NEW FINANCIAL ORDER

NEW FINANCIAL ORDER

SUMMARY

In a previous survey, the Free World Academy displayed the origins of the financial crisis (macroeconomic imbalances, immigration pressuring the wages, massive indebtedness to compensate the stagnation of wages etc. Go to Financial crisis). The present survey does not deal with these long-term causes. Our financial system is threatened by a cardiac arrest. In this circumstance, the therapy is not to advise dieting and exercise but to restart the heart. It means that this survey only proposes emergency solutions for the next financial summit, on November 15. It should set up an agenda for a new financial order.

Despite the different measures adopted by Central Banks and Governments, the financial crisis deepens. However, Central Banks as lenders of last resort have solved the liquidity problem by injecting massive money and Governments have insured deposits. The actual problem is insolvency of financial institutions notably because of their speculative positions on the derivatives.

An insurer of last resort can only solve the potential banking insolvency. Therefore, the participating States at the Conference should establish a letter of guarantee to insure the creditors of the strategic banks against any losses. In return, these banks would be bounded by five new regulatory requirements.

The adoption of this unique decision will bring a new financial order. It requires a strict methodology in order to avoid lip service.

1-METHODOLOGY 2-RESTORING SOLVENCY 3-REGULATORY 4-CONCLUSION

1-METHODOLOGY

The 15 November Conference cannot be compared with the BrettonWoods conference that took years of planning. It lasted three weeks and established the rules for commercial relations and for exchange rates to the dollar.

The next Conference must only focus on emergency measures related to the financial crisis . A first mistake should be to deal with broad subjects such as revamping the capitalism, define new exchange rates and so on. Such a matter could only lead to lip service. Another mistake should be to deal with the coming great depression. Sure, a great depression will raise unemployment but there is a delay before its happening and solutions would require an extensive preparation. Moreover, it is not possible to organize the deleveraging of the financial system and in the same time recommend the banks to lend everywhere and to anybody. An excess of credit has caused the crisis and it is not the right time to recommend more and more credit. The cause of the illness cannot be its medicine.

The European leaders must bring on the table some precise measures. Not one hundred, not ten, only one with five specifics . The US leadership will be precarious with a new president just elected and the present president still in charge. It means that the US will try to gain time and to dilute the decision into some vagueness framework for further conferences. Unfortunately, there is no more time: decision must be immediately taken to stop the meltdown.

Decisions must have effect in minutes . It is fruitless to decide some measures that would take effect within months or years (such as for example, the reform of the fair value accounting method). Emergency decisions must have immediate effect. For example, shut down the stock exchanges or forbid the short selling are decisions with immediate effect. Moreover, these measures would not be adopted for eternity. They may be provisory as most of rules in wartime. Sure, many measures should be removed once confidence is restored.

Of course, the Conference must carefully communicate in order to restore confidence and reduce uncertainty . The measures must be comprehensive, timely and should include some moral topics in order to appease the public anger against the financial meltdown.

Maybe it is too late. Many events can intervene before the 15 November. Maybe, it should be wise to shut down the stock exchanges in the next weeks to stop panic. This measure would have an advantage. Right now, the fall of the markets is boosted by the shadow financial system (hedge funds, brokers, dealers). They sell assets at fire prices to get cash and repay the redemptions of their investors (mainly located in tax haven). If stocks were closed, they could not pay redemptions and would go to bankrupt. It would clarify the situation. It would prevent the asset prices to fall much more than justified by economic fundamentals. It would appease the public anger by wiping out reckless investors.

1-METHODOLOGY 2-RESTORING SOLVENCY 3-REGULATORY 4-CONCLUSION

2-RESTORING SOLVENCY

The actual problem is the potential insolvency of financial institutions. Just as lenders of last resort addressed the problem of illiquidity, an insurer of last resort can only solve the potential banking insolvency: the State. Each Government should identify the strategic banks that cannot be allowed to fail. These institutions will receive a letter of guarantee to insyre their creditors against any losses. This common letter concerning all the banks listed by the Conference should be established by the 20 participating States.

