The British election

by Biodun Iginla and Emily Straton, Senior News Analysts, the BBC and the Economist

Forget the hypotheticals and look at the policies. On that basis, the Conservatives deserve to win

Apr 29th 2010 | From The Economist print edition

IT IS a long time since quite so much seemed to hang on a British election. With a week to go, the polls suggest that the old duopoly, with either Labour or the Conservatives commanding comfortable majorities under Britain’s first-past-the-post system, has been replaced by a three-way split, with Nick Clegg’s Liberal Democrats on course to pick up around 30% of the votes, just behind David Cameron’s Tories and a whisker ahead of Gordon Brown’s Labour. The way Britain’s voting system works, tiny changes in the popular vote could make huge differences to how many seats each party gets. Horse-trading has already begun in expectation of a hung parliament. And so has conjecture of dramatic realignments—to the centre-left, to the centre-right, to the very United Kingdom.

The exciting possibility that the country’s electoral geometry could be redrawn has overshadowed what should be the centre of an election campaign. Britons must judge the parties on the basis of their policies and their current leaders. As polling day, May 6th, approaches, it is to be hoped that debate will increasingly focus on these substantial issues.

The Economist has no ancestral fealty to any party, but an enduring prejudice in favour of liberalism. Our bias towards greater political and economic freedom has often been tempered by other considerations: we plumped for Barack Obama over John McCain, Tony Blair over Michael Howard and a succession of Italian socialists over Silvio Berlusconi because we thought they were more inspiring, competent or honest than their opponents, even though the latter favoured a smaller state. But in this British election the overwhelming necessity of reforming the public sector stands out. It is not just that the budget deficit is a terrifying 11.6% of GDP, a figure that makes tax rises and spending cuts inevitable. Government now accounts for over half the economy, rising to 70% in Northern Ireland. For Britain to thrive, this liberty-destroying Leviathan has to be tackled. The Conservatives, for all their shortcomings, are keenest to do that; and that is the main reason why we would cast our vote for them.

In the Brown stuff

What of the current lot? In some ways, Gordon Brown is underappreciated. He has stood firm in Afghanistan. He kept Britain out of the euro, which Mr Blair wanted to join. No matter what he did, Britain was always likely to get mauled in the credit crunch: with its reliance on banks and property, it was bound to be hard hit. And, since the economic crisis began, he has mostly made the right decisions. He saved the banks, pumped money into the economy and did as much as any leader to help avert a global depression.

But a prime minister should not get too much credit for climbing out of a hole he himself dug as chancellor. Chancellor Brown poured money into public services. As a result, Britain’s budget deficit is almost as big as Greece’s in proportion to its economy; its public sector is larger. This is a time-bomb of a legacy, and one that Mr Brown is ill equipped to defuse. The prime minister has tended to take the side of producers—especially the public-sector unions—rather than consumers. He frustrated some of Mr Blair’s efforts to reform the health service and education and slowed down others once he became prime minister. There are mutterings about choice in Labour’s manifesto, but Mr Brown too often reverts to old-fashioned statism. He has run a grim campaign (see Bagehot), scarcely bothering to defend his record and concentrating instead on scaring people about the Tories’ plans.

Above all, the government is tired. Mired in infighting and scandal, just as the Tories were in 1997, New Labour has run its course (see article). Some hope that a hung parliament would usher in a refashioning of the centre-left: a Mandelsoned and Milibanded party would arise. But it is better for the country that Labour has its looming nervous breakdown in opposition. A change of government is essential.

The agony and the Cleggstacy

So why not change to the Liberal Democrats? Mr Clegg’s surge has been thrilling, all the more so since the viler attempts to smear him by a panicking Tory press seem to have backfired. This newspaper has been looking for a credible liberal party in Britain for nigh on a century. Mr Clegg is clever and charming. We share his enthusiasm for civil liberties and his willingness to stand up for immigrants. And he is right that the current voting system, which could mean that he ends up with the same number of votes as Mr Brown but a third of his seats, is unfair.

But look at the policies, rather than the man, and the Lib Dems seem less appealing. In the event of another European treaty, they would hold a referendum not on that treaty but on whether to stay in or leave the EU; odd, given that they also (wrongly) want to take Britain into the euro. They are flirting with giving up Britain’s nuclear deterrent. They would abolish tuition fees for universities, which would mean either letting the quality of British higher education slide still further or raising the subsidy to mostly well-off students by increasing state funding. They are worried about climate change but oppose the expansion of nuclear power, which is the most plausible way of cutting emissions. Their policies towards business are arguably to the left of Labour’s. A 50% capital-gains tax, getting rid of higher-rate relief on pensions and a toff-bashing mansion tax are not going to induce the entrepreneurial vim Britain needs. Vince Cable, the Lib Dems’ chancellor-in-waiting, recently dismissed the bosses who argued against the government’s planned National Insurance increase as “nauseating”; that feeling might well be reciprocated by the nation’s wealth creators if the Lib Dems came into power.

An international comparison is helpful. Germany’s Free Democrats have adopted both parts of liberalism: they believe in both civil liberties and the free market. The Liberal Democrats, a coalition between the distant heirs of a once-great governing party and more European-style social democrats, have not yet made the same jump to the radical middle. Optimists cling to the hope that a hung parliament and a realignment on the centre-right would bring that leap about, but for the moment the Lib Dems seem unsure whether they are to the left or the right of Labour. To the extent that elections are holidays from normal politics, Mr Clegg has been a delightful holiday romance for many Britons; but this newspaper does not fancy moving in with him for the next five years.

That leaves the Tories. They plainly have faults. They have run a lacklustre campaign. We dislike their Europhobic fringe and their exaggerations about Britain’s broken society. We thought they were wrong to oppose the economic stimulus after the banking crash. Mr Cameron is prone to bouts of complacency—amply illustrated by his refusal last year to use the expenses scandal as a pretext finally to get rid of Lord Ashcroft, a controversial offshore donor whose money the Tories plainly no longer needed. He has not done enough to convince voters that he is the man to bring change—and thus created an opening into which Mr Clegg has ably stepped.

But just as the kaleidoscope of this weird election has painted Mr Clegg’s relatively small advances in brighter colours, it has dulled Mr Cameron’s much bigger ones. Judged over the past four years, not the past four weeks, he has done a great deal to modernise his party, stamping out social illiberalism, reducing the Europe-bashing and adding environmentalism. During the boom years, his much-maligned chancellor, George Osborne, did not give in to demands from the right for tax cuts, pointing to the deepening hole in the government finances; at the Tory conference last year, when Mr Brown was still unable to mention “cuts”, Mr Osborne was also the first politician to commit his party to an austerity programme.

