Interview with Yves Smith #2

HARRY SHEARER:  This is Le Show, and a few months ago I interviewed a blogger whom I’d been reading on the subject of the foreclosure mess by the name of Yves Smith. Her blog is called NakedCapitalism.com. And I’ve been struck by how much of what she said at that point has become near to conventional wisdom in the intervening months, so I’ve asked her back. We’re both sitting in a studio in New York City today, looking face to face, as opposed to the phone line link that we had in the previous interview. So welcome back to Le Show, Yves Smith.


YVES SMITH:  Harry, glad to be here and glad to actually meet you in person.

HARRY SHEARER:  Same here. Just background for listeners who didn’t hear the previous show, you’ve worked for some time as a management consultant, is that correct?

YVES SMITH:  Right. I specialized – to just sort of work in reverse order, I’ve been a management consultant to the financial services industry, had my own business since 1989. Before that I worked – and this is now in forward order – for Goldman Sachs in corporate finance, then for McKinsey, and started up and ran the merges and acquisitions department for Sumitomo Bank, which then was the second biggest bank in the world.

HARRY SHEARER:  You worked for Goldman Sachs when the money wasn’t quite as good as it is now, right?

YVES SMITH:  That’s correct, yes. And also, frankly, when Wall Street was only criminal at the margins.

HARRY SHEARER:  (laughs) Okay. So in the nine months since we first spoke, I get the sense, the eerie sense, that stuff that you said to me, that you’d been writing about then, which was sort of pooh-poohed by the banks and by a lot of people supposedly knowledgeable about this, has sort of become close to conventional wisdom in terms of what the judges in foreclosure cases are now saying. Can you kind of say what the trend line is along that?

YVES SMITH:  Well, it’s continuing along the same path. Basically, and this is the ironic thing about why it actually wasn’t so difficult to call, was the fact that if you did look at what had already happened in the courts by the time we spoke, it was very clear that there were serious problems with how the mortgages had been transferred into securitizations. Now this all sounds very technical, and frankly it is very technical. You know, we used to have an old-fashioned system where a person would deal directly with the bank. So the documentation was straightforward and if there were any problems –

HARRY SHEARER:  And it never moved.

YVES SMITH:  And it never moved. And if there were any problems, you know, if somebody lost their job, that person would then go back to the bank and the bank would know the local community and the bank could make a decision whether the person could be saved or not.

So it was, first thing, a much simpler system, and second, a more fault-tolerant system, because the banks were prepared, as they do in every other kind of loan, to make a modification if the borrower looked viable.

You see this in every other kind of lending. You know, if you read in all the papers, we have a process for big companies called Chapter 11, because it’s much more difficult to do that kind of negotiation with a big company, so you have a court process. But the point is the general premise is that when you’ve lent money, if you can get a half a loaf, you’re better off than none.

Now what happens with these securitizations is that the paper – the paper meaning the mortgage – had to go through a very complicated path to actually get into the securitization. And there were very good reasons for that in that they had a whole bunch of complicated legal requirements they had to satisfy. What happened over time was that the banks began violating their own procedures and yet did not change the contracts. And the consequence of that is they have a mess they can’t fix.

Normally if people deviate from a contract, you can still go back and say, “Gee, I was supposed to – you know, use this kind of steel but in fact I used that kind of steel, and so we’ll, you know, we’ll sort out some kind of number to make up for the fact that I didn’t do what I was supposed to do.” With this the whole deal was designed in such a way that it’s extremely rigid so you can’t go do those kind of waivers that you would do in pretty much any other walk of life.

HARRY SHEARER:  There’s a time deadline by which stuff has to be –

YVES SMITH:  There was a time deadline by which things had to be done, and they deliberately picked, when they designed these securitizations, they deliberately picked that the trusts would be New York – again, this is very technical, but they deliberately picked New York law because New York law was so settled on the matter of the trusts. The trust is a kind of legal box that the mortgages wind up in in the end. And New York law is extremely unforgiving. If you don’t do things exactly as stipulated in the contracts, it doesn’t work. And the contracts do not allow for anything to be done at this late date to fix them.

So the result is that these mortgages basically did not effectively get into the box they were supposed to get into. That means when you want to foreclose, you open the box and legally it’s empty. Legally you can’t, legally you can’t go back and say, “Oh, the mortgage, we kind of partly left it back somewhere earlier and now we’ll transfer it in now.” That just doesn’t work.

And that’s why we’ve had this big scandal with what’s called robosigning. Robosigning, where the banks were not merely having people sign on an automated basis, they were actually making representations. The banks want to make it sound like it’s just si– even the name robosigning makes it just sound like it’s mass signatures – which is part of what it was, but there’s another whole pattern which hasn’t gotten the attention it deserves, that the banks were actually engaging in what amounts to fabrications and forgeries of various types, of putting dates – you know, backdating documents, of having things signed by banks that literally don’t exist anymore, to make things work. Or where they couldn’t possibly have the proper approvals, where the person signing it could not possibly have gotten the authorization from the right party to make the signature they’re making.

