Too Big To Fail Versus Moral Hazard

Too Big to Fail versus Moral Hazard

By
Henry C.K. Liu

This article appeared in AToL on September 23, 2008

“Too big to fail” is the cancer of moral hazard in the financial system. Moral hazard is a term used in banking circles to describe the tendency of bankers to make bad loans based on an expectation that the lender of last resort, either the Federal Reserve domestically or the IMF globally, will bail out troubled banks.

Barely forty-eight hours after US Treasury Secretary Henry Paulson declared his firm commitment against the danger of moral hazard by promising that no more taxpayer money would be used to bail-out failing financial firms on Wall Street except in extreme situations, US authorities succumbed to the too big to fail syndrome in the case of American International Group Inc (AIG), a giant global insurance conglomerate founded in Shanghai in 1919. Paulson’s moral hazard aversion had prevented Lehman Brothers Inc, the country’s fourth largest investment bank, from getting a government bailout. Without needed government guarantee to limit the exposure of potential buyers, Lehman was forced to file bankruptcy protection at mid night on Sunday (September 14, 2008).

In March, JPMorgan Chase had been provided with a $29 billion credit line from the Fed discount window in its purchase of Bear Stearns arranged by the Treasury. In early September, the Treasury seized control of two troubled government sponsored enterprises (GSE) Fannie Mae and Freddie Mac with a $200 billion capital injection against a $4.5 trillion liability, concurrent with another government arranged “shotgun marriage” that induced Bank of America to acquire Merrill Lynch at a fire sale price of $50 billion. The Treasury has been criticized and is now sensitive to criticism of bailing out private Wall Street firms that should have been allowed to fail from irresponsible market misjudgments and Paulson is eager to show that going forward it is not government policy to increase moral hazard.

The best minds on Wall Street had been engaged to seek a private sector solution for AIG. Goldman Sachs was hired to assess the potential losses on AIG’s bad assets to set a fair market value for the firm. JPMorgan Chase and Blackstone were advising AIG on finding buyers among private equity firms and/or foreign sovereign funds while Morgan Stanley was helping the Federal Reserve to consider rescue options. After frantic efforts to raise funds from private sources to restore the giant insurer’s credit rating failed, the Federal Reserve, reportedly overriding Secretary Paulson’s moral hazard reluctance, arranged a last minute deal Tuesday night (September 16, 2008) to provide AIG an $85 billion two-year “bridge loan” from the central bank to keep it afloat to give it time to dispose of billions of dollars of valuable assets in an more orderly manner. It was an unprecedented move for the Fed, both in kind and scale. Normally, insrance companies are regulated by state insurance commissions, not the Federal Reserve.

In addition to collateral in the form of illiquid AIG assets for the $85 billion two-year bridge loan, which carries a usurious interest rate of 8.5 percentage points above LIBOR (London Interbank Offer Rate that banks lend to one another and a widely used short term interest bench mark – 2.75% on September 17), the Fed would receive equity warrants, technically known as equity participation notes, for a 79.9% stake in AIG. The issuance of the warrants (contract to buy the shares at a pre-agreed price) to the Fed is designed to prevent existing AIG shareholders from profiting from a government rescue of the company, which has been hobbled by massive losses from exposures on complex structured finance instruments backed by mortgages and other debts. Aside from the high interest rate, the Fed can veto any dividend payments, and AIG is expected to sell assets over the next two years to repay its debt. Senior AIG management will be replaced.

The Fed repeated a pattern established with Bear Stearns in March and with Fannie and Freddie earlier this September of wiping out shareholders while protecting holders of debt. By now, investors have learned the pattern and bet on future bailouts by selling stock and buying bonds in distressed firms. The result pushed down a company’s share price, which can exacerbate its troubles. Both Morgan Stanley and Goldman Sachs became targets of this strategy.

By all accounts, AIG qualifies as a too-big-fail candidate. What made Fed and Treasury officials apprehensive was not simply the prospect of another giant bankruptcy on Wall Street, but AIG’s role as an extensive provider of esoteric financial insurance contracts to investors who wanted to hedge potential losses on complex debt securities they bought. The problem insurance contracts take the form of credit-default swaps (CDS) which effectively required AIG to cover losses suffered by the buyers in the event of counterparty default. AIG was potentially liable for billions of dollars of risky securities that were considered safe in normal time.