Since then, like the other parties, the Tories have gone quiet on the question of cuts. But, more than their rivals, they are intent on redesigning the state. They would reform the NHS by bringing in more outside providers; their plans to give parents and teachers the right to set up schools are the most radical idea in this election. Centralisers under Margaret Thatcher, they now want to devolve power to locally elected officials, including mayors and police chiefs. Some of this is clouded in waffle about a Big Society. Other bits do not go far enough: it is foolish to rule out letting for-profit companies run schools and wrong to exempt the NHS from cuts. But Mr Cameron is much closer to answering the main question facing Britain than either of his rivals is. In this complicated, perhaps inevitably imperfect election, he would get our vote.

Posted by biginla at 8:48 PM BST

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Financial regulation in America

by Judith Stein and Biodun Iginla, Financial Analysts for the BBC and the Economist

Banks face up to a tougher derivatives regime than many had expected

Apr 29th 2010 | NEW YORK | From The Economist print edition

FOR all the recent posturing on Capitol Hill, financial reform is coming. On three consecutive days this week Republicans blocked a motion to allow debate of America’s financial-regulation bill to begin on the Senate floor, an obstruction that Harry Reid, the chamber’s majority leader, denounced as “absurd and stunning”. The stand-off finally ended on April 28th, when the opposition party’s senators, worried about being branded as bankers’ friends, agreed to let discussion proceed.

The bill is now very likely to pass in some form, possibly as early as the end of May. But with the two parties’ chief negotiators having reached an impasse in bilateral talks, a number of big issues will have to be thrashed out on the floor. One is the treatment of troubled financial giants (although the two sides have got closer on some points). Another is the proposed consumer-protection bureau, which Republicans fear could be a recipe for regulatory overreach. A third is derivatives.

The last of these has been causing particular consternation on Wall Street. Until recently banks thought they knew what was coming: a palatable batch of changes that included standardised over-the-counter (OTC) bilateral contracts being pushed through central clearinghouses (which guarantee trades if one party defaults); exchange trading for more liquid standardised contracts; and higher capital and margin requirements for derivatives that are too customised for clearing.

Something changed in recent weeks, however. The fraud charges filed against Goldman Sachs, over synthetic derivatives, emboldened those looking to crack down on exotic instruments. On April 21st the Senate’s Agriculture Committee—which oversees the Commodity Futures Trading Commission (CFTC)—passed a surprisingly draconian set of derivatives provisions. Elements of this will be offered as an amendment to the main bill.

The most controversial bit is Section 106, which would prohibit entities with access to the Fed’s discount window—ie, banks—from trading swaps or using them to hedge their own exposures. At the very least, it would force banks to spin off their derivatives desks into non-bank subsidiaries, though some interpret the language to mean an outright ban. Some believe that Section 106 has been left in as a bargaining chip, to be removed in return for a Republican concession. But bankers are edgy. The White House, though queasy about a swaps ban, has not publicly opposed it.

A mere five entities account for more than 95% of American financial firms’ derivatives holdings. Of these, Morgan Stanley has the least cause for worry, since its swaps already sit in a non-bank subsidiary (see chart). For the others, moving the business would be costly, because bank-holding companies generally have a higher cost of funding than bank subsidiaries. Estimates of the extra capital required vary from $20 billion to several times that.

This puts a cash cow at risk. Derivatives-dealing has become one of the most profitable activities for Wall Street’s giants. The business is thought to have generated revenue of around $22.6 billion in 2009. JPMorgan Chase has said that fully one-third of its investment-banking profits came from OTC derivatives in 2006-2008.

Regulators, too, are nervous. The rules could drive derivatives to offshore markets, over which they have less control. The Fed would not be thrilled at the prospect of having to rely more on non-American banks as dollar intermediaries in the foreign-exchange-swap market. Pushing swaps into new entities may simply create a new class of firms that are too big to fail.

Even if Section 106 is dropped, there are other controversial derivatives-related issues. The bill has been toughened up to require all contracts that can be centrally cleared to be traded on exchanges (partly in response to lobbying from unions, which blame OTC derivatives for falling pension values). To the extent that this exposes in real time the volumes and prices of transactions, it is welcome. Bourses can expect to reap benefits (see article).

But some bankers worry that it could be the equivalent of ramming square pegs into round holes. Mandatory exchange trading is “a solution looking for a problem,” says the head of one bankers’ association. “End-users”—firms that use derivatives for hedging, such as airlines—are “not exactly clamouring for it,” he says.

Many of those end-users, which collectively hold 10-15% of OTC derivatives outstanding, also want exemptions from clearing. Without one, they argue, increased collateral requirements for cleared trades would make hedging their everyday risks much more expensive. As things stand, some commercial firms would get an exemption, while others—such as sweetmakers hedging against swings in sugar prices—would not. Other sorts of carve-out are being sought, too. Warren Buffett’s Berkshire Hathaway has lobbied hard, but so far unsuccessfully, against having to post more collateral for existing trades in its $60 billion derivatives book.

Regulators have further worries, too. In a memo circulated this week, the Fed complained that the bill’s language is too “hard wired”, leaving insufficient room to tweak rules as markets evolve. It also thinks the legislation unnecessarily restricts data-sharing among regulators. But it is the banks that are most perturbed. They shiver at the possibility of ceding ground to foreign rivals as forced spin-offs raise their costs—or, worse, having to use the likes of Deutsche Bank to hedge their interest-rate risk. Such worries may prove overdone. But a tougher regime than any of them expected a few months ago appears likely.

Posted by biginla at 8:40 PM BST

Updated: Friday, 30 April 2010 8:45 PM BST

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A special report on television

by Biodun Iginla, Tech Analyst for the BBC and the Economist

Television rushes online, only to wonder where the money is

Apr 29th 2010 | From The Economist print edition

Hulu’s stylish threat to TV

UNUSUALLY for a microchip-maker, Intel employs a team of anthropologists. The researchers travel from country to country, interviewing people and spending time in their homes to find out how they use technology. The ethnographers also quiz floor managers in electronics stores about what their customers want. These days many of the salesmen tend to say the same thing. People want a cable that will allow them to connect their computers to their television sets.

Just a few years ago the notion of using a computer to deliver television seemed far-fetched. There simply was not much video online—not much that was legal and non-pornographic, at any rate. That has changed. Each month the British request some 120m television and radio programmes from iPlayer, a website run by the BBC. Hulu, a website that offers shows from three of America’s four big broadcasters, streamed more than 1 billion videos in December 2009. YouTube, the biggest video-streaming website of all (and the oldest of the bunch, at the grand age of five), continues to expand.

At present online video draws fewer eyeballs than television, and for much shorter periods. The average YouTube user spends 15 minutes a day on the website, compared with the five hours that the average television viewer spends in front of the box. But the rapid growth of video-streaming websites, particularly in America, is worrying TV executives. As people acquire televisions, games consoles and set-top boxes that connect to the internet, will they come to see online video as a replacement for the regular stuff? “There is a small segment of the population for whom it is already a replacement,” says Chase Carey, the president of News Corporation.

