By Julian Delasantellis
In the 1939 movie adaptation of L Frank Baum's 1900 novel The Wonderful Wizard of Oz, all the characters were in awe of the tremendous magisterial power of the Wizard. Dorothy, the friends she met on her journey (the Tin Man, the Cowardly Lion, the Scarecrow), and all the other various citizens of Munchkinland, they all believed that it was the Wizard, in his castle in the Emerald City, who possessed the powers to make all their problems right, to make all their lives sweet.
Then Dorothy's little dog Toto pulled away the cujavascript:void(0)
Publish Postrtains that concealed the Wizard's supposed magic machine, and found only smoke and mirrors; as for the Wizard himself, he was just a rather ordinary little man.
In what must have been one of the last plays presidential adviser Karl Rove called from the sidelines and which was sent into the huddle of his reliable right-wing spin machine, the editorial page of the Wall Street Journal, Fox News, along with commentators Larry Kudlow and Jerry Bowyer, all said that Bush and his laissez-faire economic philosophy had delivered to the world an economy sufficiently robust to withstand any challenges from the chaos spreading out of the markets for subprime mortgages.
But in the expanse of time from those long-ago blissfully halcyon economic days of a week and a half ago, much of the laissez-faire economic community has treaded a path reminiscent of Caledon Hockley (Billy Zane) in the 1997 movie Titanic, from first denying that there was any problem with the unsinkable ship, to now pushing aside women and children to get a place in the lifeboats. As the great ship World Liquidity raises its mighty stern into the air to commence its slide into the sea, these previously pleased pundits started screaming out for help from the Federal Reserve.
And they got it, as the Fed cut a key benchmark interest rate by 50 basis points. But as their rescue is proving Bernanke to be, like the Wizard, more Kansas carnival barker than omnipotent seer, it may be creating more problems than it solves.
There are three main cannons in the arsenal of any US Federal Reserve field marshal. One is called open market operations, another is the operation of what is called the discount window, the third is targeting a specific level of the Federal Funds rate. In the past 10 days, the US Federal Reserve has shot off two of its three cannons. The first was an abject failure; the second has had an infinitesimally small effect. Maybe the citizens of Munchkinland will stand for the exposure of their avatar as a fraud, but the citizens of Moneymarketsland will certainly not.
The open market operations were the almost US$400 billion of reserves injected into the world's money markets by the US Fed and other central banks since August 8; I described the mechanics of these procedures in my August 14 article cited above. The results of these procedures can probably be best described as very expensive failures. With billions of dollars of liquidity evaporating daily in the markets, interest rates had been rising in the specific money markets that the Fed and the other central banks had influence over; in the US, the Federal Funds rate, targeted at 5.25%, topped 6%. The interventions settled things down - a bit - the Federal Funds rate returned to its target range, but other indicators of the health of the private short-term money markets remain in very tenuous shape.
The market in what is called commercial paper, very short-term (frequently no more than a day or two) corporate borrowing of money needed to fund a company's temporary funds shortage (or lending of funds from companies with a funds surplus) has closed for companies thought to have even the remotest connection with the subprime-mortgage debt in peril; no amount of open market operations will reach these borrowers.
If they can't find lending to fund a short-term liquidity need, they will begin to be pulled inexorably toward bankruptcy. Other indicators of the health of the short-term money markets, such as the London Interbank Offered Rate (LIBOR), the core indicator of what has come to be known as the Eurodollar market, are also indicating that these Fed monetary firehouse operations have yet to rain down on them with any needed liquidity.
After being ensconced around 5.30% all year, this rate climbed to almost 5.90% in the midst of the Fed interventions; that means that wherever the money the Fed was attempting to put in the markets was going, it wasn't getting to the US.
So where were the billions of dollars in Fed intervention going? The market for US government-guaranteed three-month Treasury bills is one short-term money market where the Fed probably has not wanted to have the effect that it has. Rates in this market saw an astounding fall last week, dropping almost 130 points, to reach just under 3.6% at their lows in the middle of the week.
Looking at this market, you can just smell the fear permeating world money markets; investors in the US are now willingly sacrificing almost 200 basis points, 2% of yield, to be able to go to bed and know that their money will still be there next morning. This is not the case with lending in today's commercial-paper or LIBOR markets, where traders just can't be sure if the counterparty they just lent $100 million to is going to get detoured to the bankruptcy court before the loans can get repaid.
With the money market operations proving as ineffective as they did, the US Fed had to proceed to the next step, lowering the discount rate. In and of itself, the current construct of a free economy's central bank is a relatively recent phenomenon. Before the early 20th century, if one bank's impending insolvency threatened the insolvency of the entire financial system, it would either have to get an emergency loan from a wealthy private citizen (such as J P Morgan in the US, or the Rothschild family in Britain), or it would go under.
This was the cause of the grossly amplified economic booms and busts of the world's capitalist economies leading up to the crash of 1929. With the 20th century came the realization that this function, ensuring the stability of the financial system as a whole, best resided with the government, since its proper operation benefited the nation as a whole.
The aftermath of the "Great Panic" of 1907, wherein the US economy was only saved from the deep depression it would face 22 years later by the intervention of J P Morgan, led Congress to pass the Federal Reserve Act in 1913. The Bank of England was created in 1694, but it was only under the governorship of Sir Montagu Norman, beginning in 1920, that its function changed from a commercial bank, charged with making a profit, to that of a central bank, charged with maintaining the viability of the system as a whole.
Much like Pig Pen in the Charles Schulz comic strip Peanuts, sometimes a situation arises where there is one bank that the other banks just don't want to play with anymore. Nobody wanted to play with Pig Pen because they were afraid that the cloud of dust that encased him might rub off on them; likewise, nobody wants to lend to an alleged weak bank, because they fear that the cloud of possible insolvency that surrounds it may affect them, in that their loans to that bank would not get paid back.
Before modern central banking, these banks would close. That would then threaten with insolvency the banks to which the closed bank owed money; if those banks closed, then their creditors would be in jeopardy, and so on and so on, until the whole banking system was in jeopardy. In economic jargon, this type of crisis is called a "contagion", and it's a very apt metaphor: like someone sneezing in a hot, crowded elevator, one institution's sickness can make a lot of others very sick very fast.
Here, the central bank moves in, acting as the "lender of last resort". It, when no one else will, can lend to the first threatened bank. The interest rate it charges to these banks is called the discount rate, and it was that rate that the US Fed lowered on Friday morning.
The rate was cut 50 basis points, a half of a percentage point, from 6.25% to 5.75%. This is still 50 basis points above the standard interbank lending rate, the Federal Funds target rate, which has stood at 5.25% since June 2006. This is deliberate - the discount rate is supposed to be what is called a "penalty rate", like a teen asking Dad for money and getting a lecture along with the cash, the Fed wants to be available, but not an easy touch.
This crisis seems tailor-made for discount-rate lending and borrowing, at what is metaphorically called the discount window. (There is no actual teller wearing a green eye-shade behind something with the words "Discount Window" at the Fed headquarters on Constitution Avenue in Washington. All these transactions are effected through electronic funds transfer - EFT.)
Those commentators who say this entire crisis is overblown, that the world is still awash with liquidity, are correct, up to a point. There continues to be huge supplies of liquidity in the world's markets. The problem is that a lot of financial institutions now need some immediate contact with some of that liquidity, and are not getting it. One of those might be Countrywide Financial, the largest US mortgage lender. Countrywide's stock has declined 60% in a month, and it burned through its entire $11 billion emergency line of credit in a few hours on Thursday. Thus the Fed discount-rate move on Friday.
Soon we'll get data from the Federal Reserve that show how liberally the threatened banks used the now more reasonably priced discount window but, as for Friday, the market's reaction to the rescue move was, "Is that all?"
There is no evidence that the freeze-up in the commercial-paper market has thawed as a result of the discount-rate cut. Three-month Treasury bill rates did bump up, and LIBOR rates did bump down, but only nominally. They are still at levels that would have been associated with a serious system crisis only a month ago. The Vix volatility index, the global markets' fear thermometer, at 30, is remaining at historically high levels.
On its open, the US stock market behaved oddly. The Dow Jones Industrial Average rallied more than 400 points, but that was the high for the day. Midday, the market lost almost all of its gains before rallying again into the close, to end up with a gain of 233 points. US television news anchors reported these developments as if they were auditioning for the role of John the Baptist in their church's passion play, proclaiming the "Good News" of an imminent salvation.
But in reality, this rally was far from impressive, particularly considering recent bouts of high volatility in US and world equities. The 20-day mean of the Dow Jones index price change stands at 155, with a standard deviation of 105. If I've just transported you back to the yawning void of existential horror that was your secondary-school statistics class, the point here is that 233 points just isn't that much of a rally these days.
What does the Fed next do if the crisis, and the equity-market selling, resumes this week? Early-20th-century Harvard professor and philosopher George Santayana once defined a fanatic as someone who redoubles his efforts as he loses sight of his goals. In that light, Bernanke could throw in another 50-point discount-rate cut. That, however, would put the discount rate even with the Federal Funds rate, at 5.25%; that would eliminate the penalty aspect of borrowings at the discount window.