So basically you have a whole huge pattern of fraud and forgeries to allow the servicers, who are the people who act on behalf of the trust, to do foreclosures. And that’s such a large-scale pattern now that it’s become undeniable.

HARRY SHEARER:  So judges have become aware of this pattern of practice and are ruling in more and more cases that the foreclosures are not valid as a result?

YVES SMITH:  That is correct. And that’s a huge problem for the banks also. Now still there are still some judges that are very bank friendly, so it’s not as if this is happening universally. But the bank-friendly judges tend to be, to the extent they’re around, are at the higher court level.

The robosigning scandal led to a huge shift in the attitude of judges, because before, foreclosure defense attorneys had been coming in and been pointing out these problems and the judges’ response had been basically – in many cases, been, “Well, the guy’s still a deadbeat” – you know, somehow the money’s owed here.

And when they realized – the judges take the integrity of the court very seriously. So, in their framework, the fact that banks were submitting false affidavits – to them that’s very close to submitting false testimony, and that’s just such a sin that the presumption that the banks were right has gone away. And the judges have become very skeptical. They’re now looking at the cases with a really jaundiced eye, and the result is that increasingly banks are finding it very difficult to get foreclosures through.

I mean, in New York, which has gotten tough on two levels:  In New York the skepticism of the judges has become very high, and on top of that they now have a standard in the courts that the attorney on the foreclosing side has to submit – basically it’s a certification that all the paperwork is correct. And really this is just a belt and suspenders. I mean they should be submitting everything correct anyhow. But that certification makes it easier for the borrower’s counsel to challenge a foreclosure.

So procedurally it’s important. Because normally it’s very bad form for the defense attorney to say, “I think he’s pulling one here.”

As a consequence, foreclosures in New York are – the banks basically are still finding people delinquent – you know, obviously somebody’s in default, they’re in default – but the foreclosures are now so backed up that it would take literally 62 years to clear the backlog at current rates. And that – you know, critics are liking to say, “Oh, that’s the court’s fault.” No, it’s actually the banks are holding them back too. The banks are holding them back because they know New York judges won’t stand for it.

HARRY SHEARER:  And as I read your blog, one of the attempts to solve this problem is in Florida, where the governor is now proposing that they do away with courts as a way station for foreclosures and have so-called nonjudicial foreclosures, right?

YVES SMITH:  Right. And frankly I think that would be – I mean that doesn’t mean that there won’t be an attempt to get that through. There’s been a very big backlash in Florida among the – some of it’s among more conservative judges, because they have had some success in stacking the court system in Florida, but the flip side is that for example the state attorney general, Pam Bondi, is under a lot of pressure because she tried to do some housecleaning in her office and cleaned out some – tried getting rid of some staffers that found improprieties in how foreclosures were being done, and that’s going down very badly in the press. So the fact that Bondi’s attempts to cover for the banks are not being well received suggests that there would be a big pushback if the state government were to try to go that route.

HARRY SHEARER:  Then on the other side, I think also via your blog, I just read in the last few days about the experience of a fraud investigator inside Countrywide?

YVES SMITH:  Yes, in the Countrywide case, basically they had an internal investigator who was looking at trying to find out what was happening with some offices that looked like they were problematic. And the very high concept of the story is that she found that there were really severe abuses, that in certain offices they were literally taking and cutting and pasting information from one application to another – they would use appraisals –

HARRY SHEARER:  To enable –

YVES SMITH:  To enable the deal to go through. They would use an appraisal from one deal, from one mortgage, on another. I mean, it was really grossly improper stuff. And when she started finding it, she began being frozen out of certain investigations. She began being frozen out of certain offices. It was clearly being blocked at extremely high levels of Countrywide. And although they don’t have proof, the sense of the report is that this was blocked basically at the executive level, that it went to, if not Mozilo, the guys right under him.

HARRY SHEARER:  Angelo Mozilo, the former – the founder –

YVES SMITH:  Well, one of the two founders. He’s one of the two founders and the CEO at the time of Countrywide.

HARRY SHEARER:  This goes to, I guess, another guest on this program and somebody that I started reading through your blog, Bill Black’s theory that fraud is not a side effect of all this, fraud is the cause of much of the mess we’ve been seeing, that fraud is a feature not a flaw.