Most video-streaming websites are supported by advertising. Anyone who wants to watch a video has to sit through a short “pre-roll” ad as well as a few short breaks in the course of a programme. These breaks are often accompanied by a countdown clock to reassure itchy viewers that they will not go on for ever. Advertising rates are high: reaching a viewer on a video website can be more expensive than on television. Yet this is achieved in part by restricting supply. A viewer who watches an hour-long drama on Hulu will be subjected to only a quarter of the number of advertisements that a viewer of the same show on TV has to sit through. The returns from online video are thus poor even before the websites take their cut.

And there are other knock-on effects. Because so many programmes are available at the click of a mouse, people may be less likely to buy boxed sets of their favourite shows. Spending on DVDs in America fell from $20 billion in 2006 to $16 billion in 2009. That was partly because of the recession and the spread of kiosks that rent out DVDs cheaply, but Mr Bewkes of Time Warner says there has been a particularly steep decline in DVD sales of TV shows available free online.

The biggest worry about online video is a broader one. The television industry is a complex and delicate edifice made up of many interlinked businesses. Online video threatens its stability—and, by extension, the fortunes of media companies.

One of the myths about the large media companies based in America is that they are diversified conglomerates. True, they do a lot of things. As well as making TV shows and films, News Corporation produces books and newspapers. Time Warner also makes magazines. Disney runs theme parks and licenses its characters to toothbrush-makers. Yet all these companies tend to derive the largest share of their revenues, and more than half their profits, from television.

The conglomerates’ TV businesses are themselves rather concentrated. Most of their revenues come from America. Their pay-TV channels are worth much more than their broadcast networks. And most of those pay-TV revenues come not from advertising but from the affiliate fees paid by cable and satellite firms for the privilege of carrying their programmes. A fifth of Disney’s entire turnover in the financial year 2008-09 came from this single source. In short, media companies depend on people’s willingness to stump up for multi-channel television each month.

So far they have not been disappointed. But in America, the world’s biggest pay-television market by far, all is not well. Viewers’ monthly bills for television have gone up by more than the rate of inflation in the past few years, pushed up by media firms’ demands for higher affiliate fees. Now broadcast TV stations are also demanding “retransmission fees”. Cable and satellite companies make little money on video as it is and do not want to see their margins eroded further, so disputes are becoming more frequent. Cablevision subscribers missed the first few minutes of the Oscars ceremony this year as the distributor fought with ABC over payment.

The routes out of this morass are unappealing. Cable and satellite distributors could drop the least popular channels. They could increase subscription fees. They will probably do both, which means people will be asked to pay more for less. “If the incumbents aren’t careful they are going to price their customers out of the market,” says Craig Moffett of Bernstein Research. And thanks to the video-streaming websites, viewers are no longer faced with a stark choice between a handful of live broadcast channels and a pay-TV service with hundreds of channels. A home with a broadband connection can get hold of broadcast TV shows both live and archived (the latter playing online with delightfully few advertisements), as well as a few programmes from pay-TV networks. These shows are arranged on websites that are attractive and easy to navigate. Best of all, this option is free.

Why pay?

How much video can viewers get hold of? Bain & Company, a consulting firm, studied the American TV schedules from the first few months of 2009 and found that just under half of the most popular shows were available free online within a week of being aired. Another 10% could be bought from services like iTunes, Apple’s media store. No doubt all the others could be obtained from websites like The Pirate Bay, which facilitate the exchange of copyrighted content.

The experience of other countries suggests that viewers will plump for something in between basic broadcast television and pay-TV. In Britain 17m households receive Freeview, which offers about 50 channels without charge. In Italy the number of households receiving free digital terrestrial television rose from 4.5m in 2007 to 11.6m in 2009, according to SNL Kagan, a research firm. Italians can use pre-paid cards to buy additional access to sport and films if they like. In both countries the rise of satellite TV has probably slowed as a result, although it has not stopped.

Here’s to a new business model

It is one thing to retard the growth of pay-TV, quite another to reverse it. In America, where nine out of every ten households already pay for television, that would require people to drop a service to which they have become accustomed. Still, some of them are tempted. In 2008 Dan Frommer, who writes for the Business Insider website, announced he was cancelling his cable TV service and becoming a “Hulu household”.

Television ventured beyond the box in search of viewers, which it found, and revenues, which it did not. Indeed, its pockets have been picked along the way. But TV executives know how to turn a plot. With much greater alacrity than people in other parts of the media industry, they have recognised the danger they are in and begun to construct a better online business model. They now think carefully about when and where they put their shows online. They usually leave a decent pause, generally between a few hours and a day, between a show airing and appearing on the internet. Viewers who really want to see a programme must watch it on television. After about a month many shows disappear from video-streaming websites altogether to protect DVD sales. Earlier this year Viacom pulled some of its comedy shows from Hulu and put them on its own websites, which carry more advertising. And there is talk about turning Hulu into a “freemium” service, with some shows accessible only to subscribers.

Experiments with charging are already in progress in Europe. RTL, a German free-to-air broadcaster owned by Bertelsmann, allows people to catch up free on many recent shows but charges them to view older episodes. It also lets people pay to see online episodes of “Gute Zeiten, Schlechte Zeiten”, a popular prime-time soap opera, several days before they air on television. It turns out that some people cannot wait to find out which handsome Berliner will end up kissing which other handsome Berliner. About two-thirds of those who pay for shows order advance episodes.

Canal Plus, a French pay-TV outfit controlled by Vivendi, has responded to the growth of online video and the advance of a telecoms competitor by offering lower prices. It launched two budget services, CanalSat Initial and Canal Plus Week-End. Firms like Canal Plus know that few people drop pay-TV once they have it—and they can always be “upsold” to more expensive packages.

Gamekeepers turned poachers

Perhaps the most important change is that cable and satellite distributors are developing their own online video services. Britain’s BSkyB is a pioneer. In 2006—the year after YouTube appeared—it launched a video download service, “Sky by Broadband”. Now rebranded as Sky Player, it streams 30 pay-TV channels to those who subscribe to the satellite service. Sky Player is also available, for a fee, for streaming via games consoles to those who do not have satellite dishes. That has brought quite a few customers to the service.

In America a more ambitious project, known as “TV Everywhere”, is under way. Pushed by Mr Bewkes, this would make pay-TV channels like HBO available online to all who can prove that they subscribe to them on television. TV Everywhere is a bold scheme—more of an aspiration, really—that demands co-operation from many media firms, television distributors and internet-service providers, all of whom have their own ideas about how to build an online video portal. But at least it has a sound business plan.

When the first TV Everywhere system launched, in December 2009, a few pay-TV networks caused surprise by running the same number of advertisements as they do on television. That was an abrupt change from the be-gentle-to-the-customer ethos that guided the early move online. It was also perfectly sensible. Although habitués of video-streaming websites scream whenever they see ad numbers increase, the average viewer seems to put up with it. Quincy Smith, who advises CBS, says the network has experimented with running 14 to 17 online advertisements in the course of a half-hour comedy show—quite close to the 19 ads a viewer would expect to see on television. More people watched the online shows to the end than the television ones.