21-The solvency problem

Illiquidity cannot be compared with insolvency. Illiquidity is just a circumstance and can affect a very sound firm. Insolvency means that the firm is structurally in bankrupt and appears in the accounts when the owner’s equity becomes negative. The Owners equity or net value is the amount left for the company’s owners after subtraction of liabilities from the assets. In a sound business Assets— liabilities = positive owners’ equity.

On the paper, the main banks have yet positive owner equity. Unfortunately, they have taken large speculative positions on the derivatives market. As a result, nobody can calculate what the real credit exposure is and the owner equity. All the banks suffer from a general uncertainty about their solvency.

Moreover, the banks are heavily leveraged . It means that they use debt rather than their own funds to finance their assets. Indeed, the leverage is good as long as the profit yields are superior to the interests paid! When business goes wrong, the leverage becomes a dreadful vulnerability. Let us suppose that with a capital of 10 and 90 of debts, you have 100 assets. If the assets only fall by 10%, your capital is lost! To evaluate the financial leverage, one compares in a ratio the owner equity to the assets. In a very safe banking, the ratio should be about 30% (Assets 30; capital 10). According to the IMF, the ratio only attains 5% for the US banks and 3% for the European banks in 2008 (Assets 300; Capital 10). It means that a fall of 3% in the assets can wipe out the owner equity of the banks. It means that, in present circumstances, all the banks are in potential insolvency.

Facing this situation, the banks must raise their capital . More capital means more assets in cash and a rise in owner equity. Unfortunately, since the over the counter operations are quite impossible to value, it is difficult to calculate the present equity price and nobody want to invest in a dark hole. As a result, the private market cannot play its role and the banks cannot find the funds they need. On the other hand, it is impossible to let banks going to bankrupt! The bankruptcy of a major bank has a systemic effect and can put in distress others banks in the world. Moreover, the depositors should be completely ruined.

22-Ineffective methods

In the present situation, the potential banking insolvency can only be solved by the State. Once this principle is stated, there are three methods: two bad and one effective.

221-The Paulson plan

The Paulson plan contemplated only the purchase of bad assets with its “Troubled Assets Relief Program” (TARP). Despite its amount of $700 billions, the Paulson plan did not stop the fall of the markets. The reason is easy to understand: consider again our solvency equation Assets— liabilities = positive owners’ equity with the following figures

Bad assets: 30 + good assets: 70- Liabilities: 90= owner equity: 10

Now let us suppose that the bad assets are purchased at their face value. In the equation, cash replaces the bad assets. The owner equity does not change but the bank situation looks far better. On the other hand, if the Treasury Department purchases at face value, the taxpayers are disavantaged because these bad assets have in fact a lower value than 30. Now let suppose that the Treasury purchases the bad assets at their real price: for example: 10. The bank equation becomes as follow:

Cash assets: 10 + good assets: 70 – Liabilities: 90 = owner equity: -10

It means that the bank is in bankruptcy. Therefore, the purchase of the troubled assets must be followed by the bringing of Treasury funds in order to restore the owner equity ( Right now, the Treasury Department announced the purchase of equity stakes in U.S. banks in order to increase the capital levels of those institutions).

Moreover, the program is very complicated and difficult to implement because there is not any valid price for these troubled assets (5; 10; or Zero ). The risk is to disavantage either the shareholders, either the taxpayers. An objective criteria for pricing these assets requires that financial analysts have to examine the underlying value of each asset. It could take several months and finally the Paulson plan did not bring its expected results.

222- Government ownership and nationalizations

Another method already used in Europe (Dexia; Fortis) consists to raise the banks equities with government participation, long-term loans or nationalizations. Of course, it is said that these programs are temporary and that the banks can be privatized again after proper restructuring.

