World Markets Simplified

Facebook might file for IPO as early as wednesday, according to sources. Facebook will launch its long awaited IPO with the offerings of $5 billion. Initially the size of IPO was $10 billion, but company is being cautious in the market.

WORLD BANK CUTS GLOBAL GROWTH OUTLOOK, SEES EURO-AREA RECESSION

Bloomberg, which just released an embargoed summary of the World Bank action, summarizes it all.
World Bank cuts global growth forecast by most in 3 yrs as euro area recession threatens to exacerbate slowdown in emerging markets, World Bank says in Global Economic Prospects report.
Sees world economic growth of 2.5%, down from June est. of 3.6%
Sees euro area GDP contracting 0.3% in 2012, compared with pvs est. of 1.8% growth
World Bank estimates euro area entered recession in 4Q
U.S. outlook cut to +2.2% from +2.9%
Japan forecast cut to 1.9% growth from 2.6%
China's GDP growth will slow to 8.4%, unchanged from interim revised projection released in Nov.
India forecast cut to 6.5% from 8.4%

And the punchline:
World Bank urges developing economies to "prepare for the worst" as it sees risk for European turmoil to turn into global financial crisis reminiscent of 2008
Even achieving much weaker outcomes is very uncertain

 
Bill Gross, who runs the world's biggest bond fund at Pacific Investment Management Co., said Greece is heading for default.

The downgrade of European ratings by Standard & Poor's last week shows countries can fail to meet their debt obligations, Gross said in a Twitter posting. Greece will prove to be the latest example, Gross wrote.

Greek officials will meet with lenders on Jan. 18 after discussions stalled last week over the size of investor losses in a proposed debt swap, raising the threat of default. European officials and creditors plan a 50 percent cut in the face value of Greek debt by voluntarily exchanging outstanding bonds for new securities, though the two sides haven't been able to agree on the coupon and maturity of the new debt.

France and Austria lost their top rankings in a series of downgrades Jan. 13 that left Germany with the euro area's only stable AAA grade, as S&P warned that efforts to address Europe's financial problems are falling short. The region's leaders are struggling to tame a crisis now in its third year and convince investors they can restore budget order.

S&P cut Greece's grade to CC in July, meaning the nation's debt is "highly vulnerable" to nonpayment, based on the company's rating definitions.

Pimco's $244 billion Total Return Fund, run by Gross, increased its holdings of U.S. government debt to 30 percent of assets in December, the most in 13 months, according to the company's website.

"The bulk of sovereign-bond holdings should be in the U.S.," Gross wrote Jan. 4 on the Newport Beach, California, company's website. Investors should favor Treasuries, he said, "as long as European credit implosion is possible."

That makes the central bank unique. Its creditors cannot change the terms on which it borrows. As a result, the capital position of central banks is all-but irrelevant—it neither affects the central bank's cost of funds, nor its ability to fund itself.

The privileged position of issuing fiat money enables central banks to operate with skinny capital. The Fed's capital is $50bn—not much when compared to a balance sheet over $2.5 trillion. Were it a bank, on the other hand, the Fed's capital ratio of less than 2% would have already landed it in bankruptcy court. Moreover, central banks can tolerate write-downs. In part, that is because they don't require capital to borrow. But equally, it is because they are moneymaking machines in a different sense as well—they make fat profits (known as seigniorage). Central banks enjoy unparalleled net interest margin (borrowing at near-zero interest rates [Central banks will incur borrowing costs to the extent they pay interest on reserves, but those 'borrowing rates' are typically very low—much lower than the yield on the assets they hold and much lower than any private sector financial intermediary could hope to attain.], while investing in much higher yielding government or credit securities). Last year, for example, the Fed earned $76.9bn in profit, more than its total capital base.

Typically, central banks return all but a small fraction of their earnings to the government. In bad times, however, those earnings could be used to offset realized losses, bolstering the capital of the central bank.

But the key point is this one—even if the central bank incurred sufficiently large losses to create a negative equity position, that outcome would not change its ability to borrow via securities purchases. In short, even negative equity (technical insolvency) would not prevent a central bank from performing its customary open market operations nor its lender of last resort function.[Some observers have noted that the ECB's low seigniorage revenues do not provide the same 'earnings-based' capital cushion available to other central banks. But the essential point is that capital does not determine the central bank's ability to perform its mandated functions.] So when does a central bank actually go bust? The answer is when it cannot make payments, which would be the case if the central bank borrowed in foreign currency (i.e., money which it cannot 'print'). That is not the case for the Fed, BoE or ECB—the liabilities of all three central banks are almost exclusively in their own currency.[In the event a country exits the Eurozone, its central bank would issue new national fiat currency, effectively re-denominating its liabilities.]