A big reason why online video is so popular is that it is so pleasant to use. Hulu’s website is beautifully designed; YouTube has a useful recommendation engine. By comparison, the video-on-demand services offered by most cable and satellite companies are primitive. Many households have old set-top boxes, limiting efforts to build a better system. Even so, the user experience could be improved. For example, more advanced remote controls might be used to search for shows. Traditional TV will never be as innovative as the internet, but it can close the gap.

Those who expected television to wither when it encountered the internet greatly underestimated its ability to adapt. Some have even conceded the fight. Earlier this year Mr Frommer, who had given up pay-TV and become a “Hulu household”, took out a subscription to cable television. The decision was not his alone, he explained: his girlfriend wanted to watch fashion shows. The desire to please others is one big reason why television has proved so resilient.

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Posted by biginla at 7:52 PM BST

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The euro zone's debt crisis

by Biodun Iginla, Senior News and Finacial Analyst, BBC News and the Economist

Panic about the Greek government’s ability to repay its creditors is infecting other euro-area countries’ sovereign debt. Where will it end?

Apr 29th 2010 | From The Economist print edition

AFTER simmering for months, the Greek sovereign-debt crisis has boiled over. The promise of a rescue by the IMF and the country’s euro-zone partners, worth €45 billion ($60 billion) or more, is no longer enough to persuade many private investors to hold Greek public bonds. Opposition to the bail-out in Germany meant that market confidence had all but vanished by April 27th, when Standard and Poor’s (S&P) slashed its rating of Greek government bonds to BB+, just below investment grade. The rating agency also lowered its rating on Portugal, to A-; a day later it downgraded Spain from AA+ to AA.

In keeping with its practice when rating bonds as junk, S&P gave an estimate of the likely “recovery rate” should the worst happen. It said bondholders were likely to get back only 30-50% of their principal were Greece to restructure its debt or to default. That prompted panic in bond markets. The yield on Greece’s ten-year bonds leapt above 11% and that on two-year bonds to almost 19% at one point on April 28th. Portugal’s borrowing rates jumped, too (see chart 1). At those rates, the racier sort of hedge fund might still be prepared to gamble on Greece paying back its debts at face value, but mainstream funds are abandoning the bonds in their droves. The speculators blamed by officials for precipitating the crisis may now be the only people willing to take a punt on Greece.

Had the rescue been swift and squabble-free, there was a chance, albeit slim, that private investors might have rolled over their existing holdings of Greek debt at tolerable interest rates. That Greece’s would-be rescuers may not after all stump up the money they promised is one of the risks that bondholders are loth to bear—though Germany may now approve its share of the bail-out by May 7th (see article). Another is that Greece will not be able to stomach the programme of budgetary and economic reform which the IMF is due to set out in early May, and on which the euro-zone rescue funds will depend.

A third concern is that even if the programme runs smoothly, the debts that Greece will continue to rack up will be too great for its feeble economy to bear. Earlier analysis by The Economist suggested that Greek government debt would rise to 149% of GDP by 2014 even if its deficit reduction went well. It assumes that Greece could sustain a brutal reduction in its primary budget deficit (ie, excluding interest costs) of 12 percentage points. Even that relied on an interest rate of 5%, roughly what euro-zone partners have agreed they will levy on Greece, on all new borrowing and on maturing debt. If interest costs are much higher, the government will have to find extra savings elsewhere. The deep cuts will only prolong Greece’s recession. Wages will have to fall if the country is to regain the cost competitiveness needed for a recovery. Both influences will push down nominal GDP for a while and make crisis management all the more difficult.

The scale of the task and the bungling of the rescue make the bond market’s capitulation seem natural. Greece needs so much money that the only thing standing between the country and default is open-ended funding from the IMF and the rest of the euro area. The €45 billion fund announced on April 11th would be enough to cover Greece’s budget deficit and repay its maturing debts (including the €8.5 billion that falls due on May 19th) for the rest of 2010. But Greece may need as much again in 2011 and still more thereafter. In an average year, Greece has to refinance around €40 billion of its debt (this year, would you believe, is a mercifully light one for redemptions). Add to that the €70 billion or so of fresh borrowing that may be needed to cover Greece’s cumulative budget deficits until 2014 and the scale of a credible rescue fund becomes clear.

Yet Greece’s would-be rescuers may feel they have little choice but to press on with the bail-out. A default that would cut the value of Greek public debt by a half or more would cripple the country’s banks. (S&P has also downgraded four of them to junk status.) It would also spark a wider financial panic in Europe. Around €213 billion-worth of Greek government bonds are held abroad. The Bank for International Settlements (BIS) estimates that foreign banks’ lending to Greece’s government, banks and private sector was €164 billion at the end of last year. How much of this is public debt is unclear. But if half of the foreign holdings of government bonds are held by banks, and if each country’s banks owns those bonds in proportion to their total holdings of Greek assets, then perhaps €76 billion is held by euro-zone banks (see table 2).

Euro-zone countries might be tempted to let Greece default, force non-bank investors to take a hit, and use the funds earmarked to rescue Greece to fortify their banks instead. That would cost perhaps €53 billion if, as S&P fears, a restructuring of Greek debt resulted in losses of as much as 70%. That may look small next to a rescue fund. But if Greece defaulted it would still rely on its EU partners to fund its budget deficit, which will take time to shrink from the 13.6% of GDP it reached last year. It seems there are no longer any options for Greece that will not cost its partners a lot.

The risk of contagion

Other countries may now need a helping hand, too. The hope that Greece’s problems could be contained now seems faint. There is growing anxiety about the poor state of public finances in Portugal, Ireland, Italy and Spain. Each has some combination of big budget deficits and high public debt, though none is as financially stretched as Greece. But their deeper problem stems from a decade when wage growth ran far ahead of productivity gains. Stuck in the euro, they can no longer cure that malady by devaluation. The only remedies are a period of wage restraint combined with structural reforms aimed at boosting productivity. These will take time, as well as political will, to put in place. The danger is that restless bond investors will not wait.

Portugal is first in the markets’ sights. Its ten-year bond yield rose to 5.7% on April 28th, the highest for more than a decade, in the wake of the S&P downgrades and the anxiety about the size and timing of the Greek bail-out. A week earlier its yields were below 5%. Portugal could be forgiven for feeling picked on. Although its budget deficit last year was an alarming 9.3% of GDP, that was lower than Greece’s. Its public debt, at 77% of GDP last year, is less scary too. That is, in part, the result of a programme to slash the deficit in the years before the global financial crisis struck, and gives Portugal’s government a credibility that Greece lacks. On April 28th its prime minister, José Sócrates, said he and the opposition had reached agreement on speeding up an austerity programme.

Yet Portugal shares three weaknesses with Greece. First, its economy is small (smaller, indeed, than Greece’s), accounting for 2% of euro-area GDP. It offers investors very little diversification. Those who want safe claims in euros can simply lend to Germany or France, and save themselves any worries about Portugal’s economy and public finances.