That opens up the possibility of a cut in the Federal Funds rate, perhaps at the Fed's next board meeting on September 18, maybe sooner, perhaps after an emergency Fed teleconference, as happened with the discount-rate cut on Friday. A Federal Funds rate cut delivers liquidity to the markets with more of a scattershot approach; as yet, that doesn't seem to be what the economy needs. It's not that the system is short of liquidity right now; the steep fall in the three-month Treasury bill rate proves that. Discount-rate borrowing, targeted like a sniper's rifle to borrowers who really need it, is the preferred mechanism to deal with the credit quality, not quantity, issues the markets are dealing with now.
That's why it's such a problem that the Fed's Friday discount-rate cut had so little effect. If what comes out of the barrel on firing your most powerful weapon is only a little stick with a flag that says "Bang" on it, your enemies, in this case the markets, will see that there's nothing you can do to deter them, to frighten them, to change their course of action. Panic will set in, perhaps worse than before; past the curtains, the smoke and mirrors, the Wizard is seen as impotent.
Who will then be charged with saving the financial system? Will it be the political system, Congress and the executive branch?
That's a frightening prospect: the political system would require that any possible solution travel the same route that all US political policy issues now must do; it would have to pass muster from focus groups in the US heartland. That might result in a congressional debate on whether old farmer Johnson's patented moonshine-fueled flush toilet will solve all the nation's ills.
Or maybe the crisis will be solved in the same manner in which the United States has solved all its economic problems this decade - through reliance on China. Michael Pettis, a Peking University professor of finance, has suggested China's government-run investment agency, its Sovereign Wealth Fund (SWF). I discussed SWF in my June 22 ATol article Careful what you wish for, China may grant it). SWF may swoop in and buy, at the bargain prices generated by the crisis, the discounted mortgage securities at the core of the crisis. Then, since they're also now selling at fire-sale prices, they may buy up some of the finance companies themselves - a rumor circulated around Wall Street last week that agents acting on behalf of China's still-nascent SWF were making inquiries related to picking up Countrywide Financial on the cheap. As Pettis puts it, "The large-scale shift of global reserves into what are being called sovereign wealth funds may provide the party with at least one more bowl of industrial-strength punch."
This solution makes perfect sense. The singular aspect of US economic life this decade has been that it has proved itself to be a society hell-bent on living beyond its means - the 7% of US gross domestic product represented by America's current account deficit means that the country sees nothing very much out of the ordinary or improper at consuming 7% more than it produces.
Much of that excess consumption was provided for by China. In the same manner, the current subprime crisis started with homeowners wanting to live in more houses than they could afford, mortgage brokers lending out more mortgage than the borrowers could repay, and fund managers buying up subprime-mortgage collateralized debt obligations, hoping to earn higher investment-portfolio returns than their intellect and trading skills could generate.
If the US does allow China to bail it out of a mess solely of its own creation, the US will prove itself less of a world superpower and more of a poor, hapless junkie walking into a pawnshop, desperate to sell another bit of its hard-earned family heritage built up over 200-plus years for just one more fix of plasma TVs, MP3 players, Barbie dolls and all the rest of the catalogue of cheap Chinese manufacture on which Americans are now hooked.
In recent years, an entire literary-theory subculture has arisen devoted to the belief that Baum's Wonderful Wizard of Oz was not meant to be just the pleasant, deracinated children's fable it is today, but a pointed allegorical tale related to the raging economic and finance controversies of its time.
This was the era when the debate was between those who wanted the United States to stay on the restrictive gold standard, the bankers and already-rich interests of the US east (as in the Wicked Witch of the East) and those, such as western farmers and populists, who wanted the US to adopt a looser, more accommodating silver standard - just like what Dorothy's magic slippers were made of (they were changed to ruby in the 1939 movie).
This is seen as Baum, a noted populist, advocating the silver standard as the solution to the nation's, particularly the rural and agricultural west's, economic travails. Dorothy's perilous journey down the yellow brick road is here seen as an allegorical warning about over-reliance on the gold standard. The Wizard, the potentate of the Emerald City, provided advice that was worthless, just as emerald-green US paper money unbacked by physical assets was seen to be.
If future literary theorists find an edition of The Wonderful Wizard of Oz that they think was first published in 2007, how will they decipher its symbolic code?
Poor, hapless Dorothy would be seen as representing an unfortunate subprime-mortgage borrower, her dreams of first-time home ownership, with its implied access to the American dream, spinning away and lost in the gale. The Good Witch Glinda, who tries to help Dorothy find her way in this new maze of financial uncertainty, would, of course, be seen as representing none other than the US CNBC cable network's curvaceous "money honey", financial journalist Maria Bartiromo.
The Tin Man with no heart would be the bankers foreclosing on Dorothy's mortgage; the Lion with no courage would be seen as a symbol of America's ruling neo-conservatives, the men who sent today's youth off to die in their wars to hide the fact that they did everything in their power to avoid doing the same in Vietnam. As for the Scarecrow with straw for brains, future literary theorists would pore through current media and conclude that he was an obvious reference to Bush.
But the story would need a new hero. Instead of the hapless Wizard - Ben Bernanke - it would be none other than the kindly, avuncular, bespectacled Zhou Xiaochuan, governor of the Bank of China, whose deployment of foreign-exchange reserves was seen to have saved both Dorothy's home and the US financial system
Tuesday, August 21, 2007
Tuesday, August 14, 2007
Central banks' easy virtue, easy money
By Julian Delasantellis
There's an old story about the late British statesman Winston Churchill at a party. Probably on one of those many nights where never in the field of human excess had so much cognac, brandy and scotch been consumed by a person who historians now say was not an alcoholic, he staggered up to a socialite matron and posed a question:
Churchill: "Madam, would you sleep with me for 5 million pounds?" (In the 1930s, when the British pound was worth more than twice as much to the US dollar than it is now, this was a particularly impressive sum over which to surrender one's virtue.)
Woman: "My goodness, Mr Churchill ... Well, I suppose ... we would have to discuss terms, of course."
Churchill: "Would you sleep with me for 5 pounds?"
Woman: "Mr Churchill, what kind of woman do you think I am?!"
Churchill: "Madam, we've already established that. Now we are haggling about the price."
Thanks to last week's events in the financial markets, we now know the price at which the world's three largest central banks, the Bank of Japan, the European Central Bank and the Federal Reserve Bank of the United States, will drop their posturings about the importance of setting good examples regarding promoting sound banking, lending and credit usage policies and put their principles up for sale.
If the world's stock markets lose, oh, say, US$2 trillion of valuation or so in a month, well, it looks like it's at that point they start "discussing terms". Since March, I've written a number of times in Asia Times Online about what has come to be known as the "subprime crisis", but it was at the end of that first March 6 article, Rocking the subprime house of cards, where I first postulated that this situation would eventually degenerate to a point where central banks and bankers would be called on to intervene. This happened last week.
The Fed and other central banks put up a good fight for their virtue. After the Fed's August 7 meeting, its board of governors produced a statement aggressively optimistic about the state of the US economy and contemptuously dismissive about the possibility that the subprime crisis might represent a potential cloud or two on this relentlessly blue horizon. After reading it, one might have wondered if chairman Ben Bernanke needed his manic-depressive prescription refilled.
The next day, as markets reacted against the Fed statement and the attendant realization that no immediate central bank help was on the horizon, the Fed and the world's other major central banks reversed themselves and went full-throttle floozy for the rest of the week. According to Reuters, by the end of last week the world's major central banks had put more than $325 billion of extra liquidity into the system; the Fed's contribution to that total is said to be in the neighborhood of more than $100 billion.
The US media report stories like this in much the same way they report baseball statistics or Hollywood blood-alcohol test results - lots of coverage but little real understanding. It is only in knowing the mechanics and causation of these events that one can understand just how serious this crisis is now becoming.
The media verb of choice for these procedures is that the Fed has "injected" reserves into the banking system, but this does not mean this exercise is such that you have bankers reporting to Dr Bernanke's office, wherein they lower their Hugo Boss suit trousers to receive a hypodermic syringe's bolus of bucks into their buttocks.
The core method in which the US Federal Reserve exercises day-to-day control over the economy in its purview is through operations that buy and sell debt securities in what is called the Federal Funds market; these are called open market operations. If a central bank wants to withdraw reserves from the banking system, it will sell from their portfolios a quantity of government debt securities into the market; when the buyer clicks a button on his trading terminal and transfers the purchase price of the securities via the miracle of electronic funds transfer (EFT) out of the institution's account into that of the central bank's, the supply of money decreases in the banking system by an amount concomitant with the worth of the securities.
Many of the transactions in this market are repurchase agreements, or repos, wherein one party, usually a large money-center bank, agrees, for a fee, to lend specific securities to another party with a need to fund its reserve requirements for a short period, sometimes as short as one night. The process is reversed when, as happened last week, the central bank wants to increase the supply of money in the banking system. There it buys securities; when it pays for them via EFT, then the money supply gets increased in a similar fashion. In the United States, this process is effected through the Federal Reserve's ongoing relationship with 21 large commercial banks called "primary dealers".
In the 1980s, when central bankers worshipped pint-sized monetarist economic guru Milton Friedman as the living god of wealth, the purpose of these operations was to set and meet a defined policy objective as to where the absolute quantity of money in the economy should be. These days, central bankers are more likely to target a previously specified interest rate; when the media report the results of a Federal Reserve or other central bank's interest-rate decision, this is this rate to which they are referring.
Since an interest rate is, in essence, the price of money, as it goes up so does the cost of borrowing money from a lender, and as it goes down the reverse. This is how the world's interest rates act as the world's economic throttle.
