Wednesday, November 18, 2015

Shaky Ground: The Strange Saga of the U.S. Mortgage Giants by Bethany McLean

Bethany McLean’s new book, Shaky Ground: The Strange Saga of the U.S. Mortgage Giants, is short (about 150 pages) but filled with useful information and analysis concerning the two biggest government-sponsored enterprises (“GSEs”), Fannie Mae and Freddie Mac. I recommend this book for anyone wondering about these entities and why they are still in conservatorship.

I should point out at the outset that I spent most of my career in the Domestic Finance section of Treasury, and the Treasury, no matter the political complexion of the Administration, took a dim view of Fannie and Freddie. The career Treasury official I worked for in the first half of the 1980s summed up the attitude succinctly by remarking that Fannie Mae and Freddie Mac officials paid themselves private sector salaries without taking private sector risks. While Treasury would take every opportunity to say that GSE debt was not guaranteed by the U.S. government, the market assumed, rightly as it turned out, that if the GSEs ever got into trouble, the U.S. government would make good on the debt. In other words, Treasury was correct as a legal matter in saying that the debt was not guaranteed, but most, if not all, Treasury officials knew that the Treasury would have to do something if they got into financial trouble because of the implicit government guarantee. The shock to the financial system of a Fannie or Freddie default would be too great.

In fact, it was the implicit government guarantee that effectively saved Fannie Mae in the 1980s. Fannie Mae was then faced with the same problem as the savings and loans in a rising interest rate environment. Both Fannie and the S&Ls were financing long-term assets (home mortgages) with shorter term financing. When the cost of financing became much higher than the return on their assets, this proved to be a big problem. Fannie solved this by resorting to issuing mortgage-backed securities, on which Fannie bore credit but not interest rate risk, and by changing its financing strategy so that the duration of its liabilities more nearly matched the duration of its assets, thus reducing its interest rate risk. (I am using the term “duration” in its technical sense, which is related to but not the same as maturity, but you can probably follow what I am saying even if you do not how to calculate duration.) Fannie would not have been able to do this and effectively grow out of its problem without the implicit government guarantee that afforded it continued access to the credit market. Real private companies would have faced downgrades on their debt and eventual failure.

Another reason for Treasury resentment of the GSEs is that, when it came to policy issues that affected them, the GSEs would either argue as if they were  private corporations or as if they were government entities, depending on the particular issue. Fannie Mae, in its publicity, stated that this mixture of public and private worked for the benefit of housing and the U.S. economy. From the Treasury perspective, Fannie and Freddie did just enough for low income housing in order to form a formidable political coalition including the housing finance industry, real estate brokers, and advocates for low income housing.

Further, Treasury was keenly aware that Fannie and Freddie were thinly capitalized. Officials from both companies would argue that they had a good handle on their risk, and that the only thing that could bring them down was a housing bust all over the United States, rather than in  particular regions. Treasury was resigned to appreciating that nothing really could be done about them unless they got into real trouble. In the event, there was a housing bust, and the U.S. government took them over.

Nevertheless, I do not subscribe to the view that the activities of Fannie and Freddie were major causes of the financial crisis. The person most associated with pushing this view is Peter Wallison, a former General Counsel of the Treasury Department during the Reagan Administration and currently co-director of financial policy studies at the American Enterprise Institute, a conservative think tank in Washington, D.C. He was also a member of the Financial Crisis Inquiry Commission and wrote a dissent from the Commission’s report. In his dissent, he argued that a prime cause of the crisis was the affordable housing goals of Fannie and Freddie. This was too much for his fellow Republican commissioners, and they jointly filed a different dissent, which, as I have previously commented, made reasonable arguments.