YVES SMITH:  I would agree with that. I mean it’s become, I mean where we’re seeing it now is in the foreclosure arena. But if you back up, there was a lot of activity that took place by the employees of the banks themselves that to call it gaming the system is being charitable. You had, for example, traders who would book trades that they knew were not going to work out, but they worked according to their bonus system. Now when they’re caught individually, they’re called rogue traders. But we had this being done on a systematic basis, approved at higher levels, and it really hasn’t come out to a proper degree even now because there haven’t been serious investigations. I mean the senior management of these banks are much more culpable for the blowups at the banks than has really been widely discussed or proven.

HARRY SHEARER:  And when you say “these banks,” you want to name names?

YVES SMITH:  Oh, for example, the one place where it did come out, for example, was UBS, the bank that’s now in the spotlight with its rogue traders, a sort of, you know, round two. They were one of the few banks that was subject to any kind of real disclosure. Because Switzerland still had – Switzerland is a little country with big banks, therefore it can’t afford to really have its banks blow up because it would blow up the entire country.

HARRY SHEARER:  All you got left is [inaudible]

YVES SMITH:  (laughs) Yes! And good chocolate.

HARRY SHEARER: Good chocolate.

YVES SMITH:  And so, so what happened is that when UBS needed a bailout, they made UBS hire external, really truly independent – because sometimes we have external investigations that are really not truly independent? They made them hire truly independent external investigators and write a report on what happened. And basically there was a unit which, because it looked to be profitable, everybody gave it a free pass and it was booking collateralized debt obligation trades which were just clearly not going to work out but short-term looked profitable. And I can explain the mechanics of why it worked, because it was also regulatory gaming, but effectively they were abusing the system. Some of it was incompetence and some of it was the executives had every reason to sign off on it because they would get bonuses based on these dubious profits also.

So there was some degree of disclosure in the UBS case and there’s good reason to think that similar things were happening at the other Eurobanks, that the traders were basically engaged in a strategy that amounted to looting. That if you had thought about it or had real independent risk-management systems, you would have been able to tell that, but the way the banks are set up is that risk management is actually a fig leaf for the senior executives, that they have plausible deniability when they go for these short-term strategies that are almost certain to blow up.

HARRY SHEARER:  So that’s where we’re at in the American situation, except for one thing that I wanted to pursue with you, and you’ve been consistent on this since I started reading you, that the problem with the American financial system is that there is this enormous amount of second mortgages held by banks, which they’re claiming are worth what they thought they were worth in 2008 and are refusing to acknowledge that in the intervening time those houses that the second mortgages are written on have dropped in value, which means the second mortgages have dropped in value, and those would be enormous losses for the banks. Have I got that right?

YVES SMITH:  That’s correct. I mean the one with the biggest second mortgage book, and in most cases they’re overwhelmingly home equity lines of credit – and I’ll get to why that matters in a second – but the – of course in a foreclosure, with so many houses in America under water, these seconds are worth nothing. And with a very high unemployment rate, you know, sort of rationally you’d expect consumers to favor their first mortgage over their second mortgage since the second mortgage would be wiped out if they got in real trouble – you know, that they should be able to go in and negotiate and bargain to get the second re-done and would have more trouble getting the first re-done. We had this all working backwards, because the banks have kept the second mortgages on their books and it was the first mortgages that they securitized.

So what happens is the banks, who both own the second mortgage book and will own a servicing operation, will have very aggressive debt collection on the second. They’ll harass the borrower and have them terrified on the second.

And the other thing that happens on the second mortgages is that because they’re home equity lines of credit, if a borrower makes any kind of minimal payment, they can pretend that it’s current. So let’s say on your second mortgage you owe $250 a month and you’ve missed two payments. If you miss a third payment, they will have to report that as severely delinquent. And that’s something that bank analysts monitor. What they’ll do is sometime between the second payment and the third payment is call up and the bank will basically say, “Send us anything.” And they’ll treat it as current and they’ll argue in the press, “Oh, these are really current! You know, really, there’s no problem with these seconds! And all the people in the press who are saying that there’s a problem, they’re just alarmists and wrong!”

You know, and what of course happens in those cases is that when they cut the payments that much, that means they add the part that the borrower hasn’t paid and should have paid, they add that to the principal balance. So it’s not like there’s been any forgiveness here, it’s just a way of stringing things along. And if a borrower is in that much trouble that they can’t make their second mortgage payment? This thing is probably a goner. I mean, who are we kidding? It just might be on a longer path than it would be otherwise.

HARRY SHEARER:  So the import of all that is that the banks have yet to acknowledge – American banks – have yet to acknowledge enormous losses. What would you estimate the value that we’re talking about here?

YVES SMITH:  Well, for the five biggest banks it’s about $380 billion in aggregate.


YVES SMITH:  And to give you an idea – and the one that’s got the heaviest amount outstanding, is Bank of America at about – now I’d seen older numbers at more like $96 billion, I’m told it’s currently more like $80 billion, so this last round I think they increased their reserves quite a bit on them. But in any event, Bank of America, it’s $80 billion, versus book equity of around 200, a bit over $200 billion.