A second weakness is competitiveness. Greece at least had a boom after it joined the euro in 2001. Portugal seemed to exhaust the benefits of the euro before the currency was born. It grew healthily in the late 1990s as its interest rates fell to converge on Germany’s in the run-up to the euro’s creation. But it has never recovered convincingly from the downturn that followed. GDP grew by an annual average of less than 1% between 2001 and 2008; productivity growth was weak. Nominal wage growth of 3% a year further undermined competitiveness.

Portugal has got by on a drip-feed of foreign capital. Its current-account deficit averaged 9% of GDP in 2001-08. The cumulative impact of those deficits is behind the third weakness it shares with Greece: the foreign debts that its firms, households and government have run up. The IMF reckons that Portugal’s net international debt (what residents owe to foreigners, less the foreign assets they own) was 96% of GDP in 2008, an even higher ratio than Greece’s (see chart 3).

A good chunk of the gross debt is held by foreign banks: The BIS puts the figure at €198 billion at the end of last year, around 120% of GDP (see table 4). The bulk of this has been borrowed by homeowners and businesses. The debt has to be rolled over from time to time, which makes Portugal, like Greece, vulnerable to a sudden change in sentiment. As with Greece, the bulk of public debt is held abroad and the country’s low saving rate means it too depends on foreign buyers of fresh debt.

Could contagion spread further? Spain looks most at risk. Its dependence on foreign finance is on a par with Greece’s. Spain’s public-debt burden, at 53% of GDP last year, means its fiscal position is among the least worrying of all rich countries’ (though an eye-watering deficit means that burden is rising fast). The country’s biggest task is to convince foreign investors that its economy will revive without further infusions of credit. Though Italy has a big public-debt burden, it can hope to rely on domestic savers to buy its government bonds. Its net foreign debts and current-account deficit are fairly small by rich-country standards. Much of the Irish assets held by foreigners are factories and offices, rather than bonds and loans, so Ireland is less prone to a sudden stop of overseas finance. It also has a good record of putting its public finances right.

Do the rumblings in Greece signal a wider retreat by investors from sovereign debt? Defensive Eurocrats point out that the public finances of the euro area as a whole are no worse than America’s. The IMF reckons that America’s net public debt will be 70% of GDP this year, against a euro-zone average of 68%. But the zone is not a single fiscal entity and investors are wary of countries whose finances or growth prospects are worse than average.

America has the great advantage of issuing the world’s reserve currency. In crises, scared investors rush into American Treasuries, which are prized for their liquidity. That is why Treasury yields fell this week as Greece’s soared. That hunger for American assets has lifted the dollar against the euro (and the yen, sterling and the Swiss franc) since the start of the year. That at least is some comfort for members of the euro zone. When countries accounting for more than a third of its GDP are struggling in export markets, that is exactly what they need.

Posted by biginla at 7:45 PM BST

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Germany and Greece

by Biodun Iginla and Natalie de Vallieres

The prospect of a bail-out is causing resentment in both Germany and Greece

Apr 29th 2010 | ATHENS AND BERLIN | From The Economist print edition

A message from Athens

ANGELA MERKEL’S political credibility has not yet been downgraded to junk status, but the past few days have done it no good at all. A few weeks ago the German chancellor was basking in plaudits for taking a hard line against a European bail-out of Greece. That was before George Papandreou, the Greek prime minister, bowed to the inevitable on April 23rd and asked for the €30 billion ($40 billion) loan pledged by Greece’s euro-zone partners, of which Germany’s share is about €8 billion. A further slice, of perhaps €15 billion, may come from the IMF.

Now Mrs Merkel is under fire both from those who had praised her and from those who now blame her for dragging out the rescue, further destabilising financial markets and raising the ultimate cost of the bail-out. Reported politicians’ estimates of the whole bill have soared to €120 billion and far beyond, with a correspondingly greater contribution from Germany.

Many Germans feel they are being forced to choose between two basic principles of their post-war economic order: economic stability and integration within Europe. They gave up the D-mark in 1999 on the understanding that the euro would be equally stable and that German taxpayers would not have to pay for other members’ mistakes. The impending bail-out of Greece—and perhaps later of Portugal and even Spain—would mean the end of that bargain. A Greek bail-out would no doubt face a challenge in Germany’s constitutional court. But to withhold aid would endanger the currency and rattle the banks, some of them German, with billions of euros’ worth of Greek debt on their books.

The crisis could not have come at a politically more awkward moment. On May 9th elections will be held in North Rhine-Westphalia, Germany’s most populous state. There, a coalition of the Christian Democratic Union and the liberal Free Democratic Party, the same alliance that Mrs Merkel leads in Berlin, is fighting an uphill battle to remain in office. A loss would cost her government its majority in the Bundesrat, the upper house of the legislature. But the perception that she is dragging out the process to avoid irritating voters is also damaging her credibility both at home and abroad.

Now the process seems to have shifted into higher gear. On April 28th the chiefs of the IMF and the European Central Bank met German parliamentary leaders in Berlin. The finance minister, Wolfgang Schäuble, says the government could agree on legislation by May 3rd and get it through the parliament by May 7th. Voters in North Rhine-Westphalia will then decide whether to punish Mrs Merkel.

If Germans resent having to bail out the Greeks, the Greeks dislike the terms on which the rest of the euro zone and the IMF will come to their aid. The official jobless rate has risen to more than 11%, but that fails to take into account many women reluctant to register as unemployed.

Things are about to become more difficult. A three-year reform programme being put together by the IMF, the European Commission and the ECB aims to cut the budget deficit from 13.6% to 2.7% of GDP in just three years, an ambitious target in a shrinking economy. A new pensions law, which is due to be adopted in May, will raise the retirement age for both men and women and reduce the pensions paid by state-controlled corporations. Applications by civil servants to take early retirement under the existing scheme have already jumped by 30%.

The overstaffed public sector will be severely pruned. No one is certain how many jobs will go. But if the programme is rigorously implemented, more than 100,000 Greek public-sector workers will be put out of work by 2013—by a government that came to power promising “more social protection”.

So far, resignation not fury has marked street protests organised by trade unions and the Greek communist party. Fortunately for Mr Papandreou, his Panhellenic Socialist Movement, known as Pasok, dominates both ADEDY, the umbrella public-sector union, and GSEE, its private-sector partner. But the austerity measures the government adopted before the crisis reached boiling point—civil service pay cuts and a hiring freeze—are only just beginning to bite. Infighting in both unions is on the rise; small private-sector unions have already broken ranks and other hardliners are likely to gain ground.

Opinion polls suggest more than 60% of Greeks oppose the government’s decision to call in the fund. The IMF’s reputation for imposing harsh reforms, along with the partial surrender of sovereignty to an American-based institution, seems bound to make Greeks cross. Criticism of Germany, by comparison, is muted.

