About 10
years ago, at the time global markets came to
grips with the significant frauds at the heart of
various organizations such as Enron, WorldCom and
Tyco, it was said repeatedly that accounting had
become the most adventurous profession on earth,
belying the general social classification of
accountants as boring middle-aged men wearing
glasses.
Indeed, the spectacle was
unexpected by the markets to the point that some
accounting firms such as Arthur Andersen and to
a lesser extent Grant
Thornton were pitchforked out of town as a result
of these scandals.
At the heart of the
accounting scandals that felled the mighty Arthur
Andersen was the inherent conflict of interest
between firms retained on behalf of shareholders
to verify the veracity of financial statements
(auditing) and firms that looked for ways and
means to improve the financial performance of
these very companies by effecting organizational
changes, cost cutting and strategic acquisitions
(consulting).
Over a period of time it
became obvious for accounting firms that their
consulting divisions were far more profitable - by
a factor of 10 times or so - compared to the
drudgery and resource intensiveness of auditing.
Boring middle-aged men wearing glasses
they may have been, but accountants were also
numerate enough to work out which way to lean
between auditing and consulting practices; and
whenever a conflict presented inevitably due to
little details on the auditing side, they chose to
side with the strategically more profitable
consulting division, thereby allowing financial
scandals to slowly fester under their very noses.
It was thus that when the scandals broke
loose various regulatory agencies and social
grandees gathered up the pitchforks and attempted
to set right the conflicts of the accounting
department.
That in effect meant that
auditors, instead of standing on the sides and
providing a watchful eye on proceedings at
companies, themselves became part of the action.
An analogy would be for a football (soccer)
referee to start playing for one of the teams
right in the middle of the game, even as he
attempted to call off-sides and dish out yellow
cards for foul tackles along the way. Conflicts of
interest are much worse in the world outside
sport, but are unfortunately not as easy to spot.
The new accountants What
accounts for the volatility in markets for the
past few days, barely a few weeks after central
bankers claimed to have created enough impetus for
an economic recovery globally? At the heart of the
volatility is the market's fear about central
bankers becoming sportsmen rather than staying as
regulators of the system.
Specifically,
the fear is that both the Federal Reserve and the
European Central Bank have abrogated their
responsibilities towards monetary policy and are
instead fully political arms of their respective
member governments.
Consider the Federal
Reserve: two massive injections of quantitative
easing (QE and QE2) aside, the Fed has also been
active in providing easy liquidity to both US
banks and European banks that need US dollar
funding.
By far the biggest one though is
the man I called the "master of illusion" (see Draghi:
Europe's master of illusion, Asia Times
Online, January 21, 2012), and referred to (albeit
tongue in cheek) as the Man of the Year 2012 in
January itself. The reason for that bit of
irritation with Maro Draghi, president of the
European Central Bank since last November, was of
course the idea that instead of serving as a
central banker he had become a full-fledged market
participant himself.
Consider the famous
"LTRO" or Long-Term Repo Operations that the ECB
took up. These were essentially below-market rate
loans to European banks (and a host of non-euro
area banks that bothered to have convenient
branches inside the eurozone) against secured
collateral. The trade worked for a bank as
follows:
Buy three-year local government bonds yielding
say 5% (Italian and Spanish banks could easily
achieve this earlier in the year thanks to the
sovereign bond crisis at the time).
Take the securities over to the ECB, which
would lend you money for three years at say 1%.
Banks would then post 4% profit on the deal
for the three years.
This is pure
arbitrage - and that is how the markets saw it.
With a capital gap of over US$150 billion,
according to the European Banking Authority (EBA),
in effect the granting of around $1 trillion by
the ECB in two tranches (the first in December and
the second in February) provided European banks
with "guaranteed" profits of over $40 billion
annually for three years, ie a net benefit of $120
billion. So, European capital problem solved and
off to the races we go: at least that was the
market's opinion in January, which is why we had a
great stonking global risk asset rally in the
first quarter of the year.
Except when
stuff doesn't actually follow the script: the
problem with the referee also doubling as the
center forward (going back to my soccer analogy)
is that sometimes they get tackled by the opposing
center forward and then can hardly get up, dust
themselves off and flash a yellow card. Not that
notions of propriety ever stopped central bankers,
as Exhibit A: the Swiss National Bank and its
duffer-style peg of the Swiss franc to the euro at
1.20 shows; the existence of such a rate simply
invites market participants to keep kicking it and
so they have with the level being penetrated this
week.
In Exhibit B, the problem with the
LTRO for European banks is of course that in order
to make the extra money that boosts their capital,
banks have purchased the debt of risky European
governments. Its not a problem if you purchase
bonds of France of Germany, but then there isn't
much money to be made between the yields of French
and German government bonds against the borrowing
rate from the ECB.
Thus the ECB action
essentially pushed a lot of European banks to
purchase the debt issued by the likes of Italy,
Spain and Portugal, accounting for the strong
performance of the bonds of these countries even
as the Greek sovereign bond tragedy worked its way
through the markets in the first quarter of this
year.
That is where the ECB fails as the
central bank - instead of being on hand to protect
the stability of the banking system it supposedly
has responsibility for ultimately, the central
bank has instead emerged as a gambler of last
resort, pushing banks to take on irresponsible
risks for short-term benefits.
The risk
for unsecured creditors - for example holders of
senior bank debt - has increased as a result of
ECB actions because any losses on government bond
holdings will not affect the ECB (as a secured
creditor) but rather hit bondholders and equity
holders.
Thus, the quality of capital
provided by central bank actions has been
exceptionally poor; and this is the "foundation of
tofu" on which global risk assets today find
themselves resting on.
People of the
American persuasion shouldn't exactly feel smug
about any of the above. If anything, the Fed has
been a worse culprit for the past three years by
taking a series of actions intended to preserve
the fake valuations rampant across mortgage-backed
securities in the books of US banks.
Indeed, it was actions such as TARP that
helped to ramp up the staffing levels of US banks
after 2009 with the resulting round of firings in
2011 and this year heaping significant
restructuring costs on their operations.
It is with some irony therefore that I
note the outlook for financial system stability in
both the US and Europe is seriously clouded by the
bankers' strategies resulting from central bank
initiatives. I believe that the case for gold as a
hedge against global financial system collapse has
been vastly strengthened by the actions of the Fed
and the ECB over the past few months.
(Copyright 2012 Asia Times Online
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