Right now, the target interest rate for funds lent and borrowed in this market is 5.25% in the US; on many days the Federal Reserve Bank of New York, operating on instructions from Federal Reserve headquarters in Washington, DC, goes into the market either to add required liquidity or to sop up and remove excess liquidity, to keep the target interest rate, called the Federal Funds rate, in line.
It is not at all uncommon for the Federal Funds rate to vary from the target rate. Around the Christmas holiday season, the system is frequently short of reserves, as people empty their bank accounts to buy presents; this was particularly true during the holiday season of 1999, when people emptied their bank accounts both to buy presents and because of media reports warning that middle America would soon resemble Fred Flintstone's Bedrock City after the biblical-level devastation soon to be visited on the heartland by Year 2000. Likewise, in the spring, as people deposit their income-tax refund checks, bank reserves are plentiful.
This week, the Federal Reserve noticed that the Federal Funds rate had jumped well beyond its target of 5.25% toward the low and middle 6% range. Other world central banks noticed similar increases beyond their target ranges; in Europe, after news that America's subprime problems had jumped the Atlantic and had been found in European financial institutions such as BNP Paribas and Germany's IKB group, rates had moved to 4.5%, a half-point beyond their target range.
The most common factor that traditionally explains rising interest rates is economic growth; more companies and individuals are borrowing from banks to finance their economic expansion plans. This was not the case last week; borrowings from the system were stable.
The problem wasn't the demand for money; it was the supply. The subprime-mortgage banking crisis, which a year or so ago began in far-distant fields of verdant identical pastel highrise condominiums in such places as San Diego and southern Florida, had finally spread into the absolute core of the modern financial system, this interbank market for overnight reserves.
Calling this entire thing the "subprime crisis" evokes the incorrect notion that the entirety of the "storm and stress" of what the world's markets are going through these days is centered on those poor sods sitting in their overpriced houses on which they've stopped making payments, awaiting the morning when the local county sheriff knocks on their door to put all their rented furniture on the sidewalk when evicting them.
This is where the crisis started but, in reality, like a toy balloon filled with too much air that tears apart at a random point on the balloon's surface, the bursting of the credit/liquidity balloon that so inflated this decade could have begun at any number of the places where irrational exuberance-greed had affected allegedly rational economic actors.
So, out there in the hinterlands of economic activity, subprime borrowers are not paying their mortgages. The people who bought these mortgages, rolled and bundled up into interest-bearing bonds called collateralized debt obligations (CDOs) , now find that they have what is delicately called a "liquidity crisis"; in real-people-speak, they have no income. They are no longer receiving the CDO coupon interest that derived from the mortgage interest payments.
That's a problem both for them and for the institutions they might have borrowed the money from to get the funding to buy the CDOs. If they're not receiving any income payments from the CDO owners (because the CDO owners aren't receiving the mortgage interest payments from the subprime borrowers), then soon they'll be suffering their own "liquidity crisis".
And so on and so on, on and on up the finance food chain until you get to late last week, the arrival of the crying baby of this crisis at the doorstep of the interbank market for short-term reserve finance. The problem has been particularly exacerbated by the current trend in finance to manage balance-sheet assets and liabilities aggressively; in essence, at every level the financial system is now continually doubling down on every bet it makes. If you've got an asset worth x, you might use it as collateral to borrow 5x or 10x, and a pretty similar process governs lending as well.
In many of my articles here I have noted that the key component of modern international finance has been the massive "wave of liquidity" that has buoyed prices on everything from private-equity buyouts to 1950s-era TV-show lunch boxes on eBay.
The wave of liquidity is one of the central arguments for those who believe that the entire subprime crisis is just a tempest in a teapot, that it will have little or no effect on the "real" economy. At a news conference last Wednesday, US President George W Bush opined, "Another factor one has got to look at is the amount of liquidity in the system. In other words, is there enough liquidity to enable markets to be able to correct? And I'm told there is enough liquidity in the system to enable markets to correct."
The essential assumption in that sentiment is that the amount of liquidity, of money and credit, in the system is fixed, as if it's all safely stored away in neat little shrink-wrapped bundles or something.
The very concept of a credit crunch, illustrated in last week's markets, proves this false. We are now seeing that much of the world's liquidity wave can disappear with the same effortless ease with which it was created. Specifically, as the market values of CDOs decline, less can be lent out using them as collateral. With globalized finance meaning that subprimes are now being found in so many more portfolios than previously expected, such as those of BNP and IKB, the process of credit contraction immediately spreads across the planet, much as the global equity-market selloffs are illustrating.
A special factor that spooked the Federal Funds market late in the week, and probably the one that most directly led to the intervention of the Fed and other central banks, was that this market's players can push back from the table any time they want.
The transactions in the Federal Funds markets carry no type of federal deposit-insurance coverage or protection. Thus if you make a deal with another player to be repaid in 24 hours, and if your counterparty goes belly-up in that period, you get right into line at the courthouse door with all the other institutions to which the dearly departed bank owed money; an intended 24-hour transaction might turn into one that lasts a decade, with you paying hefty lawyers' fees the entire time.
Amazingly enough, late last week such gross fear spread through the markets that there were concerns that one or more primary dealers, institutions such as Goldman Sachs, JPMorgan and Credit Suisse, the most cerulean names in US blue-chip finance, might fail to roll up their window-shades and open their doors for business the next morning. Rather than make uncovered loans to these potential cordon bleu deadbeats, other players got up from the table and pulled in their lending to this market. That produced the shortage of lendable reserves in this market that caused the rise in short-term interest rates, and was what drove the central bankers to ride in and attempt their first of what could be many rescue attempts.
Elvis Presley was more likely singing about women than international financial-market liquidity when he sang the title track for a movie in 1967, but the principle is the same. Easy come, easy go.
Illustrative of the fact that, yes, the subprime crisis is having an effect in the "real" economy is the rather anomalous behavior currently going on in the commodity markets, particularly for petroleum products. (See my April 4 article Crude: Barrels of fun to crack you up and the April 24 article Why oil chiefs are feelin' groovy, on last spring's activity in the oil markets.)
In late spring and early summer, it seemed that oil and product futures prices were on a one-way trajectory straight to the moon and stars, as shortages in US refinery capacity were putting tremendous upward pressure on these markets. However, since August 1, oil futures prices have plunged 11% on US markets. Much like equities, there's just not enough money and liquidity around to support the previously high prices anymore; beyond that, there's an extended message that the markets are trying to deliver, that soon a lot of people are going to be focusing their driving efforts more on short trips to the local unemployment office than to some far-flung mall.
The response of Bush and other economic conservatives (such as the ones he appointed to the US Federal Reserve Board) to the rescue of the subprime market now underwater has been in essence similar to his response to the rescue of New Orleans when it was underwater from Hurricane Katrina in 2005. No.
Late last week, a possible solution to the subprime crisis was raised; the US semi-official mortgage guarantor agencies, the Federal Home Loan and Mortgage Corp (called Freddie Mac in the markets) and the Federal National Mortgage Association (similarly called Fannie Mae), suggested they might be willing to buy up at risk subprime paper in the market, thus allowing the homeowners to stay in their homes. More important for Wall Street, it would take the now-radioactive subprime CDOs off its hands and inject more liquidity into the system. Bush sniffed at the suggestion; he said the two agencies had to be first "reformed" of the rampant corruption that economic conservatives always seem to find in public agencies.
In general, economic conservatives say the role of government in ameliorating this crisis should be, at most, virtually non-existent.
Much like pregnant ghetto teenagers, they say that those suffering in the subprime crisis are there wholly through their own misguided actions, specifically, their greed. No government actions, including anything by the Federal Reserve, should be taken on their behalf. They must suffer the pain that is the rightful and just consequence of their imprudent actions. An editorial in Saturday's Wall Street Journal summarized this philosophy very succinctly.
No one wants to see someone lose his home to foreclosure. But many of those most at risk bought their homes with little or no money down, and so have very little at stake economically. Bringing in the feds to bail them out would send precisely the wrong message - that risky or overly aggressive borrowing will be rewarded by the government rather than punished in the marketplace. To the extent that bad loans were made, the market needs to clear, not be propped up by federal aid programs ...
With the current market turmoil, Mr Bernanke faces his first big test as chairman of the Federal Reserve. The biggest favor he could do for himself and the markets is not to give in to the temptation to do favors for Wall Street or anyone else, and to remain focused on his price-stability mandate.
What this editorial is trying to say is that the markets must be disabused of the notion that some institutions are, like those that lent billions to hedge fund Long-Term Capital Management in 1998, or the banks that lent to Mexico in 1982, "too big to fail". Much as the ghetto teenager who loses her welfare benefits and so, like a modern-day Flying Dutchman of the service sector, is sentenced to push a broom at McDonald's for all eternity, those who make mistakes must forever pay for their actions.
Warnings against the dangers of excessive credit utilization are also a regular part of Federal Reserve communications with the general public. In a publication titled Building Wealth, the Federal Reserve Bank of Dallas provides these dictums.
Liabilities are your debts. Debt reduces net worth. Plus, the interest you pay on debt, including credit-card debt, is money that cannot be saved or invested - it's just gone. Debt is a tool to be used wisely for such things as buying a house. If not used wisely, debt can easily get out of hand ...
Develop a budget and stick to it. Save money so you're prepared for unforeseen circumstances. You should have at least three to six months of living expenses stashed in your rainy-day savings account, because as the poet [Henry Wadsworth] Longfellow put it, "Into each life some rain must fall." When faced with a choice of financing a purchase, it may be a better financial decision to choose a less expensive model of the same product and save or invest the difference. Pay off credit-card balances monthly.