Bethany McLean easily demolishes Wallison’s argument by pointing out, among other things, that the mortgages Fannie and Freddie bought or securitized were not as risky as Wallison claimed and the two institutions were latecomers to the subprime party. As for the more sophisticated argument that Fannie and Freddie took all the good loans, leaving only bad loans for the private sector, McLean writes that “this leaves a lot of other factors unexplained. Among them: Why was there so much money, for a period of time, to be made on these fringes? Why didn’t the private sector do what it was supposed to do best, namely manage risk?” (p. 55)

It is unclear why Wallison has been obsessed with Fannie and Freddie. He may be trying to make a political case that stricter regulation of the private financial sector is unnecessary because the financial crisis, in his view, is the result of government policies. As I have indicated, I am not a fan of these companies and their activities were part of the myriad of causes for the financial crisis, but focusing on these companies and leaving out other actors, which had much more to do with the crisis, is a mistake. There is plenty of reason to question whether initially privatizing Fannie and Freddie (their respective histories, incidentally, are different) were good ideas, and, as McLean points out, the political process has not produced any consensus about what to do with these entities.

Fannie and Freddie are currently profitable, but the profits are flowing to the U.S. government, which I suppose should please deficit hawks. For example, in calendar year 2014, Fannie paid the Treasury $20.1 billion in dividends and Freddie paid $19.6 billion. However, when the government put the two GSEs into conservatorship, it left 20.1% of the common stock in private hands in order not to include the two companies’ debts on the U.S. balance sheet. Now the holders of the common stock and preferred stock have gone to court because they believe that they have a right to some of the profits the GSEs are generating. Whether or not they do has not been finally decided by the courts.

Fannie and Freddie are providing significant financial support to the housing market. Left undecided is what role the government should play in housing. The 30-year fixed rate mortgage is possible because of Fannie and Freddie, and U.S. homebuyers have become accustomed to the availability of this type of loan. On the other hand, government subsidies to housing – and Fannie and Freddie are only part of that – arguably distort markets and encourages more resources to be devoted to housing at the expense of other sectors of the economy and encourages families and individuals to buy larger houses than they really need or would otherwise buy. Since there is no consensus on what to do with the GSEs, they continue in conservatorship and, at least until the courts have finally spoken, providing their profits to the U.S. government, which also effectively bears the risks from their operations.

There is much more to the book, including discussion of Ed DeMarco, who was acting head of the regulator of  Fannie and Freddie, defying enormous pressure to have them provide relief to borrowers. There are also some errors and oversights in the book, though none are critical. I will single out two here. The author uses the term government-sponsored enterprise to refer to only Fannie and Freddie. In fact, there are other GSEs, such as the problematical Farm Credit System. (The GSE that has been successfully spun off from the government is Sallie Mae, which is active in the student loan market.)

Also, the author quotes former Treasury Secretary Tim Geithner saying “how little authority we had over Fannie and Freddie” without mentioning that Treasury had the authority to approve (or disapprove) their debt issuances. Treasury had used that authority mainly as a traffic cop, that is, to make sure that the Treasury and the GSEs were not all issuing debt at the same time. Treasury stopped acting as a traffic cop during the Clinton Administration. However, in the early 1980s, Treasury used the authority to stop Fannie Mae from issuing debt in a manner motivated by questionable tax strategies. In one instance, it stopped Fannie from setting up a Netherlands Antilles financial subsidiary as a way to issue bonds in Europe without imposing a 30% foreign withholding tax. (Tax law regarding the 30% foreign withholding tax was subsequently changed to exempt “portfolio interest income.”) The Treasury could likely have been more aggressive in using the debt approval authority, as Fannie and Freddie grew their mortgage portfolios, on which they bore both interest and credit risk, in the decade leading up to the financial crisis, but shied away from doing that.
Fannie and Freddie have long been absent from the headlines, but what ultimately to do about them is important. They should not be in conservatorship forever. Despite my quibbles, I recommend this book is for those interested in the subject, whether or not they are previously familiar with these two companies.

Thursday, October 15, 2015

Treasury Auction Manipulation Investigations and Litigation – Some Comments

There have been allegations of manipulation by major dealers of the auctions for U.S. Treasury securities. Apparently, at least twenty-five lawsuits have been filed, and the U.S. Justice Department and the New York Department of Financial Services are investigating. The back story to these lawsuits and investigations is not public, and the Treasury does not seem to be commenting.