HARRY SHEARER:  Book equity meaning the –

YVES SMITH:  What they report publicly as their common shareholders’ equity.

HARRY SHEARER:  The value of the company as reflected by the stock market.

YVES SMITH:  Well, no, not as reflected by – the stock market is much less these days.


YVES SMITH:  The stock market is at considerable discount.


YVES SMITH:  So if you – and I should have looked at Bank of America’s stock before I came in, but their market value has been as low as just above 50% of their book value, so it’s probably – and I haven’t – I should have, so – let’s just pick a number and say it’s in the $100-120 billion range right now.

HARRY SHEARER:  Does that suggest that people who are trading in Bank of America stock are taking cognizance of this overhang of second mort– ?

YVES SMITH:  Yes. Yes. And in fact I’m trying to think of it – I know that it was as low as $89 billion and I think it’s down to that kind of level. So basically their reported value of the second mortgage book is about as big as their market capitalization.


YVES SMITH:  That gives you an idea.

HARRY SHEARER:  Well if investors in bank stocks are acknowledging these losses, what’s in it for the banks to keep pretending that these losses don’t exist?

YVES SMITH:  They believe they can’t afford to go down the alternative path. The alternative path is admitting how greatly undercapitalized they are. They would have to do huge sales of stock at very low prices that would dilute the current owners. That would almost certainly, even though that’s sort of doable from a financial standpoint? I mean in theory it’s doable, in practice what happens is – remember early 2009 when Citibank and Bank of America looked very rocky. What typically happens is these banks don’t raise enough money when times are good, they think of these maxes of equity raises only when their backs are against the wall, and doing something like that would almost certainly result in senior management being fired because it would be so dilutive that the board – and such an emergency step – that the board would have to get rid of incumbent management. So this is basically, you know, to a significant degree, protecting current management and the board.

The next part of that is that the other thing that the banks should be doing, and to some extent Bank of America has started doing that, is to try to shrink and simplify their business. Again the problem is now that the banks are all looking wobbly and are on the ropes, nobody wants to buy the good businesses that these banks have. So for example Bank of America sold its stake in the Chinese – part of its stake in the Chinese construction bank. Even that was a difficult sale because – not that that’s a bad business, and they had a gain in that company, but because it happens to be at this time lots of similar banks in China are also looking to raise money, so there was quite a lot of competition to be raising money at that time.

But the point is that what happens once – you know, think of what happens if an individual gets in trouble and they suddenly need, you know, they suddenly just have a medical emergency, let’s say, and they don’t have enough cash. They start – you know, what are you going to sell? You’re going to sell your best stuff. You’re going to sell your china. You’re going to sell, you know if you’ve got any investments that are any good, you’re going to sell the stuff that’s easiest to sell and has the best gain in it. Unfortunately, as a business, that’s going to be your best businesses. So the effort to fill their hole is actually making the business weaker.

HARRY SHEARER:  We’ll continue our conversation with Yves Smith, author of the book ECONned, moments from now here on Le Show.

* * * *

HARRY SHEARER:  We’re resuming our conversation with Yves Smith, who’s a blogger, management consultant and author of the recent book on all of this stuff called ECONned. This is a week in which we’re recording this conversation on Monday. Hopefully it doesn’t get all compromised by intervening events. But this is a week in which already those, I think among whom I count you, who’ve been saying the world economic situation looks bad, have been joined by Christine Lagarde of the International Monetary Fund, I think over the weekend the head of the Brazilian central bank, a lot of people coming out, a lot supposedly authoritative people coming out with very dire predictions for the state of the global economy, partly based on what’s going on in Europe. Let me ask you:  I, as a reader, it looks to me as if what you described with the American banks and their holding onto the second mortgages and continuing to deny their plummeting in value, is analogous to what the European banks have been doing with Greek debt. Is that close to the mark?

YVES SMITH:  Oh that’s – that’s almost exactly accurate. In fact, there are some direct parallels, because we in the US had a series of stress tests which were really not legitimate stress tests at all but were an effort to persuade the markets that the banks weren’t in such bad shape, and the notion the US was a G– once they got to be in a little bit better shape they would sell stock at higher prices and strengthen their balance sheets.

Well, then we do the first part of the equation. They did – you know, the Treasury led this big confidence-building exercise with enough kabuki with bank pushback that hopefully the children would be fooled – and then the banks didn’t go raise enough equity. So the banks had the opportunity to straighten themselves out a bit, and instead what did they do? They continued to pay themselves very large bonuses, which also prevented more money from being retained to strengthen their balance sheets, and they didn’t sell more stock.