This is all sound, prudent and conservative financial advice; the underlying cause of the subprime crisis is that, for much of this decade, America's financial elite has basically not practiced any of it. Do as I say, be cautious and careful, not as I do; I'm borrowing and lending like a drunken sailor with free tickets to a beer fest.
With this as intellectual background, you might have expected the conservative-libertarian economic community to have decried the Federal Reserve money-market interventions. After all, if a few or more primary dealers had imprudent connections, even if they were once, twice or more removed, with the subprime market, their insolvency and bankruptcy could only have a proper disciplining effect on the market. The example of their misery and penury will act to ensure that future market participants eschew the next upcoming financial-market inanity.
Not on your life. While it's true that these economic conservatives are cradle-to-the-grave misanthropes who decry everything from government funding of infant inoculations to Meals on Wheels for elderly shut-ins, still they are proving themselves to be a lot more sanguine about the prospect of government assistance if the assistance is directed at members of their own elite class.
As former Ronald Reagan-era (1980s) economic official and current CNBC economic commentator, Larry Kudlow, put it in his National Review Online blog, "The Fed and other central banks are prudently injecting $131 billion of new cash to 'facilitate the orderly functioning' of markets. Fed chairman Ben Bernanke has the story right."
Of course he has. Principles and ideologies are fine on a sunny day, but the subprime crisis is now threatening core institutions of the financial system that has rewarded the elite so generously - beliefs be damned, Bernanke, get in there and save our portfolios. For all the "financial education" the US Federal Reserve provides the masses, and all the verbiage about what cautious, exacting, circumspect bankers they are, this crisis, like all the rest that came before them and all those that are to follow, prove that they are, at crunch time, just Wall Streetwalkers, always available to compromise their principles to pleasure their masters.
In 1925, George Orwell lyrically described an encounter he had with a member of the sisterhood of the oldest profession in the world.
When I was young and had no sense
In far-off Mandalay
I lost my heart to a Burmese girl
As lovely as the day.
Her skin was gold, her hair was jet,
Her teeth were ivory;
I said, "For twenty silver pieces,
Maiden, sleep with me."
She looked at me, so pure, so sad,
The loveliest thing alive,
And in her lisping, virgin voice,
Stood out for twenty-five.
That's also sage counsel for Bernanke. As the credit crisis continues to deepen, and as calls rise for a 50-basis-point cut in Federal Reserve interest rates, he can always provide an effective palliative for his conscience by saying he "stood out for twenty-five".
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
There's an old story about the late British statesman Winston Churchill at a party. Probably on one of those many nights where never in the field of human excess had so much cognac, brandy and scotch been consumed by a person who historians now say was not an alcoholic, he staggered up to a socialite matron and posed a question:
Churchill: "Madam, would you sleep with me for 5 million pounds?" (In the 1930s, when the British pound was worth more than twice as much to the US dollar than it is now, this was a particularly impressive sum over which to surrender one's virtue.)
Woman: "My goodness, Mr Churchill ... Well, I suppose ... we would have to discuss terms, of course."
Churchill: "Would you sleep with me for 5 pounds?"
Woman: "Mr Churchill, what kind of woman do you think I am?!"
Churchill: "Madam, we've already established that. Now we are haggling about the price."
Thanks to last week's events in the financial markets, we now know the price at which the world's three largest central banks, the Bank of Japan, the European Central Bank and the Federal Reserve Bank of the United States, will drop their posturings about the importance of setting good examples regarding promoting sound banking, lending and credit usage policies and put their principles up for sale.
If the world's stock markets lose, oh, say, US$2 trillion of valuation or so in a month, well, it looks like it's at that point they start "discussing terms". Since March, I've written a number of times in Asia Times Online about what has come to be known as the "subprime crisis", but it was at the end of that first March 6 article, Rocking the subprime house of cards, where I first postulated that this situation would eventually degenerate to a point where central banks and bankers would be called on to intervene. This happened last week.
The Fed and other central banks put up a good fight for their virtue. After the Fed's August 7 meeting, its board of governors produced a statement aggressively optimistic about the state of the US economy and contemptuously dismissive about the possibility that the subprime crisis might represent a potential cloud or two on this relentlessly blue horizon. After reading it, one might have wondered if chairman Ben Bernanke needed his manic-depressive prescription refilled.
The next day, as markets reacted against the Fed statement and the attendant realization that no immediate central bank help was on the horizon, the Fed and the world's other major central banks reversed themselves and went full-throttle floozy for the rest of the week. According to Reuters, by the end of last week the world's major central banks had put more than $325 billion of extra liquidity into the system; the Fed's contribution to that total is said to be in the neighborhood of more than $100 billion.
The US media report stories like this in much the same way they report baseball statistics or Hollywood blood-alcohol test results - lots of coverage but little real understanding. It is only in knowing the mechanics and causation of these events that one can understand just how serious this crisis is now becoming.
The media verb of choice for these procedures is that the Fed has "injected" reserves into the banking system, but this does not mean this exercise is such that you have bankers reporting to Dr Bernanke's office, wherein they lower their Hugo Boss suit trousers to receive a hypodermic syringe's bolus of bucks into their buttocks.
The core method in which the US Federal Reserve exercises day-to-day control over the economy in its purview is through operations that buy and sell debt securities in what is called the Federal Funds market; these are called open market operations. If a central bank wants to withdraw reserves from the banking system, it will sell from their portfolios a quantity of government debt securities into the market; when the buyer clicks a button on his trading terminal and transfers the purchase price of the securities via the miracle of electronic funds transfer (EFT) out of the institution's account into that of the central bank's, the supply of money decreases in the banking system by an amount concomitant with the worth of the securities.
Many of the transactions in this market are repurchase agreements, or repos, wherein one party, usually a large money-center bank, agrees, for a fee, to lend specific securities to another party with a need to fund its reserve requirements for a short period, sometimes as short as one night. The process is reversed when, as happened last week, the central bank wants to increase the supply of money in the banking system. There it buys securities; when it pays for them via EFT, then the money supply gets increased in a similar fashion. In the United States, this process is effected through the Federal Reserve's ongoing relationship with 21 large commercial banks called "primary dealers".
In the 1980s, when central bankers worshipped pint-sized monetarist economic guru Milton Friedman as the living god of wealth, the purpose of these operations was to set and meet a defined policy objective as to where the absolute quantity of money in the economy should be. These days, central bankers are more likely to target a previously specified interest rate; when the media report the results of a Federal Reserve or other central bank's interest-rate decision, this is this rate to which they are referring.
Since an interest rate is, in essence, the price of money, as it goes up so does the cost of borrowing money from a lender, and as it goes down the reverse. This is how the world's interest rates act as the world's economic throttle.
Right now, the target interest rate for funds lent and borrowed in this market is 5.25% in the US; on many days the Federal Reserve Bank of New York, operating on instructions from Federal Reserve headquarters in Washington, DC, goes into the market either to add required liquidity or to sop up and remove excess liquidity, to keep the target interest rate, called the Federal Funds rate, in line.
It is not at all uncommon for the Federal Funds rate to vary from the target rate. Around the Christmas holiday season, the system is frequently short of reserves, as people empty their bank accounts to buy presents; this was particularly true during the holiday season of 1999, when people emptied their bank accounts both to buy presents and because of media reports warning that middle America would soon resemble Fred Flintstone's Bedrock City after the biblical-level devastation soon to be visited on the heartland by Year 2000. Likewise, in the spring, as people deposit their income-tax refund checks, bank reserves are plentiful.
This week, the Federal Reserve noticed that the Federal Funds rate had jumped well beyond its target of 5.25% toward the low and middle 6% range. Other world central banks noticed similar increases beyond their target ranges; in Europe, after news that America's subprime problems had jumped the Atlantic and had been found in European financial institutions such as BNP Paribas and Germany's IKB group, rates had moved to 4.5%, a half-point beyond their target range.
The most common factor that traditionally explains rising interest rates is economic growth; more companies and individuals are borrowing from banks to finance their economic expansion plans. This was not the case last week; borrowings from the system were stable.
The problem wasn't the demand for money; it was the supply. The subprime-mortgage banking crisis, which a year or so ago began in far-distant fields of verdant identical pastel highrise condominiums in such places as San Diego and southern Florida, had finally spread into the absolute core of the modern financial system, this interbank market for overnight reserves.
Calling this entire thing the "subprime crisis" evokes the incorrect notion that the entirety of the "storm and stress" of what the world's markets are going through these days is centered on those poor sods sitting in their overpriced houses on which they've stopped making payments, awaiting the morning when the local county sheriff knocks on their door to put all their rented furniture on the sidewalk when evicting them.
This is where the crisis started but, in reality, like a toy balloon filled with too much air that tears apart at a random point on the balloon's surface, the bursting of the credit/liquidity balloon that so inflated this decade could have begun at any number of the places where irrational exuberance-greed had affected allegedly rational economic actors.
So, out there in the hinterlands of economic activity, subprime borrowers are not paying their mortgages. The people who bought these mortgages, rolled and bundled up into interest-bearing bonds called collateralized debt obligations (CDOs) , now find that they have what is delicately called a "liquidity crisis"; in real-people-speak, they have no income. They are no longer receiving the CDO coupon interest that derived from the mortgage interest payments.