So if central bank capital is all but irrelevant, why have it? Alternatively, why worry if it is eroded by losses?

The answer may be, in part, optics.[The statutes of central banks may also require it.] No one, not even a central banker, wants negative net worth. But more subtly, it is also undesirable to incentivize central banks to maximize seigniorage (i.e., to earn their capital). After all, given a fixed net interest margin, maximizing seigniorage is about boosting assets 'under management'. In turn, that requires creating excess money, which raises the risk of inflation. So the preferred public policy is to endow central banks with capital rather than to compel them, however infrequently, to earn it. Lastly, the source of central bank capital—the national government—acts a subtle yet powerful reminder that the central bank is not utterly independent, but ultimately is answerable to the taxpayer.

The Eurozone is different
That's why recapitalization is probable if a central bank suffers large enough losses to wipe out its capital.

So who recapitalizes the central bank? And why is the Eurozone different?

Insofar as central banks are a part of government [Technically and historically, this is not quite right. Central banks historically may have public-private roots. The Fed is a quasigovernmental organization and, as noted earlier, the ECB shareholders are the 27 national central banks of the EU. But insofar as they deliver public goods (a medium of exchange and, hopefully, price stability) and because they have (near) monopoly issuance of money, they are commonly assumed to be part of government.], the taxpayer ultimately stands behind them, at least where a central (federal) government exists. In the event necessary, it is widely assumed that the Treasury (or a European Finance Ministry) would recapitalize its national central bank.

Yet the act of doing so is a fiscal transfer, making it subject to legislative approval. It isn't far-fetched, therefore, to imagine that if a central bank required a capital infusion, politics would intrude. To be sure, even if recapitalization were held up by politics, the central bank could perform its mandated duties, as previously noted. But political intervention could have other unsettling byproducts, such as de jure or de facto restrictions on the central bank's operational independence (or even its revocation altogether).

The Eurozone is a special case because there is no central (or federal) government that stands ready to recapitalize the ECB. Moreover, some of the ECB shareholders (the national central banks) might find themselves in a pinch at the same time that the ECB needs a capital top-up. That's because some Eurozone national central banks have similar or worse 'risk asset' exposures than the ECB. For example, via the Emergency Liquidity Assistance (ELA) facility, several national central banks have extended considerable collateralized lending to banks in their countries, reportedly accepting even weaker collateral than the ECB has in its own operations. Accordingly, it is possible that a series of Eurozone sovereign or banking defaults could simultaneously erode the capital position of the ECB and those of some of its shareholding national central banks. That outcome would imply that central bank recapitalization would have to be led by a subset of creditor countries (i.e., Germany). That's potentially a problem—recent history reminds us that Europe's creditors have a proclivity for prevarication where asymmetric bailouts are involved.

Summary and conclusions
Central banks have taken on more risk in recent years. That's been necessary and highly desirable during the most severe financial crisis since the 1930s, followed by the 'great recession'. One shudders to think of the consequences of the alternative—'Austrian' central bankers running the show.

Yet the actions of central bankers in recent years may yet have undesired consequences. Central banks have claimed to have exercised prudence in demanding sufficient collateral and adjusting 'haircuts' to the value of collateral. But with central bank balance sheets swollen relative to their capital and a second recession underway in Europe, credit losses could mount. Stuff happens.

To emphasize, the risk is not that large central bank losses would impair the ability of the monetary authorities to provide liquidity, conduct open market operations, target policy rates, or safeguard the payments system. Rather, in the event that losses wipe out too much of their capital, the chief risk becomes the intrusion of politics into central banking. It might even bring about the end of independent central banks.

Food for thought indeed as EFSF structural support is worn away by ratings agency downgrades (requiring perhaps explicit central bank support and lower collateral standards), ESM subordination concerns pressures existing sovereign bond holders to unwind/hedge exposure (requiring non-economical buyers of last resort), and increasingly complex agency relationships as ponzi-bonds are swapped into and out of national and super-national central banks.