In brief the allegation is that major dealers collude in keeping the yield up (or price down) in Treasury auctions. The complaints compare the auction results to trading in the when-issued market for the same security and contend that statistical analysis shows that there must be collusion.

It is certainly possible, but, after having read two of the complaints (State-Boston Retirement System v Bank of Nova Scotia et al, U.S. District Court, Southern District of New York, No. 15-05794 and Cleveland Bakers and Teamsters Pension Fund et al v. Bank of Nova Scotia, New York Agency et al), I do not think the issue is that clear. The statistical evidence in these complaints is badly presented, and the authors, while assuming the pose of experts on the government securities market, seem to have studied up on this market fairly recently. For example, their knowledge of bond math is limited.

One problem with their argument, as “Yves Smith” on her naked capitalism blog points out, bidders in Treasury auctions may effectively demand a concession in price to act effectively as underwriters for a sizeable chunk of securities.  She thinks, though, that the plaintiffs will avoid a summary judgment against them and will proceed to discovery. If there is evidence of collusion, such as emails or chat room discussions, then there will be a case to be made.

While this is interesting, what the commentary I have read misses is that prior to changes that happened in the government securities market, by government actions, market developments, and technology, the information advantage that primary dealers enjoyed was much more significant. For example, in the 1970s and 80s, primary dealers were the only ones allowed to trade at the major interdealer brokers, with the exception of Cantor Fitzgerald, which operated a government securities trading facility. Consequently, the primary dealers had access to an inside market which was not transparent to anyone outside the club. One firm, which was not a primary dealer, Lazard Frères, complained loudly about this state of affairs, but got no support from Treasury and made no headway in its complaint.

When it came to the auctions, at the time Treasury auctions were multiple price, that is, Treasury accepted bids at the highest prices (or lowest yields) until the amount offered was sold. Competitive bidders had to pay the price that they bid, even if that was higher than the average price. This type of auction poses the problem of the “winner’s curse” for participants; in other words, they run the risk of paying too high a price for the securities. Large investors, therefore, bid through the primary dealers, because they knew that the primary dealers were better able to know the real prices in the market. The primary dealers provided this service for free, because the amounts their customers were bidding for provided them useful information about the underlying demand for the securities. This system worked for the Treasury, but it undeniably gave the primary dealers an advantage and could be criticized as unfair.

Since then, the interdealer market has changed, and prices are much more freely available (though some firms, such as Bloomberg, charge a considerable amount for the use of their terminals). Also, the primary dealer advantage in the auction has been eroded, since Treasury now auctions its securities in single-price auctions. The best bids are still the ones accepted, but all successful bidders pay the lowest price accepted, thus doing away with the winner’s curse problem. (The argument from a cost perspective for Treasury is that the amount of money that Treasury “leaves on the table” is made up for or more than made up for by the higher prices bidders offer in this type of auction. In other word, bidders are not tempted to shade their bids but are more willing to bid based on their true demand curve in this type of auction, since they know that they will not overpay for the securities.)

In single-price auctions, there is less reason for investors to go through a primary dealer, and the amount of direct bids by investors has increased. This seems to be a fairer system for Treasury auctions. However, one can easily see that single-price auctions do leave room for collusion, and perhaps game theorists should study whether the opportunities and temptations to collude are greater in single-price or multiple-price auctions.

In any case, it will be interesting to see if the government investigations or the private class action lawsuits develop any hard evidence beyond the statistical analysis. One interesting point is that the statistical evidence for collusion apparently end after the Libor manipulation investigations become public.

