institutions from collapse.

European Rescue

European governments have rescued four banks in two days and the Federal Deposit Insurance Corp. said today it helped Citigroup Inc. buy the banking operations of Wachovia Corp. after its shares collapsed. The Standard & Poor’s 500 Index fell 3.8 percent and the cost of borrowing dollars for three months rose to the highest since January. The rate for euros hit a record.

“If people think the authorities may give in to fears, they are wrong,” Financial Stability Forum Chairman Mario Draghi said today in Amsterdam, where the international group of regulators and finance officials is meeting. “There is willingness and determination on winning the battle to restore confidence and stability.”

Banks and brokers have slowed lending as they struggle to restore their capital after $586 billion in credit losses and writedowns since the mortgage crisis began a year ago. The bankruptcy of Lehman Brothers Holdings Inc. also sparked fears among banks they wouldn’t be repaid by counterparties, driving up the cost of short-term loans between banks.

Funding Risk

“By committing to provide a very large quantity of term funding, the Federal Reserve actions should reassure financial market participants that financing will be available against good collateral, lessening concerns about funding and rollover risk,” the central bank said.

The Bank of England and the ECB will each double the size of their dollar swap facilities with the Fed to as much as $80 billion and $240 billion, respectively. The Swiss National Bank and the Bank of Japan will also double their dollar swap lines, while the central banks in Australia, Norway, Sweden, Denmark and Canada tripled theirs.

All the banks extended their facilities until the end of April 2009.

The Fed is also increasing the size of its three 84-day TAF sales to $75 billion apiece, from $25 billion. That means the Fed will make a total of $225 billion available in 84-day loans. The central bank will keep the sales of 28-day credit at $75 billion.

Special Sales

In addition, the Fed will hold two special TAF sales in November totaling $150 billion so banks can have funding available for one or two weeks over year-end. The exact timing and terms will be determined later, the Fed said. The TAF program began in December, totaling $40 billion.

The bank-rescue plan being debated by Congress today would give the Fed more power over short-term interest rates by providing authority as of Oct. 1 to pay interest on reserves held at the central bank by financial institutions. That would make it easier for the Fed to pump funds into the banking system.

Paying interest on reserves puts a “floor” under the traded overnight rate, which would allow a central bank “to provide liquidity during times of stress” without affecting the rate, New York Fed economists said in a paper last month.