Posted by biginla at 7:34 PM BST

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Europe's sovereign-debt crisis

by Natalie de Vallieres and Biodun Iginla, Financial Anlaysts for BBC News and the Economist

The Greek debt crisis is spreading. Europe needs a bolder, broader solution—and quickly

Apr 29th 2010 | From The Economist print edition

THERE comes a moment in many debt crises when events spiral out of control. As panic sets in, bond yields lurch sickeningly upwards and fear spreads to shares and currencies. In September 2008 the failure of once-stellar Lehman Brothers almost brought down the world’s banking system. A decade earlier, Russia’s chaotic default on its sovereign debt rocked the credit markets, felling Long Term Capital Management, a hugely profitable American hedge fund. When the unthinkable suddenly becomes the inevitable, without pausing in the realm of the improbable, then you have contagion.

The Greek crisis—or more properly Europe’s sovereign-debt crisis—looks dangerously close to that (see article). Even as negotiators from the European Union and the IMF are haggling with the Greek government over an ever-growing bail-out package, the yield on Greek debt has ballooned: two-year bonds soared towards 20% this week. Portugal’s borrowing costs jumped. Spain’s debt was downgraded, along with Portugal’s and Greece’s, and Italy came worryingly close to a failed debt auction. European stockmarkets have slumped and the euro itself fell to its lowest level in a year against the dollar.

The road into Hades…

It will strike some as mystifying that a small, peripheral economy should suddenly threaten the world’s biggest economic area. Yet, though it is only 2.6% of euro-zone GDP, Greece sounds three warnings that reach far beyond its borders.

The first is economic. Greece has become a symbol of government indebtedness. This crisis began last October when its new government admitted that its predecessor had falsified the national accounts. It is labouring under a budget deficit of 13.6% and a stock of debt equal to 115% of GDP. It cannot grow out of trouble because of fiscal retrenchment and its lack of export prowess. It cannot devalue, because it is in the euro zone. And yet its people seem unwilling to endure the cuts in wages and services needed to make the economy competitive. In short, Greece looks bust.

Few, if any, European countries suffer from all of Greece’s ills, but many scare investors. Portugal has a high budget deficit and is chronically uncompetitive. Spain has a low stock of debt, but it seems unable to restructure its economy. So too Italy, which is heavily indebted to boot. Non-euro-zone Britain has let its currency fall, but its budget deficit is unnerving.

The second lesson is political. Two weeks ago, having concluded that an eventual Greek restructuring was all but inevitable, we said Europe’s leaders had “three years to save the euro”. We presumed that they would quickly get a proposed €45 billion ($60 billion) deal to stave off an imminent and chaotic Greek default, buying time for an orderly rescheduling and for the other weak economies to begin overdue structural reforms. We overestimated their common sense.

The chief culprit is Germany. All along, it has tried to have it every way—to back Greece, but to punish it for its mistakes; to support the Greek economy, but not to spend any money doing so; to treat this as just a Greek problem, when German banks and German citizens, who lend to Greece, stand to lose money too. German voters do not favour aiding Greece. But rather than explain to them why it is in Germany’s interest, the chancellor, Angela Merkel, has run scared of upsetting them before a big regional election on May 9th.

Playing for time has backfired. Now the mooted rescue plan has climbed above €100 billion because no private money is available. The longer euro-zone governments dither, the more lenders doubt whether their promises to save Greece are worth anything. Each time politicians blame “speculators” (see article), investors wonder if they understand how bad things are (or indeed that investors have a choice). Euro-zone leaders initially refused to seek IMF help because it would be humiliating. Their ineptitude has done far more than their eventual decision to call in the IMF to damage the euro.

This political and economic failure leads to the third Greek warning: that contagion can spread through a large number of routes. A run on Greek banks is possible. So is a “sudden stop” of capital to other weaker euro-zone countries. Firms and banks in Spain and Portugal could find themselves shut out of global capital markets, as investors’ jitters spread from sovereign debt. Europe’s inter-bank market could seize up, unsure which banks would be hit by sovereign defaults. Even Britain could suffer, especially if the May 6th election is indecisive.

What then is to be done? The mounting crisis—and the fact that Greece will almost certainly not pay everybody back on time—will renew some calls to abandon it. That would spell chaos for Greece, European banks and other European countries: the effect would indeed be Lehman-like. Hence the necessity, even at this stage, of a show of financial force, linked to the construction of a stronger firewall between Greece and Europe’s other shaky countries. The priority for European policymakers is to do the same as governments eventually did with the banks: to get ahead of the crisis and to convince investors that they will spend whatever is necessary.

…and the expensive way back

The economics starts with the politics. Europe will not stem this crisis unless its decision-making apparatus is overhauled and Germany radically changes its tune. Mrs Merkel needs to go on German television and explain to her people what is at stake—laying out how much Germany has gained from the euro and what it has to lose from a cascade of chaotic sovereign defaults. Germans need to understand the risks to their banking system and their prosperity. They need to understand that stemming Greece’s debt crisis is less an act of charity than of self-interest. However unfair it seems—and the frugal Germans are as furious about the profligate Greeks as the rest of the world was about bankers—a bail-out is justifiable on the same logic: doing nothing would cost them even more.

The resolve cannot stop at Germany’s borders. Financial markets have no idea who is in charge. Europe’s Byzantine decision-making structure does not help but Germany needs to ensure that decisions are reached fast, that Europe speaks with one voice—and that co-ordination with the IMF is smooth. As a way to convince financial markets that the political weather has changed, the euro zone should set up a single crisis-management committee, with the power to take decisions.

Political resolve won’t work unless the underlying economics make sense. The first test of this is the Greek package. In return for fiscal and structural adjustments that give the economy a hope of stabilising its debts, this must provide enough money to prevent a forced default. Up to €150 billion may be needed over the next three years—better to err by offering too much. But the firebreak between Greece and the other embattled sovereigns of the euro zone is even more important. In economic terms, that should not be too hard to justify. Despite their problems, no country other than Greece is manifestly bust. Portugal is in the greatest danger, but it has a better history of fiscal adjustment which, under plausible assumptions, could allow its debt to stabilise at a manageable level. Spain and Italy could be made insolvent by a long period of high interest rates. But none has the near-inevitability of Greece.

Europe’s policymakers must make those distinctions clearer. The vulnerable economies must step up the reforms they need to rein in deficits and boost growth. Portugal, especially, needs action. The European Central Bank should demonstrate that it has the tools to maintain liquidity even if there is panic. Euro-zone governments should pre-emptively create inter-governmental liquidity lines. Thanks to extraordinary incompetence, Europe’s leaders have almost ensured that the Greek rescue failed before it began. They are paying for that today.

Posted by biginla at 7:09 PM BST

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The Goldman hearings

by Judith Stein and Biodun Iginla, BBC News and the Economist

A ghastly day on Capitol Hill for Goldman Sachs’s top brass

Apr 28th 2010 | NEW YORK | From The Economist online

“ONE of the worst days of my professional life” was Lloyd Blankfein’s characterisation of April 16th, when the Securities and Exchange Commission (SEC) filed civil fraud charges against Goldman Sachs. The bank and an employee were accused of failing to disclose that a hedge fund that had influenced the composition of a complex mortgage-debt transaction was also shorting it. April 27th was surely not much better, either for the Wall Street firm’s boss or any of the six other current and former Goldman investment bankers who testified before the Senate Permanent Subcommittee on Investigations. The roasting, which lasted more than ten hours, was as dramatic as any hearing focused largely on synthetic collateralised-debt obligations (CDOs) could be.