Sunday, September 20, 2015

Update on VW Diesel Emission Investigation

After I posted my last entry on this blog, “Volkswagen, Diesel Emissions, and Regulatory Failure,” Bloomberg published an article on its website, “VW's Emissions Cheating Found by Curious Clean-Air Group,” which explains how the VW diesel emission issue was discovered.
Briefly, according to the article, the International Council on Clean Transportation (“ICCT”), a non-governmental organization headquartered in Washington, DC with other offices in San Francisco and Berlin, decided to test certain American versions of diesel cars in order to demonstrate that U.S. stricter emission standards could be met. In Europe, there were questions about the lab test for emissions of the European versions of these cars. In other words, the researchers were not initially suspicious of Volkswagen.
The researchers asked for help from West Virginia University’s Center for Alternative Fuels, Engines and Emissions since it had the right equipment to measure emissions while a car is being driven. The testing demonstrated the excess emission of nitrogen oxides from the VW cars. This was not the case with a BMW, which was also tested.
ICCT’s press release on this matter can be found here.      
Meanwhile, press reports (here and here) indicate that VW has told its U.S. dealers to halt sales of 2015 model year diesel cars and the 2016 diesel cars have not yet been certified by the EPA for sale. VW dealers must be fuming.                                                                                                                                    

Saturday, September 19, 2015

Volkswagen, Diesel Emissions, and Regulatory Failure

Yesterday came the news out of the blue that the Environmental Protection Agency and the California Air Resources Board are charging Volkswagen with incorporating software in 2009-2015 diesel cars that enabled cheating on emission tests, particularly the emission of nitrogen oxides. According to the EPA, VW has admitted the use of a so-called “defeat device” in these cars. The EPA letter to VW states: “It became clear that CARB and the EPA would not approve certificates of conformity for VW's 2016 model year diesel vehicles until VW could adequately explain the anomalous emissions and ensure the agencies that the 2016 model year vehicles would not have similar issues. Only then did VW admit it had designed and installed a defeat device in these vehicles in the form of a sophisticated software algorithm that detected when a vehicle was undergoing emissions testing.”
The defeat device software was designed to sense when a car was being tested for emissions and would reduce emissions in order to pass the test. However, the degree of emission control used during the test is not applied when the car is being driven, and emissions are then significantly higher for nitrogen oxides and not in conformity with EPA or California requirements.

Though this is not spelled out by the agencies, presumably turning off some of the emission controls enables better performance and better fuel mileage. Approximately half-a-million cars may have this defeat device and will have to be recalled for a fix yet to be devised. (Disclosure: I own one of these cars.) There may be some reluctance among some owners to bring their car into a dealer for the fix, if the fix for the emission issue results in less power and worse fuel mileage. How the cars will be affected is not clear at this point. VW is under orders to devise a fix, but has not yet done so.

The EPA has the power to fine VW; press reports indicate that VW’s potential fine could be up to $18 billion, but most observers think it will be substantially less than that. Meanwhile, while the EPA and the CARB continue to investigate, the Justice Department is also investigating. Justice is presumably investigating whether any criminal charges should be brought.

West Virginia University and International Council on Clean Transportation (“ICCT”) researchers initially discovered the discrepancy between emissions in real-world driving and test results. (Update: More information has since appeared about this, which I summarize in the next post. The ICCT was not initially suspicious of VW, but was looking at the differences in the emissions between European and U.S. versions of the same cars because of questions that had arisen about the emissions of these cars in Europe.)
The West Virginia researchers may not have looked at the responsible software code. An interesting article by Alex Davies on the Wired website, “The EPA Opposes Rules That Could’ve Exposed VW’s Cheating,” explains that this likely would have violated the 1998 Digital Millennium Copyright Act, which is administered by the Copyright Office of the Library of Congress. According to the article, in December 2014, the Copyright Office was asked to grant exemptions from certain provisions of the Act for software used in cars, trucks, and agricultural machinery. The article states: “Having access to car controls would allow for ‘good-faith testing, identifying, disclosing, and fixing of malfunctions, security flaws, or vulnerabilities,’ [the exemption proponents] argued, according to comments they submitted to the Federal Register.”