In Europe it’s even more dramatic, because the banks – at least the US banks have taken some steps to improve their balance sheets, even though they were inadequate. In Europe the banks went into the crisis and experienced the crisis with even weaker equity levels than the US banks and have done less to clean themselves up. So it’s universally agreed the European banks are in weaker shape than the US banks, if such a thing is conceivable –

HARRY SHEARER:  (laughs)

YVES SMITH:  – and what happened in the crisis – and this happened in the US too but even to an even greater degree in Europe – was that the costs of the crisis actually showed up as increases in government debt levels. Most people, when they look at that impact, they tend to focus only on the bailouts. You know, they think, “Oh, we had $750 billion for the TARP.” No, the impact here was much greater because you had a collapse in tax revenues as a result of the crisis. At the same time you had an increase in payments – you know, different, what we call countercyclical payments –

HARRY SHEARER:  Automatic stabilizers?

YVES SMITH:  All the automatic stabilizers. For example, you know, food stamps went up, and we now have food stamps that have been at record levels for, you know, I don’t know how long. You know, unemployment insurance goes up. There are all sorts of things, there are all sorts of pay– outgoes that happen when the economy gets really bad.

And to the implied point of what you said, normally that’s considered to be a very good thing, because then it helps – then the politicians don’t have to run around and make up emergency spending programs which are usually influenced by, you know, porky type influences. Instead we have well-designed programs that just kick in automatically and it’s not politically controversial.

We had an even worse version of that in Europe because you had some governments that already were running fairly high debt levels. I mean, for example, the poster child of this is Greece, which even though the eurozone has rules for how big deficits governments can run, Greece had consistently broken those rules, and yet nobody said anything, so it’s –

HARRY SHEARER:  Well, wasn’t part of it that Greece lied about a lot of –

YVES SMITH:  Well, some of it was that Greece lied, but Greece was known to be lying –

HARRY SHEARER:  (laughs)

YVES SMITH:  – so that really doesn’t count. And it’s also partly that people don’t talk about the fact thatGermany broke the rules too at some point, so the fact that Germany had been given a free pass probably meant they couldn’t really beat up on Greece.

So there’s, you know, there’s parts of this story that don’t get the press necessarily that they deserve. But the point is that the blowout in debt levels of the government, at the US and the European nations, is really a direct consequence of the crisis, so this is a cost of the banks’ malfeasance that is too often not attributed to the banks. It’s made into the story of, “Oh, those bad people in Greece who lived too high and now they’re paying of it,” and that’s really not the correct frame for the story.

I mean, if Greece would have had a problem, you know, X – at some point X is a crisis, but the problems in Europe are significantly a function of the financial crisis that interacted with a problematic structure for the eurozone and the fact that the banks were very highly levered. I mean, this is a much more complicated story than just, “Oh, you know, people in Greece lived too high and people in Spain bought too many houses.”

HARRY SHEARER: (laughs) Although the thing that sticks out to me about the Greece story is that everybody who writes about it eventually gets to the point where they say, “Well, they have a really, really bad problem with tax collection in Greece.” Like they don’t do it.

YVES SMITH:  Well that is – that’s true, but that’s a little more complicated story too, in that there’s basically something like – and I’ve seen the number, it’s something like somewhere between 25-35% of the population is actually subject to actually pretty good tax collection.


YVES SMITH:  So it’s the rest of the economy that isn’t. And the rest of the economy consists of a really large black market, like doctors are paid pretty much only in cash and grossly underreport –


YVES SMITH:  – and wealthy people from all over Europe who settle in Greece because they know it’s very permissive there. So some of the rich people who are in Greece wouldn’t be in Greece if it weren’t for the tax –

HARRY SHEARER:  They’re tax migrants.

YVES SMITH:  They’re tax migrants, exactly. So – but in any event, it is true that they have a very corrupt, lousy tax apparatus, and they have a second problem that they have a very bloated civil service. They have a lot of civil service jobs that are basically fake jobs.

There are some things that are said about Greece that are affirmatively untrue. You know, one of the urban legends is that, you know, Greeks don’t work very hard and they retire early. That’s affirmatively untrue. They work longer hours and retire much later than people in Germany.

But nevertheless they have a huge tax problem and they have this sort of bloated civil service problem, both of which are quite severe.

HARRY SHEARER:  Let’s get back to the banks, in the European context, because Europe, now suddenly people are becoming aware that this next dip, if there’s going to be one – and you were one of the earlier people to say there’s going to be one, I think – is related to the banks’ situation with regard to the debt. But I remember you writing that when people were blaming Ireland earlier on in the European situation, that you found German banks – I guess Dutch and German banks, to be fair – had almost kind of coaxed Ireland into this situation, or eased Ireland, or enabled Ireland, into the situation it found itself in.

