FIFTEEN MONTHS HAVE PASSED SINCE THE financial crisis exploded in the United States with the implosion of two hedge funds managed by Bear Stearns.
Since then Bear Stearns has been acquired by JP Morgan Chase. Two other veritable investment banks—Lehman Brothers declared bankruptcy and Merrill Lynch was bought by Bank of America—have also disappeared, leaving only Morgan Stanley and Goldman Sachs. Both have given up their status as stand-alone investment banks to become bank-holding companies in order to access funding from the Federal Reserve Bank (“the Fed”).
This is indeed a fall for masters of the universe, Wall Street bankers who once commanded the heights of the financial industry and thought they were invincible.
What went wrong and why has the turmoil continued unabated, lunging from one crisis to another?
Risks underestimated
All the industry players, including the Fed, have underestimated the risks and severity of the crisis.
In October last year, four months into the crisis, Lehman Brothers bought Archston and made a $3.9-billion loss, and itself is out of business today.
Several sovereign funds have also suffered huge book losses by buying into the shares of the US investment and commercial banks. Early this year, AIG, the largest US insurance company, thought that in the worst case scenario, the exposure from its credit-default swaps (CDSs) was $2.5 billion. The exposure measures the estimated losses as a percentage of the notional principal in a CDS. [Its contracts in the credit-default swaps market alone are said to be worth about $450 billion.]
Credit-default swaps are simply contracts written by a financial institution like a bank or insurance company to guarantee the underlying bonds of another issuer.
It turned out that a few weeks later, the Fed had to pump in $85 billion to keep AIG afloat. In other words, even the financial institutions that peddle and hold these innovative financial products like collateralized debt obligations (CDOs) and CDSs do not know what they are worth and how much risks they are exposed to.
CDOs involve bundling a class of asset-backed securities into a special-purpose vehicle and rearranging these assets into different tranches with different credit ratings, interest rates and priority of payment.
Are these products marked-to-market, marked-to-model, or marked-to-myth? Marked-to-market is the accounting term for valuing assets at market price rather than historical costs. Marked-to-model refers to valuing assets based on financial models.
Because these products have been widely distributed and often sit as off-balance sheet items, no one knows for sure how much is being held by whom and which financial institutions are credit-worthy.
Frozen
This has resulted in a freezing of the money market and the interbank credit market—the life line of the financial system.
Despite the Fed maintaining the Fed Fund rate at 2 percent, the three-month interbank lending rate is now trading between 80 and 160 points above the overnight index swap, indicating banks are averse to lend to or even trade with one another for two reasons.
Banks may need the liquidity themselves and hence hoard the cash to meet rainy days.
Because they don’t trust each other, at one point banks with excess cash would rather invest in the three-month Treasury bills at 0.05 percent than lend to other financial institutions at more than 3 percent.
Hence, the Fed and other central banks in Europe had to pump in more than $200 billion of extra liquidity to keep the financial system flowing.
Investor of last resort
The Fed has run out of monetary bullets. It started intervening in the capital markets on a piecemeal basis: The rescue of Bear Stearns, followed by the bailout of Fannie Mae, Freddie Mac and AIG.
The initial costs of Bear Stearns and AIG are easier to quantify at $29 billion and $85 billion; those of Fannie and Freddie are much bigger and could cost $100 billion to $200 billion.
The Fed did not bail out Lehman Brothers because it figured Lehman’s collapse would not threaten the whole financial system. However, the market did not like the piecemeal measures of the Fed and the Treasury.
So not only did the stock market nose dive, but, more worrying, banks and financial institutions also staged a capital strike. Even money-market funds that were supposed to be as safe as cash fell below their net asset value and the drying up of the $3-trillion money market would have serious repercussions on financing of the corporate sector.
Lack of confidence
Clearly, there was a total lack of confidence in the financial system. This prompted the Fed and Treasury to resort to a comprehensive bailout program by proposing the establishment of a Troubled Assets Relief Program (TARP) similar to Resolution Trust Corp. (RTC) that was set up in the late 1980s to bail out the failed savings and loans associations.
The proposed TARP would try to clean up the balance sheet of financial institutions by buying up the toxic assets such as the CDO, CDS and mortgage-backed securities so that they can hopefully return to the business of lending.
Harder to value
This was what the governments did in South Korea, Indonesia, Thailand and Malaysia during the 1997 Asian financial crisis at great costs to taxpayers.
However, this time around, the issues are not as simple as before because the assets are more complicated and harder to value. At what price would the government buy the assets? At market price? In which case there are vulture funds and private equity funds that would be willing to snap them up at bargain prices.
Social welfare for rich
This would require the selling financial institutions to take huge losses and seek fresh recapitalization, which is uncertain as the sovereign funds that were the early white knights who took huge book losses are now taking a more cautious stance.