The Alliance of Automobile Manufacturers opposed granting the exemptions, and the EPA opposed all the requested exemptions, but one, on which it did not take a position. The EPA was concerned that granting exemptions from prohibitions from examining the computer code would enable consumers to change the code in order to boost performance of their vehicles at the expense of higher emissions. The Copyright Office has not yet made a decision. The Wired article concludes:
The irony of the EPA’s concern over owners altering their vehicle code in a way that would violate the Clean Air Act is that VW was allegedly using its surreptitious algorithm to do exactly this—that is, to favor performance over fuel economy in a way that violated the Clean Air Act. And legalizing public access to the software used in the 482,000 VW cars now being recalled could possibly have revealed the alleged “defeat device” code earlier. As noted on Twitter by Thomas Dullien, a prominent security researcher and reverse engineer who goes by the handle Halvar Flake: “The VW case is an example why we need more liberal reverse engineering regulation. In a world controlled by code, RE creates transparency.”
Meanwhile, in Europe, where about half the cars are diesel, there has been concern that lab testing of automobile emissions is not providing accurate results. The European Commission plans to impose real-world emission testing requirements in 2017. There is some skepticism about whether the new testing regime will close the gap enough between test results and emissions produced by cars on the road.  

EU requirements for nitrogen oxides emissions are not as stringent as those in the U.S. Nevertheless, according to a February article in The Guardian, there are suspicions that auto manufacturers may be using “tricks” to pass the emission tests. The article does not address whether any of these suspected “tricks” are violations of law. At least some of them may be permitted loopholes. Regarding the current emission tests, the article states:
But the current ‘New European Drive Cycle’ laboratory test for measuring these emissions is a quarter of a century old, and has been outpaced by technological developments in the car industry. Studies have shown that lab techniques to measure car emissions can easily be gamed with techniques such as taping up doors and windows to minimise air resistance, driving on unrealistically smooth roads, and testing at improbably high temperatures.
Campaigners say that car makers also use tricks such as programming vehicles to go into a low emissions mode when their front wheels are spinning and their back wheels are stationary, as happens in such lab experiments.
Note that the programing trick the article refers to is similar to what VW has been accused of and admitted to doing in the U.S.  

The concern in Europe has recently been increased by a recent report claiming that only ten percent of new diesel cars meet current requirements. The concern in Europe about the health hazards of diesel cars has been building for some time. There are proposals to ban diesel cars in Paris in 2020, and the French government wants to phase out diesel cars. London is also considering restricting diesel cars, and Mayor Boris Johnson plans to impose a surcharge in addition to the congestion charge on diesel cars in 2020.
Clearly, there have been policy and regulatory failures with respect to diesel cars on both sides of the Atlantic. Europeans are reconsidering their move to diesel cars, and, in the U.S., I would think that the tax credits for diesel cars that were in place for a while to encourage diesel as an alternative automotive fuel will be viewed as a mistake. (I benefitted from that tax credit.)

Opponents of government regulation will no doubt jump at this experience to demonstrate how the government, with even the best of intentions, manages to do the wrong thing. That government policy was not well thought out in this area is clear. (I posted a comment in 2012 about how volume illusion was exaggerating the greater efficiency of diesel engines. A given volume of diesel weighs more than an equal volume of gasoline.) The inadequacy of testing and VW and perhaps other car companies apparently manipulation of test results are real failures of both the public and private sector. However, I don’t think that one can make an argument that without government regulation, automobile emissions would be less than they are now. They almost certainly would have been worse.
What VW has apparently done is appalling and that it took U.S. regulators this long – the cars in question date back to the 2009 model year – is not encouraging. VW of course will pay a price. Its dreams of becoming a major player in the U.S. market would seem to be shattered, and its bet on diesel cars is in question. It is not clear, though, whether other technologies than that used in the VW cars that are likely to be recalled and that are in use in some diesel cars in the U.S. are adequately reducing emissions. It is also possible that new cheaper and effective technologies can be developed without too much sacrifice.

Note: This post was updated in light of new information about the ICCT and West Virginia University research into this issue, which is discussed in the next post.