YVES SMITH:  Well, Ireland is a really sad case, because that was not a government debt problem. In fact, Ireland had actually been running a budgetary surplus. What happened was that literally Ireland blew up because of – I’ve heard it said that literally the actions of a dozen people. They’re basically very large banks – and you don’t have to be that big to be a big bank in Ireland –

HARRY SHEARER:  (laughs)

YVES SMITH:  – but nevertheless they’re basically what amounted to bank entrepreneurs who got very aggressively into the home lending business. And so we had the same situation we had in the US, only more so. That you had a huge housing bubble, you had these banks making very low interest rate home loans, and when the bubble collapsed the banks were bust.

And then what happened is that there was one Irish bank that was sold at a late stage and had led to basically an implosion of one of the European banks, but through a whole bunch of mechanisms the European banks were exposed to the problems of the Irish banks.

Now Ireland as a country should have stared down the European banks and said basically “Too bad, you restructure this debt.” Because the Irish had not extended a guarantee to these banks. They didn’t do what we did here. They didn’t throw a big safety net under the banks the way the US did. The Irish government would have been very much within its rights to stare down the Europeans and say basically, “Stuff it. We’re going to negotiate a solution to these banks. We’re not going to take the banks onto the national balance sheet.” Because the banking sector was massive in rela– not quite as bad as Iceland, which did let their banks fail and let their central banks fail? But it was, I think the debt to GDP ratio in Iceland was about 900% –


YVES SMITH:  – and in Ireland it was about 750%. So it’s grossly disproportionate to the size of the economy. However, the head of the Irish central bank, even though he was Irish, he was basically a career ECB – not a career ECB, but he had strong connections and reason to curry favor with the ECB and the eurozone types, so they effectively had a traitor in the form of the head of the Irish central bank, and if you don’t have your central bank supporting you, you can’t do anything. So he effectively – literally he effectively sold out Ireland. And I don’t know why he hasn’t been run out of town as a Quisling. I mean that was just a singularly destructive act.

HARRY SHEARER:  Or as an O’Quisling at least.

YVES SMITH:  Yes. Yes!

HARRY SHEARER:  ECB meaning European Central Bank.

YVES SMITH:  European Central Bank.

HARRY SHEARER:  So after months and months of people on the financial side saying the politicians are moving too slowly, there’s this flurry of activity among the politicians and the officials all of a sudden to try to appear that they’re speeding up to solve the European problem lest it plunge the world into a second great recession. Is that really what’s happening?

YVES SMITH:  Well that’s what happening. In fact, one of the commentators who had been following this quite closely, Wolfgang Münchau of the Financial Times, said he’s never seen European leaders so panicked.

And the problem is that they have a disconnect between political timetables and market timetables. You know, you can see how quickly things can go blow up. Like, you know, Bear Stearns, it was literally 10 days before a run on Bear Stearns happened and the bank was sold to JP Morgan. I mean, these things can just come apart very, very quickly. And the political process, unfortunately, involves multiple countries, oftentimes with multiple approvals required, and you just can’t move things that quickly.

I mean, for example, you know you’ve been alluding to the votes this week. Those votes are pursuant to a package that was approved July 2! Out of 17 eurozone countries that have to approve it, only 6 have approved it so far, and there are whole series of approvals that are due this week. And if any of those don’t happen, that could lead to a big market panic and meltdown, because the package of July 2 is actually kind of a minor set of tweaks, you know, on a scale of things to an existing program.

HARRY SHEARER:  Which was to bail out Greece.

YVES SMITH:  Which was to bail out Greece.

HARRY SHEARER:  Or to keep Greece afloat.

YVES SMITH:  To keep Greece afloat. Yeah, because they really haven’t fixed Greece. They just keep extending it teeny little bits of more money to tide it over to the next time it needs more money.

But in any event, and what they’ve really – you know, what they have finally realized – well, they’ve only realized one part of the problem, which is even more severe. They’ve realized that to merely paper things over, they’re talking the wrong order of magnitude of money, that this old facility was $440 billion. It’s what they call the EFSF, where there are so many acronyms you can lose keeping track which attaches to which. And now they’re realizing that they’re going to need some kind of program more like in the trillions of euros. They’re now finally using the T word.


YVES SMITH:  And they’re trying to come up with schemes. You know, so on the one hand they’re trying to look like they understand that there’s a problem and that they’re going go act quickly enough. Even then they are pushing to have some kind of announcement by the next G20 meeting, which is November 2. I mean, November 2 is an eternity as far as Mr. Market is concerned. And then that’s just going to be an announcement of what the plan is! (laughs) You know, how long is it then going to take to implement the plan? I mean, this is just – you know, so just on a political timeframe, this looks not very doable.