That's a problem both for them and for the institutions they might have borrowed the money from to get the funding to buy the CDOs. If they're not receiving any income payments from the CDO owners (because the CDO owners aren't receiving the mortgage interest payments from the subprime borrowers), then soon they'll be suffering their own "liquidity crisis".
And so on and so on, on and on up the finance food chain until you get to late last week, the arrival of the crying baby of this crisis at the doorstep of the interbank market for short-term reserve finance. The problem has been particularly exacerbated by the current trend in finance to manage balance-sheet assets and liabilities aggressively; in essence, at every level the financial system is now continually doubling down on every bet it makes. If you've got an asset worth x, you might use it as collateral to borrow 5x or 10x, and a pretty similar process governs lending as well.
In many of my articles here I have noted that the key component of modern international finance has been the massive "wave of liquidity" that has buoyed prices on everything from private-equity buyouts to 1950s-era TV-show lunch boxes on eBay.
The wave of liquidity is one of the central arguments for those who believe that the entire subprime crisis is just a tempest in a teapot, that it will have little or no effect on the "real" economy. At a news conference last Wednesday, US President George W Bush opined, "Another factor one has got to look at is the amount of liquidity in the system. In other words, is there enough liquidity to enable markets to be able to correct? And I'm told there is enough liquidity in the system to enable markets to correct."
The essential assumption in that sentiment is that the amount of liquidity, of money and credit, in the system is fixed, as if it's all safely stored away in neat little shrink-wrapped bundles or something.
The very concept of a credit crunch, illustrated in last week's markets, proves this false. We are now seeing that much of the world's liquidity wave can disappear with the same effortless ease with which it was created. Specifically, as the market values of CDOs decline, less can be lent out using them as collateral. With globalized finance meaning that subprimes are now being found in so many more portfolios than previously expected, such as those of BNP and IKB, the process of credit contraction immediately spreads across the planet, much as the global equity-market selloffs are illustrating.
A special factor that spooked the Federal Funds market late in the week, and probably the one that most directly led to the intervention of the Fed and other central banks, was that this market's players can push back from the table any time they want.
The transactions in the Federal Funds markets carry no type of federal deposit-insurance coverage or protection. Thus if you make a deal with another player to be repaid in 24 hours, and if your counterparty goes belly-up in that period, you get right into line at the courthouse door with all the other institutions to which the dearly departed bank owed money; an intended 24-hour transaction might turn into one that lasts a decade, with you paying hefty lawyers' fees the entire time.
Amazingly enough, late last week such gross fear spread through the markets that there were concerns that one or more primary dealers, institutions such as Goldman Sachs, JPMorgan and Credit Suisse, the most cerulean names in US blue-chip finance, might fail to roll up their window-shades and open their doors for business the next morning. Rather than make uncovered loans to these potential cordon bleu deadbeats, other players got up from the table and pulled in their lending to this market. That produced the shortage of lendable reserves in this market that caused the rise in short-term interest rates, and was what drove the central bankers to ride in and attempt their first of what could be many rescue attempts.
Elvis Presley was more likely singing about women than international financial-market liquidity when he sang the title track for a movie in 1967, but the principle is the same. Easy come, easy go.
Illustrative of the fact that, yes, the subprime crisis is having an effect in the "real" economy is the rather anomalous behavior currently going on in the commodity markets, particularly for petroleum products. (See my April 4 article Crude: Barrels of fun to crack you up and the April 24 article Why oil chiefs are feelin' groovy, on last spring's activity in the oil markets.)
In late spring and early summer, it seemed that oil and product futures prices were on a one-way trajectory straight to the moon and stars, as shortages in US refinery capacity were putting tremendous upward pressure on these markets. However, since August 1, oil futures prices have plunged 11% on US markets. Much like equities, there's just not enough money and liquidity around to support the previously high prices anymore; beyond that, there's an extended message that the markets are trying to deliver, that soon a lot of people are going to be focusing their driving efforts more on short trips to the local unemployment office than to some far-flung mall.
The response of Bush and other economic conservatives (such as the ones he appointed to the US Federal Reserve Board) to the rescue of the subprime market now underwater has been in essence similar to his response to the rescue of New Orleans when it was underwater from Hurricane Katrina in 2005. No.
Late last week, a possible solution to the subprime crisis was raised; the US semi-official mortgage guarantor agencies, the Federal Home Loan and Mortgage Corp (called Freddie Mac in the markets) and the Federal National Mortgage Association (similarly called Fannie Mae), suggested they might be willing to buy up at risk subprime paper in the market, thus allowing the homeowners to stay in their homes. More important for Wall Street, it would take the now-radioactive subprime CDOs off its hands and inject more liquidity into the system. Bush sniffed at the suggestion; he said the two agencies had to be first "reformed" of the rampant corruption that economic conservatives always seem to find in public agencies.
In general, economic conservatives say the role of government in ameliorating this crisis should be, at most, virtually non-existent.
Much like pregnant ghetto teenagers, they say that those suffering in the subprime crisis are there wholly through their own misguided actions, specifically, their greed. No government actions, including anything by the Federal Reserve, should be taken on their behalf. They must suffer the pain that is the rightful and just consequence of their imprudent actions. An editorial in Saturday's Wall Street Journal summarized this philosophy very succinctly.
No one wants to see someone lose his home to foreclosure. But many of those most at risk bought their homes with little or no money down, and so have very little at stake economically. Bringing in the feds to bail them out would send precisely the wrong message - that risky or overly aggressive borrowing will be rewarded by the government rather than punished in the marketplace. To the extent that bad loans were made, the market needs to clear, not be propped up by federal aid programs ...
With the current market turmoil, Mr Bernanke faces his first big test as chairman of the Federal Reserve. The biggest favor he could do for himself and the markets is not to give in to the temptation to do favors for Wall Street or anyone else, and to remain focused on his price-stability mandate.
What this editorial is trying to say is that the markets must be disabused of the notion that some institutions are, like those that lent billions to hedge fund Long-Term Capital Management in 1998, or the banks that lent to Mexico in 1982, "too big to fail". Much as the ghetto teenager who loses her welfare benefits and so, like a modern-day Flying Dutchman of the service sector, is sentenced to push a broom at McDonald's for all eternity, those who make mistakes must forever pay for their actions.
Warnings against the dangers of excessive credit utilization are also a regular part of Federal Reserve communications with the general public. In a publication titled Building Wealth, the Federal Reserve Bank of Dallas provides these dictums.
Liabilities are your debts. Debt reduces net worth. Plus, the interest you pay on debt, including credit-card debt, is money that cannot be saved or invested - it's just gone. Debt is a tool to be used wisely for such things as buying a house. If not used wisely, debt can easily get out of hand ...
Develop a budget and stick to it. Save money so you're prepared for unforeseen circumstances. You should have at least three to six months of living expenses stashed in your rainy-day savings account, because as the poet [Henry Wadsworth] Longfellow put it, "Into each life some rain must fall." When faced with a choice of financing a purchase, it may be a better financial decision to choose a less expensive model of the same product and save or invest the difference. Pay off credit-card balances monthly.
This is all sound, prudent and conservative financial advice; the underlying cause of the subprime crisis is that, for much of this decade, America's financial elite has basically not practiced any of it. Do as I say, be cautious and careful, not as I do; I'm borrowing and lending like a drunken sailor with free tickets to a beer fest.
With this as intellectual background, you might have expected the conservative-libertarian economic community to have decried the Federal Reserve money-market interventions. After all, if a few or more primary dealers had imprudent connections, even if they were once, twice or more removed, with the subprime market, their insolvency and bankruptcy could only have a proper disciplining effect on the market. The example of their misery and penury will act to ensure that future market participants eschew the next upcoming financial-market inanity.
Not on your life. While it's true that these economic conservatives are cradle-to-the-grave misanthropes who decry everything from government funding of infant inoculations to Meals on Wheels for elderly shut-ins, still they are proving themselves to be a lot more sanguine about the prospect of government assistance if the assistance is directed at members of their own elite class.
As former Ronald Reagan-era (1980s) economic official and current CNBC economic commentator, Larry Kudlow, put it in his National Review Online blog, "The Fed and other central banks are prudently injecting $131 billion of new cash to 'facilitate the orderly functioning' of markets. Fed chairman Ben Bernanke has the story right."
Of course he has. Principles and ideologies are fine on a sunny day, but the subprime crisis is now threatening core institutions of the financial system that has rewarded the elite so generously - beliefs be damned, Bernanke, get in there and save our portfolios. For all the "financial education" the US Federal Reserve provides the masses, and all the verbiage about what cautious, exacting, circumspect bankers they are, this crisis, like all the rest that came before them and all those that are to follow, prove that they are, at crunch time, just Wall Streetwalkers, always available to compromise their principles to pleasure their masters.
In 1925, George Orwell lyrically described an encounter he had with a member of the sisterhood of the oldest profession in the world.
When I was young and had no sense
In far-off Mandalay
I lost my heart to a Burmese girl
As lovely as the day.
Her skin was gold, her hair was jet,
Her teeth were ivory;
I said, "For twenty silver pieces,
Maiden, sleep with me."
She looked at me, so pure, so sad,
The loveliest thing alive,
And in her lisping, virgin voice,
Stood out for twenty-five.
That's also sage counsel for Bernanke. As the credit crisis continues to deepen, and as calls rise for a 50-basis-point cut in Federal Reserve interest rates, he can always provide an effective palliative for his conscience by saying he "stood out for twenty-five".