Goldman’s persecutor-in-chief was the panel’s chairman, Carl Levin. The gruff Democrat went beyond the SEC’s complaint, accusing the firm of having concocted several deals, not just one, to profit from the collapse of the housing market, and also of being riddled with “inherent conflicts of interest.” Not content merely to skewer America’s pre-eminent investment house, the senator harrumphed that its conduct “calls into question the whole function of Wall Street”—a market that, while supposedly free, “isn’t free of self-dealing.” His attack rested, in part, on internal Goldman e-mails. In one, a senior executive described a Goldman-underwritten CDO as “one shitty deal”. In another, a colleague applauded the structured-products team for making “lemonade from some big old lemons.”

The team’s representatives at the hearing squirmed in the spotlight. Fabrice Tourre, the employee charged by the SEC, firmly denied misleading investors. But he and his colleagues, coached by lawyers in light of the SEC case and clearly fearful of committing a legal faux pas, came across as evasive. At times the dialogue resembled a Pinter play: a question, then a long pause, followed by a spare, cryptic response.

The firm’s senior executives put up a stronger, clearer defence. In response to Mr Levin’s assertion that Goldman had profited from others’ misery with a “big short”, David Viniar, the bank's chief financial officer, pointed out that its net revenues in mortgages were a mere $500m in 2007, with a loss of $1.2 billion in 2007 and 2008 combined.

Mr Blankfein gurned incredulously at some of the senators’ questions, doubtless baffled that they would characterise as immoral profiteering what he viewed as nothing worse than prudent risk management. (He must have wondered if Goldman would have been better off from a public-relations point of view by incurring giant losses, like Citigroup.) But he also struck a conciliatory tone, expressing gratitude for support from taxpayers, who were “understandably angry” towards Wall Street, and declaring that everyone in the industry has to “ratchet up their standards”.

Nevertheless, he argued that criticism of Goldman’s motives rested on a misunderstanding of the market-making business. Unlike money managers, market-makers owe no fiduciary duty to clients, and offer no warranties; their only responsibility is to make sure those they serve are getting the risk exposures they seek. Ironically, Mr Blankfein was at his most uncomfortable when tackling questions about a disclosure the firm had made, rather than one it had not: its decision to release e-mails that happened to reveal details of Mr Tourre’s personal life, a move leading to speculation that the Frenchman was being, as one senator put it, “hung out to dry”.

The hearing produced no smoking gun, but there was much that looked bad for Goldman. The reputational damage is hard to gauge, but it was not a good sign that Goldman was the butt of jokes this week at the Milken Institute’s Global Conference, an annual gathering of businesspeople and policymakers in Los Angeles. One panellist even drew a parallel with Drexel Burnham Lambert, an investment bank that went from best to bust in a matter of months 20 years ago. Some of Goldman’s institutional clients, such as CalSTRS, a Californian pension fund, have publicly expressed concern. It won’t help that shareholders have began filing suits this week. (On April 28th, Goldman’s share price was 15% lower than on April 15th, the day before the SEC announced it was launching its case.)

Goldman’s grilling all but ensures the passage of the Volcker rule, clamping down on banks’ proprietary trading and investments in hedge funds and private equity, as part of a broader financial-reform law. It will also add to pressure for broker-dealers to act with the same fiduciary duties towards their clients as investment advisers, a move already being contemplated by lawmakers. No wonder the usually chirpy Mr Blankfein looked so drained by the time he was let go, after almost four hours in the hot seat.

Posted by biginla at 9:41 PM BST

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Thailand's crisis

by Xian Wan and Biodun Iginla, BBC and the Economist's News Analysts

No peace, no war in Thailand

Apr 26th 2010 | BANGKOK | From The Economist online

IT TOOK several anxious days, and a lethal grenade attack, for Thailand’s warring sides to reach a tentative peace deal. Its unravelling was swift and disheartening, and brings Thailand back to the brink of further unrest. On April 23rd red-shirt protesters, who are camped out in Bangkok’s shopping district, revised their demand for snap elections, saying a three-month timetable was acceptable. Peace seemed to have broken out, to the relief of residents braced for another violent showdown between security forces and the red shirts, whose rallies attract tens of thousands.

But the next day the prime minister, Abhisit Vejjajiva, shot down the peace plan. He said he would not be forced into dissolving Parliament, which is the rallying cry of the red shirts’ six-week-long protest in the capital. In a taped interview broadcast on April 25th, Mr Abhisit held out little hope of a compromise. He said his government was working to retake the streets from the demonstrators, without giving details, and said his solution “may not please everyone”. By his side, in a show of unity, was the head of the army, General Anupong Paochinda, who has been resisting pressure from government and military hawks to crack down hard. He wants a political compromise to end the crisis. He may not get one.

The seizure of Bangkok’s tourist and shopping hub is choking the city's economic recovery. Several luxury hotels and malls have been closed for weeks. Companies are pulling out expatriate staff. A grenade attack on April 22nd against a crowd of pro-government protesters that killed one person and injured dozens more has alarmed business people. Many foreign governments promptly warned their citizens against non-essential travel to Bangkok.

But a bloody attack on a sprawling fortified encampment could deal an even worse blow to Thailand’s reputation for stability. Few believe that a crackdown would silence the calls for political change. Indeed, it may inflame a movement that has the support of working-class and rural Thais who already feel cheated by Bangkok’s royalist elite and its political wing. Inside the red shirts’ squalid bamboo-fenced encampment, televisions screen bloody footage of the April 10th clashes with security forces that left 25 dead and over 800 injured.

Protests are starting to spread in the north east, a stronghold of Thaksin Shinawatra, ousted as prime minister in the 2006 coup and still a hero to many red shirts. Over the past week, protesters have blocked a train carrying troops and equipment, and obstructed police units on their way to the capital. Power lines and a fuel-storage tank have also been targeted by unknown bombers, whose sabotage thankfully failed. After four years of political upheaval, Thai newspapers fret over the risk of all-out civil strife.

The army could still be used to disperse protesters. By offering no clear alternatives to the scotched peace deal, Mr Abhisit may be leaning that way, urged on by royalist backers who see no need for a truce. He is right to argue that holding another election will not solve Thailand’s protracted crisis. There is also a risk that raising a mob to force an election becomes an accepted part of the political process. In 2008, Mr Abhisit was the beneficiary of a yellow-shirted revolt that closed Bangkok’s international airports. Now he finds himself isolated in his own party and increasingly out of his depth. “I don’t know what is keeping him there,” muses a Western diplomat.