An AIG collapse would cause it to default on all of its insurance claims. Institutional investors around the world would instantly be forced to reappraise the value of securities insured by AIG against counterparty losses. This would require them to increase their capital to maintain their credit ratings. Small investors, including anyone who owned money market funds or pension funds that hold AIG issued securities, could suffer losses. On the day before the AIG bailout became news after market closing, the New York money market firm Reserve Primary Fund with $62 billion under management announced that it “broke the buck”, meaning that its net asset fell below the standard $1 per share, a development all mutual funds normally would do everything to avoid.

During a day of emergency meetings at the New York Fed, the Treasury and Fed reversed initial reluctance to bail out another financial institution. Though unspoken, the underlying conclusion was that this was not a takeover, not a bail out. If anyone is being bail out, it is the central bank which is desperately trying to create a fire break to prevent a global capital market collapse that it may not have enough financial resources on its balance sheet to support. Treasury had to announce that it is issuing $40 billion of 45-day Treasury Bills to help buttress the Fed’s balance sheet. More will be issued as needed by the Fed.

There are signs that the government’s firefighting measures are less than effective. Market sentiment suggests that more financial firms can be expected to fail before the crisis crests. Mark-to-market requirements for valuing structured finance instruments and portfolios that are structured to appear safe in long-term probability models reduce the prospect of disaster to a very short fuse. A hedge that would be considered safe over a period of a year can suddenly be reduced to a position of high risk in a matter of days or even hours by market volatility. In such a market environment, the Fed, rather than its traditional role of market stabilizer over the long term, is often reduced to an emergency fire fighter in raging forest fires in a financial landscape infested with elements that practice arson for profit.

Still political opposition surfaced even before the Fed made its final decision to take over AIG after the market closed. Richard Shelby, ranking minority Republican on the Senate Banking Committee, warned on television during the day: “I hope they don’t go down the road of a bailout, because where do you stop?’’

Representative Barney Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee, echoing rising populist criticism against deregulation, said Treasury Secretary Paulson and Fed Chairman Bernanke had not requested any new legislative authority for the bailout at Tuesday night’s meeting. Chairman Frank complained: “The secretary and the chairman of the Fed, two Bush appointees, came down here and said, ‘We’re from the government, we’re here to help them [private firms]. I mean this is one more affirmation that the lack of regulation has caused serious problems. That the private market screwed itself up and they need the government to come help them unscrew it.”

House Speaker Nancy Pelosi quickly criticized the AIG rescue, calling the $85 billion a “staggering sum”. Pelosi said the bailout was “just too enormous for the American people to guarantee.” Her comments suggested that the Bush administration and the Fed would face sharp questioning in Congressional hearings. The White House said President Bush was briefed earlier in the afternoon. Actually, to put things in perspective, $85 billion, though no small sum, is what the US is spending on the wars in Iraq and Afghanistan each week.

Abroad, the AIG bailout was viewed as a milestone marking US rejection of free market fundamentalism to resort to government intervention, after decades of ideological hypocracy. In Asia, it has not been forgotten that during the 1997 Asian financial crisis, the IMF, dominated by US ideology, set draconian conditionality for pledging $20 billion to help South Korea from defaulting on its foreign currency obligations, to require the government to let ailing banks and industrial companies to fail without government help. Many South Korean banks and companies were taken over by foreign competitors as a result. Now the US has suddenly transformed itself as the leading practitioner of state capitalism and economic nationalism in the name of saving the global free market economy.

AIG’s plans for a private sector capital infusion fell apart after its credit ratings were cut sharply on Monday, September 15, which caused a liquidity crisis that would leave AIG defaulting on its outstanding obligation by Tuesday night in New York before markets in Asia
opened on Wednesday morning there. New York Governor David Paterson said earlier that AIG had only “a day” to solve its problems, and that its collapse would cause serious dislocation for the economies of New York State and New York City, not to mention the rest of the nation and the world. Estimates of losses for US financial institutions could reach over $200 billion as a result of AIG default.