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
Saturday, August 11, 2007
Asia and the vicious cycle of bank bailouts
By Chan Akya
In the past few days, a number of European banks have announced substantial losses on the US subprime and related sectors, which combined with a suspension of redemptions by various funds, caused temporary panic in money markets. Both the European Central Bank and the Fed responded by injecting liquidity into the system, but market confidence had been shaken so badly by then that dislocation in credit and equity markets became unavoidable.
The scale of losses has increased after Thursday's beating in the stock markets that saw US stocks lose over 3%, followed by similar declines across Asia on Friday. There is a lot of refinancing that will hit the interbank market next week, usual for any mid-month, which given this week's dislocation points to further volatility. At some point, both the Fed and the ECB will need to intervene directly (moral hazard) to avoid further panic.
Every time markets anywhere tumble, media speculation inevitably focuses on the identity of the biggest losers. In particular, the likelihood of losses being sustained by highly visible, famous or simply obscenely rich people is greeted with more than its due share of glee.
However, this article will not focus on who lost what and when, but rather will focus on the more important question of why.
What banks do
Banking is such a simple business that governments around the world feel the need to erect entry barriers, while bankers themselves adopt unnecessarily arcane jargon to give themselves an air of intellectual superiority to go with their generally good fortunes. After government bureaucrats, bankers command the highest ratio of social respect to intellectual capability. In other words, for a bunch of fairly simple if not dumb people, bankers sure are well treated by society at large.
The function of a bank is simply to collect savings from individuals, for which it pays a minimal interest rate, called the savings rate, that increases relative to the time that the funds are locked in. The funds thus collected are used by banks to lend money to companies and to purchase securities issued by governments and other borrowers, earning interest on such lending. Banks pocket the difference - or margin, to use the jargon - between the savings and lending rates, from which they deduct staff expenses and losses.
Now, that doesn't sound too complicated, does it? It's not, but there are always other factors at work that help to determine exactly how much banks can make. For example, central banks may prevent local banks from lending money abroad or, more pertinently in Asia, foreign banks from lending money locally. In some countries, there are rules about how much banks need to lend to the local government, controls on both savings and lending rates and the like.
The reason for that simplistic explanation of banking given above is not to insult the intelligence of Asia Times Online readers but rather to show how even with simple business models, people can rack up billions in losses in a matter of months. I am always intrigued by the specter of losses running into billions. A simple example would suffice - if one were physically to burn US$100 bills at the rate of one every 10 seconds (six every minute), it would take more than three years to get through a billion dollars - yet banks casually and routinely make such announcements all the time. They either must have some really large furnaces to burn all the money in, or be experts at making investment losses. Of the two, I rather suspect the latter, if only because the former still involves too much physical work that bankers are unlikely ever to pursue in their lives.
New market realities
In the comfortable existence of global bankers, this decade marked a seismic shift for reasons that are entirely outside their sphere of influence. The reference is of course to Asian central banks, which merrily started accumulating American and European bonds at a faster clip than at any other time in history. In so doing, these central banks removed the comfortable spread between borrowing rates and lending rates, because bond yields dramatically declined as a result of their buying.
Thus when central banks around the world tried to fight inflationary pressures by increasing interest rates from 2005 onward, banks found themselves in the unenviable position of having investments that yielded less than what they had to pay on savings accounts. That was the most extreme case, for some European banks, but for most banks the new reality was at least a rapidly declining margin. Because of this decline in margins, banks around the world were forced to increase their own leverage - so instead of borrowing $100 from investors and lending $100 to companies, they now had to lend $200 to make the same amount of money.
This they did by borrowing $100 from other investors, for example Asian central banks, which thought this attractive, as they received higher interest rates from banks than from governments for similar levels of risk. The rapid acceleration of reserve accumulation by Asian central banks this decade increased the pressure on lenders to borrow more money to make the same or higher net profits.
Banking on globalization
As if one external source of change wasn't enough, there was also a second factor that played an increasingly dominant role over this decade. That was demographics - the aging of populations in both Europe and the United States. While the latter managed to make do with higher immigration that helped to compensate for its population graying away, European countries remained obdurate on immigration.
As populations age, they also tend to save more than they spend. This was another source of excess savings that helped to increase the overall borrowing costs of banks in North America and Europe (remember the minimum savings rates mentioned above), while simultaneously reducing the number of customers willing to borrow (as old people tend not to borrow).
Looking for ways to manage this train wreck, these banks aggressively expanded their loans to exotic customers, the type that would have been denied banking barely a generation ago. For the US banks, the easy choice was to lend more money to immigrants, while for European banks; it was to lend more money to either US banks or to the securitized products marketed by such banks. I wrote in a previous article about Asian central banks suffering collateral damage from all this. [1]
This is globalization, after all. A saver in Sichuan or Salzburg doesn't lend money in Chengdu or Austria; because of a paucity of local opportunities, it is more than likely that they both lend to a Mexican immigrant in San Jose, California. That is the commercial extension of what I called imperialism [2] in a recent article.
Bailouts and haircuts
It is generally a feature of any market crisis over the past 20 years that a well-known European bank would announce staggering losses, and then be bailed out by its government. True to form, this week we saw announcements from Germany and France about large losses of banks there on the US subprime crisis. Authorities immediately convened rescue groups for stricken banks, helping to avoid any further fallout. For their part, American bankers have been nervous about the fate of a largish investment bank, although any speculation about a failure is being pooh-poohed vehemently.
The process of taking losses on investment losses is euphemistically referred to as "haircuts" by bankers, even if the scale of losses absorbed would argue for more colorful phrases reminiscent of the Queen of Hearts. [3] While not every haircut needs a bailout, someone eventually pays. The most common form of a bailout is a direct rescue that is arranged through the good offices of a state-owned bank.
The more indirect route to a bailout is through interest-rate policies. Former US Federal Reserve chairman Alan Greenspan notoriously invoked the option to cut interest rates on many occasions, helping to thwart banking crises in the US, but creating in its place the asset bubble that now threatens the global financial system. Today's central bankers appear to be more focused on avoiding inflationary pressures, but they haven't been severely tested with a crisis yet.
In particular, I find the social aspects of the US subprime crisis a matter of interest. It is not often in a democracy that a large and visible minority suffer the indignity of bankruptcies and losing their homes without repercussions on government. In the current situation, the preponderance of losses among younger families of a minority background mean that the chances of political intervention are simply too high.
In so doing, though, Western governments threaten to unleash another mountain of fiat money on the world, in turn reducing real returns further. While the initial moves such as cutting interest rates or providing credit relief to beleaguered individuals unable to meet their mortgage obligations may help to stem the current crisis, the longer-term impact on government credibility as well as currency values will necessarily be negative.
There is no reason for Asia to participate in this bailout; indeed, it is within its interest to exact the highest possible political costs on the US and Europe when they go about rescuing their banks or individual borrowers. This can be done only by a sensible policy of removing the automatic link between reserve accumulation and current-account surpluses. Asian central banks must reduce their holdings of US dollars and euros now, thereby pushing up borrowing costs for the US and Europe. That increase in borrowing costs will more than offset any central-bank accommodation in those countries, and help Asia to gain the upper hand in negotiations over trade, intellectual property, global warming and other issues.
Detritus, Samson and Delilah
Credit-market losses are like detritus suspended in an aquarium, mildly irritating at first but eventually toxic for all inhabitants in the system. The biblical figure of Samson was felled by Delilah; in much the same way, global banks have to endure "haircuts" on their investment portfolios that eventually will force central banks to cut rates. By blithely accumulating government bonds in the US and Europe, Asian central banks have unwittingly played the role of Delilah.
Rate cuts in the US and Europe would help generate accounting profits for Asian central banks in the near term, but the policy also sows the seeds for future crises in the US and Europe. The only way to break this vicious cycle is for Asian savers to cut their overall allocations to the US and European asset markets, focusing instead on markets around the region. The additional benefit of this approach would be immediate results on difficult negotiations involving protectionism, global warming, and intellectual property.
In the past few days, a number of European banks have announced substantial losses on the US subprime and related sectors, which combined with a suspension of redemptions by various funds, caused temporary panic in money markets. Both the European Central Bank and the Fed responded by injecting liquidity into the system, but market confidence had been shaken so badly by then that dislocation in credit and equity markets became unavoidable.
The scale of losses has increased after Thursday's beating in the stock markets that saw US stocks lose over 3%, followed by similar declines across Asia on Friday. There is a lot of refinancing that will hit the interbank market next week, usual for any mid-month, which given this week's dislocation points to further volatility. At some point, both the Fed and the ECB will need to intervene directly (moral hazard) to avoid further panic.
Every time markets anywhere tumble, media speculation inevitably focuses on the identity of the biggest losers. In particular, the likelihood of losses being sustained by highly visible, famous or simply obscenely rich people is greeted with more than its due share of glee.
However, this article will not focus on who lost what and when, but rather will focus on the more important question of why.
What banks do
Banking is such a simple business that governments around the world feel the need to erect entry barriers, while bankers themselves adopt unnecessarily arcane jargon to give themselves an air of intellectual superiority to go with their generally good fortunes. After government bureaucrats, bankers command the highest ratio of social respect to intellectual capability. In other words, for a bunch of fairly simple if not dumb people, bankers sure are well treated by society at large.