The danger for Thailand is that there are people on both sides who want to escalate the crisis. Gunmen with military weapons showed up on April 10th to aid the red shirts, who profess nonviolence. One reason why the army is hesitating is that it knows resistance would greet any move into the red-shirt camp. In his joint appearance with Mr Abhisit, General Anupong admitted that some of his troops are conspiring with the red shirts. Some active officers, and other retired soldiers, may have fought alongside the protesters, he said. Still, he added, the army is unified and supporting the government. This was not very comforting. Meanwhile, the country waits to see who makes the first move.

Posted by biginla at 2:23 AM BST

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The SEC alleges that:

• GS failed to disclose that Paulson was involved in the portfolio construction of ABACUS 2007-AC1.
• GS misrepresented to ACA that Paulson was 200m long in the equity of ABACUS 2007-AC1.
• GS entered into CDS with Paulson that allowed Paulson to buy protection on tranches of ABACUS 2007-AC1s' capital structure but did not disclose this to investors

The deal closed 2007 04 26. By 2007 10 24 83% of the RMBS had been downgraded and 17% were on negative watch. By 2008 01 29, 99% of the portfolio had been downgraded.

ABACUS 2007-AC1 was a synthetic CDO. Its assets consisted not of RMBS but of CDS referencing RMBS. In the construction of the collateral portfolio ABACUS 2007-AC1 would have to enter into these CDS with counterparties. Was Paulson a counterparty, the major or only counterparty?

It is going to be hard for the SEC to establish that GS defrauded investors by its failure to disclose Paulson's role and intentions in ABACUS. Why? Paulson wanted to make a bet. A bet is not a sure thing. If Paulson or GS could affect the outcome of the bet then that is another matter. GS was effectively Paulson's agent. GS got paid 15m to do the deal. GS job for which they were paid was to go find someone who would take the other side of the bet. GS is not bound to tell the other parties who their opposite number was. GS is indeed bound to provide full disclosure of the nature of the bet which they appear to have done. In fact, GS had a fiduciary duty to Paulson who was the paying client, a duty which includes confidentiality. One could argue that GS had a tortuous duty of care to the investors in ABACUS. Certainly there were conflicts. However, these are most certainly circumvented by the fact that IKB and ACA were market counterparties or expert and professional investors. If each party acted with due care as fiduciaries it is hard to obtain a fraud. Paulson acted for his investors. Goldman acted for Paulson and for its own shareholders. ACA and IKB all acted for their shareholders. But a bet was made and there would always be winners and losers. If anything, the quality of due diligence of ACA and IKB and the ratings agencies should be questioned.

ACA was engaged to provide an extra set of eyes on the deal. They were engaged by GS as portfolio selection agent, as well as to provide the credibility necessary to distribute the deal. It appears that ACA Capital, ACA's parent turned up to effectively underwrite the deal as well. The SEC alleges that Paulson was involved in influencing the portfolio. This is trivially true by construction, however, things are not as clear cut as that. Paulson was specifying the bets he was willing to make. Out of the 123 underlying RMBS, ACA admitted 55. The final pool had circa 80 - 90 reference credits. ACA was not compelled to take the bets, and indeed only selected a subset of the Paulson portfolio. If we accept the SEC's point of view we are accepting as logical behaviour the turning down or accepting of a bet based on the counterparty and not the information about the prospects, outcomes and probabilities of the bet itself.

The fact that the deal would not have placed without ACA as an independent portfolio selection agent, that Paulson had a hand in the portfolio selection, that Paulson made lots of money, are immaterial to the allegation. They are, however, the realities of the industry.

Did GS’s failure to disclose Paulson's position long or short, constitute fraud, is the question before the courts.

There is the second allegation that is as important if not more. In my mind, this is the SEC's stronger allegation since the misrepresentation leads to fraud. This is the allegation that GS represented to ACA that Paulson would invest 200m in the equity of ABACUS 2007-AC1. The SEC complaint does not present supporting evidence. It is possible that the evidence exists, however, they have not referred to in the formal complaint at this time. For the time being what they have in the complaint seems to indicate that ACA assumed that Paulson would be long the equity, and GS simply failed to correct them. If so, it was a costly assumption for ACA and their parent.

Why might ACA assume that Paulson was long equity? The Paulson trade resembles a more common and widely executed trade which attempted to profit regardless of the direction of credit spreads in the reference portfolio. The Magnetar trades were of this nature. The trade involves being long the equity or junior tranche of the cap structure while being short the mezz or senior tranche of the cap structure on a delta neutral basis. This trade generates profits if spreads widen or tighten. How? The equity tranche is convex to spread widening. The more senior tranches are relative concave to spread widening. By delta hedging a long equity (convex) position with a short mezz (concave or negatively convex) position, the convexity of the bundle can be very pronounced leading to a long spread volatility position. As this was a common trade at the time, ACA might reasonably assume that the Paulson was attempting the same trade. It appears not, and that Paulson did not have a long equity position against the short mezz. It was in fact an unhedged and highly speculative trade for Paulson and one which could have gone wrong with serious results. ACA had probably assumed more sophistication on the part of Paulson than was the case. Paulson was no expert in structured credit. His background was in risk arb, a very specific hedge fund strategy. Betting on mortgages was a macro call. Using structured credit instruments to leverage this bet was arguably reckless. Fortune shone on Paulson and his bet paid off.

Guilty or innocent, GS has already been condemned by the public. Investor forums are replete with condemnations of Goldman the Vampire Squid. That much is clear. Whether this is justified or not is another matter which is not so clear.

The constructive fraud issue I think is unfounded and in any case will be very hard to prove. The related misrepresentation issue will imply fraud and boils down to the evidence, which has yet to be presented definitively by the SEC.

The lesson in all this is clear. Caveat emptor. What kind of investor are you? In the context of Poker, if you play the hand, then all you are concerned with are the details of the deal. If you play the player then it is your job to find out all about who you are playing against. And do your own homework. Quite how some of the CDO liabilities got rated AAA is a mystery to me. The speed at which the underlying collateral and the tranches were downgraded certainly calls into question the quality and value of credit ratings agencies judgment.

If the SEC is successful in its complaint, it will certainly open a can of worms. Lets just look in one narrow area, retail structured products. See all those retail structured products which are offered by private banks? Some of them are constructed with the needs of the investor in mind, but some of them are constructed because someone wanted to make a bet, and the other side of the deal needed to be found. Look at the disclosure in a structured product. Are you told who designed it? Who had a hand in designing it? Who is on the other side of the trade? Was it initiated by the structurer or their client? How many private investors would even dream of asking these questions?

There is a more interesting although less likely scenario.

Say that the SEC wanted to prosecute Paulson. Why is not important. Say the SEC has no proof. A formal complaint would go nowhere and there would be a risk of a libel countersuit, or a frivolous litigation countersuit.

The SEC might decide that it has a case against GS in a related capacity, that of a conflicted agent. The case is thin but it would allow the SEC to bring allegations against Paulson, that it cannot substantiate, with immunity from libel prosection in the course of prosecuting its case against Goldman.

This is of course mere speculation.

Posted by biginla at 10:29 PM BST

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