For the short term, the market breathed a sigh of relief from the AIG bail out. But going forward, the uncertainty over when the Fed will have to intervene again in which new firm, on what terms and under what conditions will in fact increases uncertainty at a time when uncertainty has caused destructive market turmoil. Each move by the Fed has been accompanied by comforting announcements that the move would stabilize the market, only to have the credibility of the central bank chipped away further by the appearance of new crises days later.

Two days later, as the market had time to digest the still murky details of the Fed take over of AIG, panic in world credit markets reached historic intensity, prompting a frantic flight to safety of the kind not seen since the Second World War.

Barometers of financial stress hit peaks across the world. Yields on short-term US Treasuries reached their lowest level since WWII. Lending between banks in effect dried up and investors scrambled to pull their funding from any institution or sector whose safety has been called into doubt.

The $85 billion Fed bridge loan to AIG failed to curb the surge in risk aversion. Instead, markets were hit by a fresh wave of anxiety. Speculation mounted that the Federal Reserve, which refused to cut rates on Tuesday, could be forced into an embarrassing U-turn. Amid the chaos, traders were pricing in 32 basis points of rate cuts by the end of September – in essence betting that there was a 60% chance the Fed would cut rates by half a percentage point in coming days.

All thought of profit faded as traders piled in to the safety of short-term Treasuries. The yield on three-month bills fell as low as 0.02 per cent – rates that characterized the “lost decade” in Japan. The last time they were this low was January 1941. At one point, the intraday rate was temporarily negative. The government was charging investors for lending it money as a safe haven.

Shares in the two largest surviving independent investment banks, Morgan Stanley and Goldman Sachs dropped 24% and 13.9% respectively as the cost of insuring their debt from default soared several percentage points to threaten their ability to finance their own debts in the market. A wave of merger talks reflected the need of investment banks to seek shelter in large commercial banks. Morgan Stanley was reported to be holding preliminary merger talks with Wachovia, itself a troubled regional bank. Rumors werer circulating that China Investment Corporation (CIC), China’s $200 billion sovereign fund, which already owns 9.5% of Morgan Stanley, or Citic International Finance Holdings Ltd have been approached again to come to the aid of Morgan Stanley. Citic announced Wednesday (September 17) it has hired Morgan Stanley as its new financial adviser to replace collapsed Lehman Brothers Holdings Inc on the planned buyout offer for Citic shares by Citic’s parent in Beijing after Hong Kong securities regulators restricted Lehman’s four Hong Kong operating units from dealing with clients following the bankruptcy filing of its US parent. Washington Mutual, a distressed regional lender, reportedly retained Goldman Sachs to approach potential buyers, including JPMorgan Chase, Citigroup and Wells Fargo.

Newspapers headlined the shocking news that lending between banks in effect halted after the AIG bail out. The TED spread – the difference between three-month LIBOR and three-month Treasury bill rates – moved above 3%, higher than the record close after the Black Monday crash of 1987. The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another. It is also an indicator of market perception of credit risk, as T-bills are considered risk free while the LIBOR rate reflects counterparty credit risk in lending between commercial banks. As the TED spread increases, the risk of default (also known as counterparty risk) is considered to be increasing, and investors will develop a preference for safer investments.

The Securities and Exchange Commission announced drastic curbs on naked short-selling (shorting share without owning them) to stop sharp price decline in share under attack. But the new rules failed to stop heavy selling of financial stocks. The S&P 500 fell 4.7%, led by an 8.9% drop in financials. Price volatility in equities was near its highest level since March. Gold bullion price leaped 11.2% to a three-week high of $866.47 per ounce.

Some critics are suggesting that the Fed needs to define clearly the threshold above which it would intervene in the market. The problem with not being clear is that if the threshold is set too low, it increases moral hazard, and if it is set too high, it becomes self defeating as a way to stabilize the market. Further more, when the Fed set rules arbitrarily, it becomes a cat and mouse game to guess what the Fed would do next time. But playing cat and mouse with market participants is the traditional game the Fed plays to neutralize the effect of rational expectation. The game is played every three months when the Fed Open Market Committee meets to consider the Fed funds rate target.