Thursday, September 17, 2015

The Fed and Interest Rates

As of this writing, the Federal Reserve Open Market Committee has not announced its decision on interest rates. However, Binyamin Applebaum wrote an interesting New York Times article, dated September 12, about how the Fed might go about implementing an increase in interest rates – “The Fed’s Policy Mechanics Retool for a Rise in Interest Rates.” Because of the amount of excess reserves held by banks at the Fed, raising short-term rates is not as simple as in the past. Moreover, market reactions to any announcement and to subsequent Fed actions to implement a decision to raise rates, which will happen at some point, if not today, could prove to be complicating factors.  

A Few Comments on the Interagency Report on the U.S. Treasury Market on October 15, 2014

On July 13, 2015, five agencies – the U.S Treasury, the Federal Reserve Board, the Federal Reserve Bank of New York, the SEC, and the CFTC – issued a report prepared by their staffs   entitled The U.S. Treasury Market on October 15, 2014. It attempts to analyze the sharp increase in the price of the 10-year note and the quick reversal of this increase between 9:33 a.m. and 9:45 a.m. on October 15. The report reaches no conclusion as to why this happened.

Antonio Weiss, Counselor to Treasury Secretary Jack Lew, was apparently heavily involved in preparing this report. He gave a speech about the report at a Brookings event on August 3 – “Are there structural issues in the U.S. bond market?” Antonio Weiss, you may recall, is the former Lazard investment banker whose confirmation as Treasury Under Secretary for Domestic Finance was blocked by Senator Elizabeth Warren.

The report clearly entailed a lot of work and usefully highlights changes in the Treasury market and the development of technology, most particularly the growth of electronic platforms and automated trading. The report, though, is unsatisfying, and not just because the authors were unable to develop a clear explanation about what happened on October 15.

First, there is no clear explanation as to why anyone but market participants should care about this unusual event. In this connection, Jerome (“Jay”) Powell, currently a Federal Reserve Governor and a former Treasury Domestic Finance Under Secretary in the George H.W. Bush Administration (I worked for him when he was a Treasury official), remarked at the Brookings event:

“So I think it's important to take a step back and put it in context. So technology is evolving from risk appetite and risk management is evolving, the supply and demand of liquidity is evolving, and regulation is evolving, and they're all evolving at the same time. Markets are adapting to that at the same time. So you have to look at these events and ask whether they matter or not, which is kind of a sense of your question. Does it matter that the 12 minutes -- things that we couldn't really explain? So if it only happens once, maybe it doesn't matter so much, but the real question is, is there a pattern? And I just don't think we know, I think it's frustrating but we don't really know. I think rates will be increasing over time, presumably volatility as we get over the zero lower bound, volatility will return to normal levels just as an arithmetic matter we'll be able to do that. And I think we'll be learning. I think that's what we have to do is learn as this process goes on.” (Transcript, p. 62.)
Second, there is no discussion of developments that day in other financial markets, including the U.S. stock market and stock and fixed-income markets abroad, which may or may not have had something to do with what happened in the Treasury market on the morning of October 15.

Third, the report intriguingly discusses a “heightened level of self-trading” – “defined as transaction in which the same entity takes both sides of the trade so that no change in beneficial ownership results” (p. 32 of report). The report though does not analyze whether this had any effect on market prices and studiously avoids any judgment of whether any of this activity might have been illegal or an attempt at market manipulation. Given that the one group for which what happened on October 15 really mattered, the active traders that made or lost money that morning, this is a hole in the report. The enforcement staffs of the agencies which participated in this report presumably did not participate in its preparation, and it is understandable that in interviewing market participants the researchers did not want to be making what might appear as an enforcement investigation. Nevertheless, more attention to who made and lost money in this event might have shed light on what happened.