In doing so, the Government meets the same problem as the private sector. It is impossible to calculate the present equity price and the Government is obliged to act blindly and does not know how much cash will cost the program. If it wants to evaluate the risk, it must realize a complete audit of the bank. Such a complete audit could last several months. Considering emergency, it is not a safe procedure. Go to: http://www.imf.org/external/index.htm

23-Our proposal: the letter of guarantee

There are more than 10,000 banks in the world. There are only about 50 major international banks located in the world financial centers. Of course, our proposal only applies to these 50 major banks. The first task of the Conference should be to list the major banks, which cannot be allowed to fail .

Secondly, the delegates of the main States should write a common and unique letter of guarantee stating that any creditor’s losses regarding these banks should be fully insured by these states. The letter would cover all the creditors, including the depositors, excepting the shareholders, the creditors not included in the financial statements and the creditors coming from tax havens (See below).

This letter of guarantee should be communicate everywhere through financial advertisements. This solution does not need immediate cash from the taxpayers and would restore both the underlying solvency of the major banks and the confidence in the financial markets. Its effectiveness needs ten minutes: the time of writing the letter.

Thanks to this solution, I bet that the Governments and the taxpayers will not have to pay a buck. Firstly, all the creditors of the 9,950 exotic banks will check out their positions and run to the major banks, bringing them a flow of fresh cash. Secondly, all the depositors in tax haven (about $10,000 billions) will repatriate their money in the major banks. Finally, these banks would become able to restore their equities with the private market.

In return, these banks would be bounded by five new regulatory requirements.

1-METHODOLOGY 2-RESTORING SOLVENCY 3-REGULATORY 4-CONCLUSION

3-NEW REGULATORY REQUIREMENTS

We do not propose hundred measures: only five express measures with immediate effectiveness

31-Unique task force of supervisors

The 50 major banks benefiting of the government guarantee should be subjected to close regulations. Instead of a new bureaucracy, we suggest a task force through a consortium of existing institutions under the monitoring of the IMF. Moreover, this task force will appoint a controller in each major bank. The controller will have extended investigations powers and a right of veto on the decisions of the board and the heads of each bank.

The task force of supervisors will impose a standardized financial statement whatever the country, including the disclosure of all off balance items. Similarly, the Conference should have better to ignore the reform of the credit rating agencies. Considering their scandalous behavior, the best guess is to empower the central banks or the IMF to manage the credit notations.

Regarding the specifics, it is difficult to set up procedures in the hurry. For example, the financial turmoil unveiled weaknesses in the application of fair value accounting method. It seems that this method increases volatility and procyclicality and worsen the severity of the crisis. On the other hand, proposals for alternative accounting method such as historical costs would reduce the transparency. Therefore, I think that the Conference should not deal with a so complex matter.

32-Containment of tax havens

The Conference should oblige the 50 major banks to close all their operations with a short list of tax havens.

President Sarkozy argued, “No bank that works with government money should be allowed to work with tax havens” such as the Cayman Islands. We agree because as long as tax havens do exist, all the speeches about a new regulation will only be lip service.

According to Transparency International, there are 50 tax havens in which more than 400 banks, two-thirds of hedge funds, two million of corporations and $10,000 billions of financial assets. Crime, narcotics, terrorism and grand corruption fuel tax havens. Many companies and wealthy people also use the tax havens in order to avoid taxes. (Of course, one may argue that fiscal evasion is a legitimate reaction against massive fiscal pressure but I cannot agree with that. If you think that your fiscal pressure is too high, you have just to close your luggage's, to buy a one-way flight ticket and to expatriate in another country. On the other hand, when you stay in the country, it means that you continue to enjoy high roads or free education without paying the taxes. It means that you are a free rider: the other taxpayers support the taxes you do not pay!)

33-A ban on hedge funds

The Conference should order the major banks to suppress and not renew any credit line for hedge funds . The 8000 existing hedge funds are mainly headquartered in tax havens and are a permanent cause of financial disorder.

Usually any public investment company such as mutual funds or equity funds are regulated and subject to limitations on short selling and the use of leverage. On the contrary, the hedge funds are not regulated. They borrow to the banks as much money as possible and speculate. When they register losses, they cannot repay the banks and cause financial disorder. Right now, the fall of the market is boosted by the hedge funds. They sell assets at fire prices to get cash and repay the redemptions of their investors.