The function of a bank is simply to collect savings from individuals, for which it pays a minimal interest rate, called the savings rate, that increases relative to the time that the funds are locked in. The funds thus collected are used by banks to lend money to companies and to purchase securities issued by governments and other borrowers, earning interest on such lending. Banks pocket the difference - or margin, to use the jargon - between the savings and lending rates, from which they deduct staff expenses and losses.
Now, that doesn't sound too complicated, does it? It's not, but there are always other factors at work that help to determine exactly how much banks can make. For example, central banks may prevent local banks from lending money abroad or, more pertinently in Asia, foreign banks from lending money locally. In some countries, there are rules about how much banks need to lend to the local government, controls on both savings and lending rates and the like.
The reason for that simplistic explanation of banking given above is not to insult the intelligence of Asia Times Online readers but rather to show how even with simple business models, people can rack up billions in losses in a matter of months. I am always intrigued by the specter of losses running into billions. A simple example would suffice - if one were physically to burn US$100 bills at the rate of one every 10 seconds (six every minute), it would take more than three years to get through a billion dollars - yet banks casually and routinely make such announcements all the time. They either must have some really large furnaces to burn all the money in, or be experts at making investment losses. Of the two, I rather suspect the latter, if only because the former still involves too much physical work that bankers are unlikely ever to pursue in their lives.
New market realities
In the comfortable existence of global bankers, this decade marked a seismic shift for reasons that are entirely outside their sphere of influence. The reference is of course to Asian central banks, which merrily started accumulating American and European bonds at a faster clip than at any other time in history. In so doing, these central banks removed the comfortable spread between borrowing rates and lending rates, because bond yields dramatically declined as a result of their buying.
Thus when central banks around the world tried to fight inflationary pressures by increasing interest rates from 2005 onward, banks found themselves in the unenviable position of having investments that yielded less than what they had to pay on savings accounts. That was the most extreme case, for some European banks, but for most banks the new reality was at least a rapidly declining margin. Because of this decline in margins, banks around the world were forced to increase their own leverage - so instead of borrowing $100 from investors and lending $100 to companies, they now had to lend $200 to make the same amount of money.
This they did by borrowing $100 from other investors, for example Asian central banks, which thought this attractive, as they received higher interest rates from banks than from governments for similar levels of risk. The rapid acceleration of reserve accumulation by Asian central banks this decade increased the pressure on lenders to borrow more money to make the same or higher net profits.
Banking on globalization
As if one external source of change wasn't enough, there was also a second factor that played an increasingly dominant role over this decade. That was demographics - the aging of populations in both Europe and the United States. While the latter managed to make do with higher immigration that helped to compensate for its population graying away, European countries remained obdurate on immigration.
As populations age, they also tend to save more than they spend. This was another source of excess savings that helped to increase the overall borrowing costs of banks in North America and Europe (remember the minimum savings rates mentioned above), while simultaneously reducing the number of customers willing to borrow (as old people tend not to borrow).
Looking for ways to manage this train wreck, these banks aggressively expanded their loans to exotic customers, the type that would have been denied banking barely a generation ago. For the US banks, the easy choice was to lend more money to immigrants, while for European banks; it was to lend more money to either US banks or to the securitized products marketed by such banks. I wrote in a previous article about Asian central banks suffering collateral damage from all this. [1]
This is globalization, after all. A saver in Sichuan or Salzburg doesn't lend money in Chengdu or Austria; because of a paucity of local opportunities, it is more than likely that they both lend to a Mexican immigrant in San Jose, California. That is the commercial extension of what I called imperialism [2] in a recent article.
Bailouts and haircuts
It is generally a feature of any market crisis over the past 20 years that a well-known European bank would announce staggering losses, and then be bailed out by its government. True to form, this week we saw announcements from Germany and France about large losses of banks there on the US subprime crisis. Authorities immediately convened rescue groups for stricken banks, helping to avoid any further fallout. For their part, American bankers have been nervous about the fate of a largish investment bank, although any speculation about a failure is being pooh-poohed vehemently.
The process of taking losses on investment losses is euphemistically referred to as "haircuts" by bankers, even if the scale of losses absorbed would argue for more colorful phrases reminiscent of the Queen of Hearts. [3] While not every haircut needs a bailout, someone eventually pays. The most common form of a bailout is a direct rescue that is arranged through the good offices of a state-owned bank.
The more indirect route to a bailout is through interest-rate policies. Former US Federal Reserve chairman Alan Greenspan notoriously invoked the option to cut interest rates on many occasions, helping to thwart banking crises in the US, but creating in its place the asset bubble that now threatens the global financial system. Today's central bankers appear to be more focused on avoiding inflationary pressures, but they haven't been severely tested with a crisis yet.
In particular, I find the social aspects of the US subprime crisis a matter of interest. It is not often in a democracy that a large and visible minority suffer the indignity of bankruptcies and losing their homes without repercussions on government. In the current situation, the preponderance of losses among younger families of a minority background mean that the chances of political intervention are simply too high.
In so doing, though, Western governments threaten to unleash another mountain of fiat money on the world, in turn reducing real returns further. While the initial moves such as cutting interest rates or providing credit relief to beleaguered individuals unable to meet their mortgage obligations may help to stem the current crisis, the longer-term impact on government credibility as well as currency values will necessarily be negative.
There is no reason for Asia to participate in this bailout; indeed, it is within its interest to exact the highest possible political costs on the US and Europe when they go about rescuing their banks or individual borrowers. This can be done only by a sensible policy of removing the automatic link between reserve accumulation and current-account surpluses. Asian central banks must reduce their holdings of US dollars and euros now, thereby pushing up borrowing costs for the US and Europe. That increase in borrowing costs will more than offset any central-bank accommodation in those countries, and help Asia to gain the upper hand in negotiations over trade, intellectual property, global warming and other issues.
Detritus, Samson and Delilah
Credit-market losses are like detritus suspended in an aquarium, mildly irritating at first but eventually toxic for all inhabitants in the system. The biblical figure of Samson was felled by Delilah; in much the same way, global banks have to endure "haircuts" on their investment portfolios that eventually will force central banks to cut rates. By blithely accumulating government bonds in the US and Europe, Asian central banks have unwittingly played the role of Delilah.
Rate cuts in the US and Europe would help generate accounting profits for Asian central banks in the near term, but the policy also sows the seeds for future crises in the US and Europe. The only way to break this vicious cycle is for Asian savers to cut their overall allocations to the US and European asset markets, focusing instead on markets around the region. The additional benefit of this approach would be immediate results on difficult negotiations involving protectionism, global warming, and intellectual property.
Friday, August 3, 2007
Indian, Chinese banks plunge at different rates
By Chan Akya
What's the difference between falling 20 meters and falling 60 meters? Well, in the first instance you go "thud, aaaaaarrrggghhh", and in the second you go "aaaaaarrrggghhh, thud". That crude comparison could well illustrate the difference between the Indian and Chinese banking systems.
In the long run, I believe the Chinese banking system poses greater dangers and is more likely to collapse from the sheer weight of its problem loans. Foreign banks looking to enter both markets must do so with eyes wide open.
Legend has it that Chinese bankers keep a shredder handy in their office for the express purpose of destroying business cards of their borrowers. You see, they never intend to call them back about the loans, as that's the responsibility of a different department.
The latest gross domestic product (GDP) figures from China should make the the People's Bank of China nervous, as indeed it has. (The central bank announced further restrictions to lending on July 21.) While export-oriented growth remains high on the back of Americans being too lazy to manufacture anything themselves, the sector's profitability continues to decline.
Using official data from both the United States and China, it is easy to calculate that the average price of Chinese goods sold in the US has been falling the past few years, despite rising input costs (copper, for example). That puts manufacturers in a quandary, as the good old Chinese maxim of "work hard, be successful" simply doesn't work in practice.
So they do the next best thing - ie, borrow from banks and speculate in the local asset markets, particularly property and stocks. Walk around the Pudong district of Shanghai and you can see the impact of a building boom, with great monuments to corporate success all around you. More troubling, you will see the same sights greeting you in downtown Guangzhou, Shenzhen, Chengdu and, of course, Beijing.
China is a manufacturing economy, and the proportion of Grade A office space thus appears far higher than is economically warranted. This is, however, also the reason for the Chinese GDP to ramp up nicely, as all the infrastructure and building activity adds to recorded economic growth.
Banks, trying to recover their money from companies' manufacturing operations, find themselves having to support such speculation to improve their chances, echoing the "ever-greening" scandal of Japanese banks in the 1980s and 1990s. The party comes to an abrupt halt once liquidity is drained away from the system. This is precisely what the central bank is now doing with hikes in lending rates and, more important, by issuing policy diktats aimed at removing bankers' temptations to lend.
When an essential condition for banking crises does not occur, namely a wary central bank, why then do I express pessimism about the longer-term outlook? Quite simply because politics makes an essential difference. China's leaders owe their legitimacy to the continuation of strong economic conditions and, at the very least, substantial employment.
A continuation of restrictive banking policies reduces the country's ability to absorb the people being thrown off by public-sector companies, as the sector aims to achieve profitability. With profits unlikely to improve any time soon, as the export sector remains fiercely competitive, this means further job losses are unavoidable. When economic growth slows, China's government will have much to worry about, and will likely instruct the central bank to reduce or withdraw its restrictions. In effect, this would push the resolution of any asset bubble to the longer term, which would obviously also cause a manifold increase in the costs of dealing with the problems.