Finally, it is interesting to note that in response to a question Antonio Weiss emphasized the need for “better access to data” and Jay Powell said he “was very surprised at how difficult it was to the data.” It is worth noting that in this respect that in the 1992 Joint Report on the Government Securities Market, the Treasury and the Federal Reserve opposed imposing audit trail requirements on the government securities market. In the 1993 amendments to the Government Securities Act of 1986, the SEC did receive the authority to request transaction reports form government securities brokers and dealers in order “to reconstruct trading in the course of a particular inquiry or investigation being conducted by the Commission for enforcement or surveillance purposes.” The Treasury also received large position reporting authority in when-issued and recently issued Treasury securities. (Government Securities Act Amendments of 1993, Sec. 103 and 104.) There seems to be a hint that the Treasury and the Fed may be thinking of supporting legislation granting enhanced authority to impose record-keeping rules and information reporting on significant market participants and lowering the hurdles of sharing this information among interested government agencies. It is unlikely that this will happen, if at all, before the next President and the next Congress are in power.   

Tuesday, July 28, 2015

Varoufakis and Plan B; Schäuble and the European Nightmare

Former Greek finance minister Yanis Varoufakis outlined his preparations for a parallel payment system and a possible exit from the euro and made other observations, especially about German finance minister Wolfgang Schäuble, in a conference call on July 16. It was hosted by the London-based Official Monetary and Financial Institutions Forum (“OMFIF”), which appears to have institutional and individual memberships from both the public and private sector from various countries. This includes both public and private fund managers. Though this has not been mentioned in any press accounts, I think it is fair to assume that Varoufakis was paid, and probably paid well, to participate. (Varoufakis is not setting any precedents here. Ben Bernanke for example has appeared before investor groups for pay, now that he no longer works for the U.S. government.) In any case, Varoufakis delivered for his hosts. I am not sure that what he had to say would have led to any good trades, but it was uncommonly interesting.
The July 16 OMFIF conference call was held under the “Chatham House Rule,” which allows for the information to be used but prohibits identifying the source or the other participants present. At the end of the call, one of the hosts, OMFIF managing director David Marsh, aware of the “slightly sensitive” information Varoufakis conveyed, admonished the participants in the call with a somewhat stronger version of this rule:
“…I do have to say also that you did say one or two things which were slightly sensitive regarding various episodes when you were a minister, so I would just like to say to everybody that none of this information that you have been hearing here should be used to make any trades of any sort in any way. But also please do not pass those on to other people, this is a private conversation under the famous Chatham House rule. And the idea is that you hear first-hand from Yanis Varoufakis, and also Lord Lamont, about their experiences –but this is not a public broadcast, this is not the BBC.” (Transcript of the call here; audio here.)
Mr. Marsh also reported that there were “84 people on the line from all over the world.” I suspect there were more than that, since multiple people could be listening to the call on a single speakerphone. Given that, it is surprising that it took 10 days for the information about Varoufakis’ preparations to set up a parallel banking system in Greece in the event the banks to leak. It was first reported on July 26 in the conservative Greek newspaper Kathimerini, which has been critical of the current Greek government. It seems likely that the leak was meant to embarrass Mr. Varoufakis and the current government. Indeed, some claim that Mr. Varoufakis has committed treason or other crimes. (I know nothing about Greek law, but I suspect that these allegations will not go anywhere.)
Since this story broke, Varoufakis and his two questioners Norman Lamont and Marsh agreed that the recording of the call be made available online. Subsequently, a transcript has also been released at the OMFIF website.
Why Varoufakis decided to make the secret preparations for an alternate payment system, including the hacking of the website for tax payments which he says was controlled by the troika, is not entirely clear. He had to have known, Chatham House Rule notwithstanding, that the information was too explosive to stay secret, given the number of listeners.
After listening to the call, I suspect that Varoufakis has bristled at the charge that the Greek government failed badly in its negotiations with the other Eurozone countries because they had no plan, and no credible way to threaten, pulling out of the euro. He implies that Prime Minister Tsipras did not have the courage to escalate the fight with the Eurozone countries by implementing the plan when the European Central Bank (“ECB”) forced the closure of the Greek banks. Varoufakis is prompted to tell this story after Marsh asks:
“You obviously didn’t have a Plan B and did rather weaken your negotiating argument, because the others were absolutely scared of you leaving and yet you said ‘Don’t worry we’re not going to leave.’ I think though just in the last couple of weeks you yourself did start to think about a Plan B, and I think you even gave some inkling about it in your interview with the New Statesman where there was a vote in the inner-cabinet in Athens after the referendum and you were in favour of trying to prosecute a Plan B and you were out-voted. Do you think there was still a chance, if everything goes badly, that there may well be a Plan B and that the Grexit - which nobody wants in Greece, I understand that - may come about even though it is something for which you are unprepared?”
Whatever the reasons Varoufakis made this public, the story he tells shows how dangerous the brinksmanship played by both sides were to European unity. What Varoufakis had in mind, using the Greek tax website as an alternative payment site, would not have been as provocative as another scheme to take over the Bank of Greece and use the euro notes in its vaults. This has been reported to have been an idea of former energy minister Panagiotis Lafazanis and Varoufakis. If Greece had done that, the fury of the ECB would have come down on Greece, and the notes would have been declared counterfeit. Varoufakis does not mention this in the call, and it is not clear whether he really supported this. In any case, the press has dropped this story.