The one other way that could go around this would be to have the European Central Bank just do what we call in America “print.” The European Central Bank could just keep monetizing debt. That’s something the Germans are very reluctant to have happen. They have a very – they’re very, very afraid of inflation.

HARRY SHEARER:  With good historical reason.

YVES SMITH:  With good historical reason, except they also sort of look at the wrong part of the frame, which is it was at their overreaction to their hyperinflation in the early 1930s – between ’30 and ’32, their efforts to go back on the gold standard actually deepened their depression and were what led to Hitler! So that led – and right now they’re looking at the wrong part of the historical frame. We are not anywheres near in a hyperinflationary situation. We should be much more worried about the ’30 to ’32 situation which they created and led to a global disaster.

So they’ve got that problem. You know, this huge political timescale problem. But the even bigger problem is an economic problem is an economic problem. Even if they somehow managed to pull this all off, they are not solving the real problem. They still have not solved the economic problem.

So this is just basically another bigger better kick-the-can-down-the-road strategy, which they somehow think is a solution. It’s not a solution.

The solution is there are some countries that are never going to be able to pay this debt back. They need to write that debt down. That will cause a big hit to the banks. They need to recapitalize those banks, and then they also need more aggressive stimulative governmental policies, which will mean running a somewhat higher level of inflation. And they need internal adjustment.

Because another big – one of the big problems in the eurozone is that you’ve got Germany – Germany used to export a lot to the rest of the world and a little bit to the rest of the eurozone? In the last seven or eight years that’s flipped. Germany now is not that much of an exporter to the rest of the world and is a massive net exporter to Europe. That’s a big part of the reason why these countries got in so much debt! Because Germany has basically been lending them finance.

HARRY SHEARER:  You mean lending them money to buy German products.

YVES SMITH:  To buy German products. That’s part of – that’s one of the big reasons these countries went on a debt party.


YVES SMITH:  It was to accommodate the German export-driven strategy. So you can’t really fix the eurozone’s problem longer term without having Germany stop having such an export-driven strategy. And what’s coming out of the Germans’ mouths is incoherent. You know, Merkel over the weekend, who is sort of now acting like she’s gotten religion, has said, “Well, we can’t let Greece leave the eurozone,” but then her reasons say that Germany is not willing to give up the strategy. “Oh, well, if you know Greece left the eurozone, then somebody else would leave the eurozone, and then what was left of the euro would go up – you know, the price of the euro would go up, which would really hurt Germany. Which means we – Germany wouldn’t be able to export so more – ”

HARRY SHEARER:  Export so much.

YVES SMITH:  – and yet that’s what they have to give up. So she’s basically saying, “We’re not willing to give up our export-driven strategy,” when that is one of the most important things that needs to change!

HARRY SHEARER:  Just from my, you know, uneducated civilian standpoint, the specter of lending people money so they can buy more of your products sounds so much like what happened in this country, lending people money so they can keep buying, you know, whether it’s homes or home equity loans, so they can buy other stuff – this is like almost eerily a re-run, isn’t it?

YVES SMITH:  No, it’s exactly the same thing. And, again, nobody’s talking about what the real underlying problem is, that we have had rising stagnant worker wages and rising income inequality.

And this was identified as a problem back in the Great Depression. I mean, it’s ironic, after the Twenties Gilded Age, that certain members of the Roosevelt administration, particularly Marriner Eccles, recognized that the rich, as he put it, the rich needed to be saved from themselves. That if the rich kept accumulating more and more wealth, they would just wind up with empty factories, empty office buildings. That you need to have enough of the goods, the output of the economy, go to workers so that they would spend. Because workers will spend more of their income than rich people will. Rich people are in a position that they accumulate more savings. I mean, how is a guy like Warren Buffett ever going to spend all the money he makes? I mean, he’s not.

HARRY SHEARER:  I have a few ideas of what he could do with it, if he calls me, you know?

YVES SMITH:  (laughter) Exactly. But the point is that to keep a high enough level of demand in the economy, you really have to have a fairly high proportion of GDP, of growth, actually go to workers, not to capital. So that’s why there’s actually a good economic reason for things that are now depicted as quasi-socialistic, like progressive income taxes. You know, too much favoring capital just results in too much capital chasing too few investments and not enough demand in the real economy.

HARRY SHEARER:  Which is an asset bubble, by definition, right?

YVES SMITH:  Yes. Yes.

HARRY SHEARER:  Which we’ve just lived through.


HARRY SHEARER:  So, if you look ahead six months, which I’m sure you do, where’s the world?