Of course, it is impossible to control, regulate or monitor the hedge funds and other dealers, independent traders, brokers etc. Moreover, people have the right in a free society to invest and to take risk as much as they want. On the other hand, it is scandalous that they borrow in banking institutions. By the end, they risk the money of the depositors. Consequently, the Conference must clearly forbid any loan to this shadow bank system.

34-Bring transparency in the derivatives market

The Conference should decide that the major banks have to include the exposure of all the derivatives into their balances sheets. The Conference should also institute a central clearinghouse for the derivatives market.

In 2002, Warren Buffet wrote in his letter to Shareholders of Berkshire Hathaway : "The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear....[They] are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

However, a derivative is as old as finance. Today, Companies and countries purchase derivatives as insurance against a changing price of commodities and currencies or against a default credit. The value of a derivative depends on the value of its underlying financial asset ( a share of stock, an interest rate, a foreign currency, or a barrel of oil) or the current value of a benchmark, such as an index. This value is called the notional value.

The problem of derivatives has surged with a bold speculation . Let us consider the next figures coming from the Bank of international settlements:

------------------------Notional amount --------------------gross market value

Years--------------- 2005--------- 2007------------------- 2005----------- 2007

Total derivatives---- 297,606----- 596,004---------------- 9,748---------- 14,522

Credit default swap---13,908------ 57,894------------------- 243----------- 2,002

Yes, it is not a mistake: By 2007, the notional value of all the derivatives attains 596,000 billions of dollars. Just compare this value with other big pictures: The U.S. gross domestic product is about $15 trillion; the World's GDPs is approximately $50 trillion; the total value of the world's real estate, stocks and bond markets is estimated at about $175 trillion. Divide 596 trillion by the world population and it comes in $90,000 for every man, woman and child on the earth! Derivatives are broadly equivalent to three times the world asset. Clearly, speculation has gone mad!

Fortunately, the notional value is quite meaningless because there is a lot of double counting and many contracts are overlapped. According to the BIS, the real risk measure is the gross market value , which is the replacement cost of all existing contracts at prevailing market prices. On December 2007, the gross market value of derivatives was $14 trillion. It is yet a big picture (equivalent of the US GDP). It corresponds to the risk exposure if counterparties did not fulfill their contracts. Right now, many companies are discovering that their counterparty has gone to bankrupt and they must write down heavy losses corresponding to a share of their gross market exposure.

Of course, we do not recommend to shut down the derivatives market because many derivatives play a useful role for corporate and banks . However, we think that this market should be better regulated through a worldwide clearing house registering and netting all the contracts. Moreover, individuals acting as speculators should be evicted from the market, which would be limited to business pursuing useful economic purposes. Go to the Bank of international settlements: bis.org

35-Ethical laws

The Conference should adopt the principle to curb all the executives’ benefits in the 50 major banks . The single task force of supervisor should establish the new rules, enforced and checked by its controllers in each institution.

Indeed, many taxpayers become angry and do not understand how such a meltdown could occur. It is not possible to allow the bankers benefiting of the State guarantee to going on with their astronomic bonus, salaries, golden share and so on.

1-METHODOLOGY 2-RESTORING SOLVENCY 3-REGULATORY 4-CONCLUSION

4-CONCLUSION

The central banks have widened the availability of liquidities. However, the financial system is more and more weakened by illiquid assets and uncertainties about the bank solvency. It is quite impossible to find a private sector solution. Our unique proposal is the best guess to restore confidence in a new financial order.

Of course, our proposal cannot break the adverse feedback loop between the financial system and the global economy. On the contrary, we may expect that the develeraging process could curtail credit availability.

It means that a further conference will be necessary to manage the adverse effects of the coming great depression (Go to http://www.worldbank.org/.)

1-METHODOLOGY 2-RESTORING SOLVENCY 3-REGULATORY 4-CONCLUSION

Home page Legal advices Privacy policy Search engines Contact