The way the Fed has been trying to stabilize the financial market in this horrendous credit crisis since it burst open in August 2007 is looking like punching new gaping holes in the throat of the patient to deliver more air to his lungs. One of these days, it may accidentally puncture a jugular vein to end the game. The lender of last resort has become a predator of last resort, nationalizing all dying enterprises. But it seems to be racing headlong onto the road of nationalization not so much as to help the common people as to keep dying financial dinosaurs alive. The Fed continues to pretend that firms likes AIG are merely going through a liquidity crunch.

The fact is that undercapitalization is by definition a solvency problem. The problem is not that good assets are temporarily hit with prices below their real worth and that new capital is needed to maintain debt to equity ratio. The problem is that all these debts were not worth their face value to begin with. The high inflated market values of these assets were held up by circular trading of debt by assuming that they could always be sold at still higher prices way beyond their true worth. Now that the market is finally adjusting the price bubble downward and a lot of firm who were incredibly profitable on the way up are falling like leave in autumn in a bear market. The Fed is merely trying to inject money to keep prices not supported by fundamentals from falling. It is a prescription for hyperinflation. The only way to keep price of worthless assets high is to lower the value of money. And that appears to be the Fed unspoken strategy.

The US Treasury had briefly considered taking over AIG under a conservatorship, as it did with the GSEs. But it was a nonstarter, because insurance companies, unlike Fannie Mae and Freddie Mac which are government sponsored enterprises, are regulated by state insurance commissions, not the Federal government. As an insurance company, rather than a bank, AIG was supervised by the state of New York
where it is domiciled, rather than by a national regulator.

AIG’s current trouble has its roots in a decision in the late 1980s to take over a group of derivatives specialists from Drexel Burnham Lambert which went bankrupt due to speculative losses in junk bonds. AIG Financial Products (AIGFP) wrote hundreds of billions of dollars of derivatives, spilling over from AIG’s insurance business. The business model rested on leveraging AIG’s low-cost of short-term funds to profit from high yield long-term investments. With it’s AAA credit rating, AIG was an attractive counterparty for swap transactions. The Financial Products division, unregulated because it is not an insurance entity nor a banking operation, fell between the regulatory crack. It expanded geometrically over the decades into areas such as credit-default swaps (CDS) which insure against risks of default, as well as originating mortgages and consumer debt. CDS are not insurance policies but only swap instruments that act like insurance policies. During the bubble years, this business model paid off with spectacular profits in fees when default rates were uncommonly low. Part of its expansion plan included insuring investors against defaults on collateralized debt obligations (CDOs), or pools of securities backed by unbundled risks with compensatory yields. The $41 billion write-downs that AIG suffered in recent months were mostly in these swaps. .

AIG insures only “super-senior” deals, which were previously deemed so safe by the rating agencies they held a triple-A rating. AIG could profit from the low return from these near risk-free instruments because of it low cost of funds. This advantage allowed AIG to become a key player and preferred counterparty in the top layer of the structured finance market.

During the first seven years of this decade, AIGFP steadily increased its presence in this opaque, and esoteric, corner of finance and, when the credit crunch started in August 2007, a significant portion of the insurance group’s exposure to the structured credit world was in the form of super-senior debt. When the credit crisis struck, the AIGFP management expressed little concern about these holdings. As a result, AIG announced on December 5 that its cumulative loss had been just $1.4 billion.

However, one factor that forced AIG to conduct a U-turn in accounting terms at the end of 2007 was that banks came under intense pressure from auditors in the closing months of 2007 to revalue their super-senior holdings. AIG’s auditors then forced it to also revise its super-senior losses from $1.5 billion to $6 billion, for the period ending November 30, 2007. Shortly, afterwards, AIG raised this estimate again to $11.5 billion – and on May 8, 2008 the company declared that the losses had swelled by an additional $9.1 billion.

With the ABX derivatives index continuing to decline, the market feared that further write downs could be needed. The ABX Index is a series of credit-default swaps based on 20 bonds that consist of subprime mortgages. ABX contracts are commonly used by investors to speculate on or to hedge against the risk that the underling mortgage securities may not be repaid as expected. For regular payments of insurance-like premiums, ABX swaps offer protection if the securities default. A decline in the ABX Index signifies investor sentiment that subprime mortgage holders will suffer increased financial losses. A rise in the ABX Index signifies investor sentiment that subprime mortgage holdings will perform better.