YVES SMITH:  I would like to be – it would be better if I were wrong, is one of my favorite sayings, but I don’t see how we don’t have some version of a financial crisis. I don’t see how the – there – and I’ve thought this for the last two years, but now finally it’s like the plates are going to fall off the sticks. I’ve thought that what the officials have been doing for the longest time is like the guy in the circus. You know those guys in the circus who have maybe six or seven sticks with the spinning plates on top and they have to keep running from stick to stick to keep, you know, enough energy to keep the plates spinning at a high enough velocity that they don’t fall off the stick?

HARRY SHEARER:  Mhmm? (laughs)

YVES SMITH:  Well that the plates have been looking wobbly for a really long time, and there have been so many plates wobbling that the officials running around trying to keep the plates from falling have been having to run awfully fast and awfully hard, and I don’t see how these plates don’t start falling. I mean I just don’t. I mean we have political gridlock in terms of getting to the point where we have debt writedowns and debt restructurings. So it’s just, there’s just a – the banks have become, are so powerful that nobody wants to deal with them frontally, and take them down, restructure them, you know, treat them like utilities.

HARRY SHEARER:  When you say restructure, in civilian talk that means, say, that a debt that’s being carried at $100 on your books is now worth $50.

YVES SMITH:  Right. And what that means is that the people who have invested in the bank, either by being bondholders or stockholders, are going to take losses. And the normal way that you do that is that you wipe out the equity holders. Depending how bad the losses are, you might have to also make the people who had bonds take some losses too. And then you take some of those, the value of the debt that’s left, and you convert that to equity. So then the bank has this cleaned-up balance sheet, but the investors in the bank have taken losses.

And what normally happens when things are that bad with a bank is that you throw out management. (laughs) You know, I mean that’s sort of a no-brainer. If people presided over something that was that big a screwup, you throw them out.

And everybody is terrified – everybody, when I say everybody I’m talking about the regulatory officialdom – has become terrified of, “Oh my God we can’t possibly touch these banks! They’re so complicated and they’re so scary!” That’s just baloney. I mean, I’m really sorry. There’s lots of talent out there in the industry. There’s even some talent in the middle level of these banks that were not part of the problem that could move into senior level roles. There are lots of people who were thrown out at various points pre the crisis because they saw the handwriting on the wall and tried to do the right thing.

I mean, the problem is you have to work and find them. And if the officials had wanted to be on top of this, they could have had search firms looking out to find who the unemployed good guys were and have them in the wings.

This was a solvable problem. It’s not one the officials have wanted to solve because God forbid in America you be called a socialist by intervening with the banks. I mean, a lot of it is about ideology here.

And the second part, which I alluded to in the discussion with Europe, is that everybody – too many people – not everybody, because there are a whole bunch of economists that are of the contrary view, but too many people in positions of authority believe this austerity nonsense, that austerity will work. And it’s unfortunately been promoted to laypeople so that it would be politically unpopular to go against this bad austerity concept.

The problem is everybody draws an analogy from a household.


YVES SMITH:  If you as a household have overspent, you know, you cut your spending. That all seems very logical, and everybody thinks, “Gee, the government has to do that too.”

HARRY SHEARER:  Tighten its belt.

YVES SMITH:  Tighten its belt. The problem is that as a household, that assumption is based on the idea that your income stays the same. When you cut spending, it doesn’t affect your income. That is not true at a government level. The reverse is true. Government spending is part of the economy. You cut spending, you actually cut the size of the economy because you’ve reduced demand.

And the worst is that government spending is particularly powerful. It has what’s called the multiplier effect. So if you cut government spending by 100 bucks, you actually reduce the size of the economy by a number bigger than that.

And the result is that you make the debt to GDP ratio worse. That has been dem– and that’s the thing everybody’s trying to solve. And that has been demonstrated every time it’s been tried. It’s happening in Ireland that the debt to GDP ratio has gotten worse. Greece, since austerity has started, it’s even undershooting its forecasts, and its forecasts are grim. It was projected – with austerity it was projecting its economy to shrink over 3% this year. It’s now – and they revised their forecast within the last two months and it’s now going to shrink more than 5%! I mean (laughs), you know, this, this does not work! And yet everybody seems addicted to this prescription that doesn’t work.

HARRY SHEARER:  So that’s a good prognosis for the six months ahead then, right?

YVES SMITH:  Economically the outcome looks quite grim.

HARRY SHEARER:  Ahhh… well. I can’t say it’s been a, um (laughter) – a pleasant picture you paint, but you do it with utmost clarity, and I appreciate you coming in, and I appreciate very much your daily – you spend a lot of time thinking and researching this stuff, and yet you have a day job, so.

YVES SMITH:  Well, thank you so much. I really appreciate your praise. And your readership.

HARRY SHEARER:  And the clarity with which you take arcane – or at least to us, arcane economic and financial concepts and, without dumbing them down, I don’t think, clarify them, is really remarkable. So thank you again for being with me.

YVES SMITH:  Well thanks so much.