However, setting up an alternative payment system which could be switched to a new currency would have been provocative enough. Whether it would have worked at all is not clear, but it could only have bought Greece a bit of time and all hell would have been let loose in Europe. If there is a decision for Greece to leave the euro, the mechanisms to do this should be negotiated with substantial input from technical experts. It is a complicated undertaking to accomplish smoothly, and disputes over who owes what to whom are inevitable.
Also, in the conference call, Varoufakis indicates that Greece may have been set up. While the Greek parliament is passing legislation required by the preliminary agreement as preconditions to negotiating a final loan agreement, the IMF may very well decide that it cannot participate because the level of Greek debt is unsustainable. That could cause the whole agreement to fall apart, which may lead to a Greek exit from the euro, which is what Schäuble wants, though it is not the preferred outcome for Chancellor Angela Merkel.

According to Varoufakis, Schäuble wants to use Greece to terrorize France:
“[Schäuble] believes that the Eurozone is not sustainable as it is. He believes that there has to be some fiscal transfers, some degree of political union. He believes that, for that political union to work without federation, without the legitimacy that the properly elected federal parliament can render can bestow upon an executive, it will have to be done in a very disciplinarian way. And he said explicitly to me that the Grexit, a Greek exit, is going to equip him with sufficient bargaining power, with sufficient terrorising power, in order to impose upon the French that which Paris is resisting. And what is that? It is a degree of transfer of budget-making powers from Paris to Brussels.”
Schäuble is wrong both about economics and politics. Austerity has clearly not worked, and having Germany dictate to other EU countries how they should manage their affairs will also not work. In a perceptive column in The New York Times, Shahin Vallée writes that a euro leading to Germany being able to dictate will not be acceptable for other major European countries:
“…The choice will soon be whether Germany can build the euro it wants with France or whether the common currency falls apart.
“Germany could undoubtedly build a very successful monetary union with the Baltic countries, the Netherlands and a few other nations, but it must understand that it will never build an economically successful and politically stable monetary union with France and the rest of Europe on these terms.
“Over the long run, France, Italy and Spain, to name just a few, would not take part in such a union, not because they can’t, but because they wouldn’t want to. The collective G.D.P. and population of these countries is twice that of Germany; eventually, a confrontation is inevitable.”
While the France of François Hollande is not the France of Charles de Gaulle, France is still a proud country and will not stand for Germany dictating its fiscal affairs. France may be able to be “terrorized” (probably too strong a word) in the short-term, but that will not last long.

The basic problem is that a monetary union implies a fiscal union, and for that to work in Europe, it must have legitimacy and be subject to democratic control. There is no clear path for that to happen. Jean Monnet’s European dream is in danger of turning into a nightmare.