I believe that rather than the end game being forced on the Chinese banks by their own central bank, extraneous forces are more likely to cause the adjustment. Some possible examples include a recession in the US and Europe, uncovering of other banking scandals in China and, of course, internal disquiet in the country. When the reckoning does come, expect also to see a large-scale increase in problem loans from the retail sector, as was observed in the case of the various international trust and investment corporations that were shuttered in the late 1990s. Chinese people will take every opportunity to avoid paying back their loans, and a bank failure presents the perfect opportunity to do so. The resulting avalanche of bad loans will cost the country about 20% of its GDP, in my opinion.
Meanwhile, legend has it that becoming an Indian banker is the cherished dream of the middle classes, but defaulting to banks is the path to riches for India's upper classes.
The Indian banking system is a relatively small part of the economy, with banking assets to GDP barely crossing a third, and with nationalized banks such as the State Bank of India group making up a large portion. That said, private and foreign banks have an increasing role to play in the system, far higher than their command of banking assets would suggest. India's banks face losses on so-called priority loans as well as the long workout process that problem loans are subject to. However, these loans are isolated, with a few leading public-sector banks absorbing a bulk of these exposures. Also, and quite unlike in China, India's political establishment is not very sensitive to the level of interest rates, and is therefore unlikely to oppose the Reserve Bank of India's judgment in the matter.
Indian banks have been profitably lending to the middle classes for centuries now, as banking goes back a few generations, particularly in the richer parts of the country such as the north and the west. The explosive growth rate in personal and mortgage finance in recent years, however, bears close watching. A number of Indian middle-class borrowers have tapped the willingness of commercial banks to lend money, a development over the past 10 years that destroyed the dominance of the Housing Development Finance Corp in the sector.
With new private-sector and foreign banks leading the charge in innovation, even the moribund public sector has had to catch up. By and large, even with large economic risks looming - for example, borrowing by individuals working in call centers and information technology - companies could become substantially more risky if a downturn hits these sectors. Similarly, the central bank is worried about inflation causing further rate hikes, which I believe will pressure quite a few of these young borrowers and lead to bad debts climbing above 5%.
In terms of skill sets, though, unlike in China, Indian bankers go through years of credit training, with cross-department exposure available to all officers in nationalized banks. This has allowed the nationalized banks to dominate the market for large corporate lending. Changes in the mid-1990s allowed for specific banks to assume the lead position in banking consortiums, thereby reducing the ability of large corporate borrowers to "borrow from Peter to pay Paul". Larger consortiums, particularly those comprising non-nationalized banks, have been shown to have lower loan losses. This experience is vastly different from that of China.
This leads us to the main causes of banking losses in India, namely corruption, a slow legal process and government meddling. The ruling Congress party started the fashion for open house loans (known locally as loan mela), wherein banks tend to lend small amounts of money to a large number of poor peasants. Most of these loans have led to losses.
The second area of losses is due to the prevalence of corruption, particularly at the heart of the second-tier nationalized banks such as Indian Bank. These losses have usually revolved around single banks taking on the total exposure of politically connected corporates that find themselves in dire financial straits for various reasons. The process of declaring bankruptcy and imposing financial restructuring is overly long, and usually contributes to higher losses given default.
The worst-case scenario comes about if the Reserve Bank of India hikes rates even as a slowdown bites into the export-oriented sectors. Resulting losses from this scenario would cross 5% of GDP in my opinion, even after considering the lower severity of default.
What's the difference between falling 20 meters and falling 60 meters? Well, in the first instance you go "thud, aaaaaarrrggghhh", and in the second you go "aaaaaarrrggghhh, thud". That crude comparison could well illustrate the difference between the Indian and Chinese banking systems.
In the long run, I believe the Chinese banking system poses greater dangers and is more likely to collapse from the sheer weight of its problem loans. Foreign banks looking to enter both markets must do so with eyes wide open.
Legend has it that Chinese bankers keep a shredder handy in their office for the express purpose of destroying business cards of their borrowers. You see, they never intend to call them back about the loans, as that's the responsibility of a different department.
The latest gross domestic product (GDP) figures from China should make the the People's Bank of China nervous, as indeed it has. (The central bank announced further restrictions to lending on July 21.) While export-oriented growth remains high on the back of Americans being too lazy to manufacture anything themselves, the sector's profitability continues to decline.
Using official data from both the United States and China, it is easy to calculate that the average price of Chinese goods sold in the US has been falling the past few years, despite rising input costs (copper, for example). That puts manufacturers in a quandary, as the good old Chinese maxim of "work hard, be successful" simply doesn't work in practice.
So they do the next best thing - ie, borrow from banks and speculate in the local asset markets, particularly property and stocks. Walk around the Pudong district of Shanghai and you can see the impact of a building boom, with great monuments to corporate success all around you. More troubling, you will see the same sights greeting you in downtown Guangzhou, Shenzhen, Chengdu and, of course, Beijing.
China is a manufacturing economy, and the proportion of Grade A office space thus appears far higher than is economically warranted. This is, however, also the reason for the Chinese GDP to ramp up nicely, as all the infrastructure and building activity adds to recorded economic growth.
Banks, trying to recover their money from companies' manufacturing operations, find themselves having to support such speculation to improve their chances, echoing the "ever-greening" scandal of Japanese banks in the 1980s and 1990s. The party comes to an abrupt halt once liquidity is drained away from the system. This is precisely what the central bank is now doing with hikes in lending rates and, more important, by issuing policy diktats aimed at removing bankers' temptations to lend.
When an essential condition for banking crises does not occur, namely a wary central bank, why then do I express pessimism about the longer-term outlook? Quite simply because politics makes an essential difference. China's leaders owe their legitimacy to the continuation of strong economic conditions and, at the very least, substantial employment.
A continuation of restrictive banking policies reduces the country's ability to absorb the people being thrown off by public-sector companies, as the sector aims to achieve profitability. With profits unlikely to improve any time soon, as the export sector remains fiercely competitive, this means further job losses are unavoidable. When economic growth slows, China's government will have much to worry about, and will likely instruct the central bank to reduce or withdraw its restrictions. In effect, this would push the resolution of any asset bubble to the longer term, which would obviously also cause a manifold increase in the costs of dealing with the problems.
I believe that rather than the end game being forced on the Chinese banks by their own central bank, extraneous forces are more likely to cause the adjustment. Some possible examples include a recession in the US and Europe, uncovering of other banking scandals in China and, of course, internal disquiet in the country. When the reckoning does come, expect also to see a large-scale increase in problem loans from the retail sector, as was observed in the case of the various international trust and investment corporations that were shuttered in the late 1990s. Chinese people will take every opportunity to avoid paying back their loans, and a bank failure presents the perfect opportunity to do so. The resulting avalanche of bad loans will cost the country about 20% of its GDP, in my opinion.
Meanwhile, legend has it that becoming an Indian banker is the cherished dream of the middle classes, but defaulting to banks is the path to riches for India's upper classes.
The Indian banking system is a relatively small part of the economy, with banking assets to GDP barely crossing a third, and with nationalized banks such as the State Bank of India group making up a large portion. That said, private and foreign banks have an increasing role to play in the system, far higher than their command of banking assets would suggest. India's banks face losses on so-called priority loans as well as the long workout process that problem loans are subject to. However, these loans are isolated, with a few leading public-sector banks absorbing a bulk of these exposures. Also, and quite unlike in China, India's political establishment is not very sensitive to the level of interest rates, and is therefore unlikely to oppose the Reserve Bank of India's judgment in the matter.
Indian banks have been profitably lending to the middle classes for centuries now, as banking goes back a few generations, particularly in the richer parts of the country such as the north and the west. The explosive growth rate in personal and mortgage finance in recent years, however, bears close watching. A number of Indian middle-class borrowers have tapped the willingness of commercial banks to lend money, a development over the past 10 years that destroyed the dominance of the Housing Development Finance Corp in the sector.
With new private-sector and foreign banks leading the charge in innovation, even the moribund public sector has had to catch up. By and large, even with large economic risks looming - for example, borrowing by individuals working in call centers and information technology - companies could become substantially more risky if a downturn hits these sectors. Similarly, the central bank is worried about inflation causing further rate hikes, which I believe will pressure quite a few of these young borrowers and lead to bad debts climbing above 5%.
In terms of skill sets, though, unlike in China, Indian bankers go through years of credit training, with cross-department exposure available to all officers in nationalized banks. This has allowed the nationalized banks to dominate the market for large corporate lending. Changes in the mid-1990s allowed for specific banks to assume the lead position in banking consortiums, thereby reducing the ability of large corporate borrowers to "borrow from Peter to pay Paul". Larger consortiums, particularly those comprising non-nationalized banks, have been shown to have lower loan losses. This experience is vastly different from that of China.
This leads us to the main causes of banking losses in India, namely corruption, a slow legal process and government meddling. The ruling Congress party started the fashion for open house loans (known locally as loan mela), wherein banks tend to lend small amounts of money to a large number of poor peasants. Most of these loans have led to losses.
The second area of losses is due to the prevalence of corruption, particularly at the heart of the second-tier nationalized banks such as Indian Bank. These losses have usually revolved around single banks taking on the total exposure of politically connected corporates that find themselves in dire financial straits for various reasons. The process of declaring bankruptcy and imposing financial restructuring is overly long, and usually contributes to higher losses given default.
The worst-case scenario comes about if the Reserve Bank of India hikes rates even as a slowdown bites into the export-oriented sectors. Resulting losses from this scenario would cross 5% of GDP in my opinion, even after considering the lower severity of default.
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