If the government bought it at above-market price, then it is effectively asking taxpayers to subsidize the losses of the financial institutions.
The Republican administration of President George W. Bush preached the superiority of the free-market system and railed against government intervention and social welfare. Now, it is doing just the opposite.
By socializing all the risks and costs while privatizing all the gains, it is practising social welfare for the rich. While it is averse to giving a few billion dollars for social welfare programs, it is quick to bail out Wall Street that could cost more than $1 trillion.
Revolving door
Treasury Secretary Henry Paulson, an ex-chair of Goldman Sachs, is now hailed as the savior of Wall Street. Without subscribing to a conspiracy theory, we cannot overlook the close connection between Wall Street leaders and the highest ranking officials in the Treasury and the Fed.
There is a revolving door between Wall Street, Capitol and Pennsylvania Streets. Many past Treasury and Fed officials join Wall Street after they leave their jobs and vice versa. They all share the same paradigm and values. In fact, Wall Street has overshadowed Detroit and the manufacturing industry in its influence over Congress and the Executive branch.
Tail wagging the dog
While Detroit struggles to get $25 billion in soft loans from the government, Wall Street has little difficulty in obtaining a trillion-dollar bailout. The power of finance capital has overshadowed productive capital; proverbially, the tail (the financial system) is now wagging the dog (the real economy).
The liquidity system of the financial system resembles an inverted pyramid—with power money (M1 to M3) forming only 10 percent at the base; above that is securitized debt (20 percent); and on top are derivatives (70 percent), according to David Roach of Independent Strategy.
Root cause of instability
For example, the notional principal in the CDS market alone rose from $15 trillion to $62 trillion between 2005 and 2008. (The world’s GDP in 2006 is slightly under $50 trillion.) This high leverage (borrowing) and capacity of banks and the shadow banking system to create money are the root causes of financial fragility and instability.
The average Wall Street bank is leveraged 30 times (from 12 times in 2004), while the average commercial bank (without investment banking activities) is leveraged 10 times. If off-balance sheet items are included, the leverage is much higher.
Leveraging, deleveraging
Leveraging and playing the maturity mismatch (i.e. funding long-term, higher-yielding assets with cheaper short-term funds) are the stuff that makes money for financial institutions.
Prudently managed they are acceptable; recklessly mismanaged they are lethal.
Hyman Minsky predicted 20 years ago that the financial system was increasingly becoming more fragile as it moved away from hedge financing to speculative and Ponzi financing.
Hedge financing is where the debtor is able to pay principal and interest; in speculative financing, the debtor is able to service interest but the principal is rolled over.
In Ponzi financing, the debtor has difficulty doing both. Bankers lent based not on the cash flow ability of the debtor to repay debt, but on the expectation that the rising value of collateral (land, houses, stocks, etc.) would enable the debtor to service part of its debt. This happened to subprime mortgages and leverage buyout loans.
Leveraging is a wonderful ride when the markets are rising, but is fatal in declining markets.
What we are witnessing today is the deleveraging process in which asset values are falling, and individuals and institutions are forced to sell assets to cover their liabilities.
This, in turn, sends prices spiraling downward with each wave of selling. This deleveraging process has not stopped both for consumers and for financial institutions.
The prices of houses and shares are still falling and have not reached bottom. US consumers with negative savings rate are struggling to keep afloat and cannot take on any more debt.
For financial institutions, deleveraging has a great multiplier effect. For every dollar of capital lost, banks have to reduce their lending by $10; for Wall Street firms the deleveraging is 30 times.
The equity markets cheered and skyrocketed for two days after the announcement of the proposed bail out plan. But as they digested the news, they became more sober. This bailout will add to the US government’s debt which stands at about $10 trillion.
This, combined with the current account deficit, could threaten the AAA-credit rating of the United States. The government has a few options—to raise tax which is deflationary and/or to inflate its way out of the debt which will cause the dollar to tumble further.
Already, the United States is the largest debtor in the world. How much longer will the rest of the world, particularly Asia and the Middle East, continue to finance the United States and at what price? This will determine the fate of the US economy.
It is likely the financial turmoil has not run its full course yet.
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(Michael Lim Mah-Hui wrote in the Nov. 18, 2007 issue of Talk of the Town about the roots of the subprime crisis. He also wrote in the March 30 issue about the metastasizing crisis. He worked for more than 20 years in various international investment, commercial and development banks like Credit Suisse First Boston, Deutsche Bank and Chemical Bank (now JP Morgan) and Asian Development Bank. He is now a senior fellow at the Asian Public Intellectuals Program of the Nippon Foundation. He can be reached at limmahhui@gmail.com)