Outside its Financial Products Division, AIG holds valuable insurance assets. These businesses include the largest commercial and industrial insurer in the US, and a business offering mainly car insurance to individuals. Yet these assets will decline in market value in a severe depression caused by the credit crisis. AIG also owns 59% of Transatlantic Holdings, a separately listed reinsurer. AIG is also one of the US’s biggest life assurers, dominating the market for fixed annuities, a popular retirement savings product.

Globally, AIG is a big player in 130 countries, particularly big in Asia. In addition, it owns one of the world’s biggest aircraft leasing operations and a sizeable asset management business. With such valuable assets, there should be no shortage of interestd buyers for AIG’s units in normal times. Prudential of the UK, Warren Buffett, Allianz, Munich Re, have all indicated interested in acquiring some parts of AIG’s businesses. But these are not normal times. Asset deflation can be expected to last some years, causing the market value of AIG asset to stay way below the company’s current liabilities.

Maurice Greensberg, former chairman of AIG, claimed publicly on television that the company only needs a bridge loan, not a bail-out. The company faces a liquidity crisis, not a solvency problem. Its core insurance operations, both in the US and abroad, are financially sound, and it can raise more than $20 billion through orderly asset sales, Greenberg said. For these reasons, a bridge loan – from the federal government if sufficient private capital is not forthcoming – will not mean a bail-out. A temporary bridge loan will prevent further rating agency downgrades, which would require AIG to post billions of dollars in additional collateral and which would likely prove fatal.

But the Fed has decided that the bridge loan needed to be $85 billion, more than four times the amount Greenberg said the company could raise by selling assets. And $85 billion was in addition to the $20 billion AIG already borrowed from its subsidiary as approved by New York State insurance regulators as an emergence measure. The best accountants in the business could not tell how much AIG would really need to become solvent again.

Greenberg asserts that it is in US national interest to save AIG because it operates in some 130 countries and has more than 100,000 employees worldwide, some 62,000 work in Asian. It provides credit protection to tens of thousands of financial institutions and other companies around the world. About 40% of its $54 billion in annual life insurance premiums and retirement services fees is from Asia, not counting Japan. Its failure would pose systemic risk to the US and the international financial systems.

According to Greenberg, AIG is not an ordinary company. It has opened markets for the US all over the world and, for more than three decades, stood at the vanguard of the liberalization of global trade in services. Its stock is owned directly or indirectly by millions of US citizens. And it has contributed significantly to the US gross domestic product directly and indirectly over the four decades of its existence.

Yet a case can be made that AIG contributed to the bubble economy in the last two decades of disguising debt as wealth. It is not clear if Greenberg’s argument is a reason for saving AIG or a reason for dismantling liberalization of global trade.

It is true that allowing AIG to default on its obligations would be more dangerous than allowing Lehman to go bankrupt. Yet it is not clear that keeping AIG afloat could stop this raging financial fire. AIG may be just one domino in a interconnected pile of falling dominos, albeit the biggest one to date.

AIG is faced with $441 billion of exposure to credit-default swaps and other derivatives. Losses on these contracts have driven AIG into a vicious downwards spiral in which it needs ever more cash to remain a top-rated counterparty. JPMorgan Chase and Goldman Sachs had been charged by the government with finding $75 billion from private sources to rescue failing firm. They both failed. The shares of Morgan Stanley and Goldman Sachs themselves were down sharply one day after the Fed issue an $85 billion bridge loan to keep AIG from defaulting.

Currently, the only regulatory checks on credit-default swaps are requirements on counter-party risk. As long as AIG continued to be over-rated by lenient, even unrealistic, credit agency ratings, it seemed to be an excellent counter-party. It increased its systemic importance as it became less stable. Regulators put unjustified faith in credit-rating agencies whose judgment can be impaired by conflicts of interest.

The disjointed structure of US regulatory agencies is outdated for dealing with today’s brave new world of complex and interwoven financial instruments. As big financial “supermarkets” came into existence through deregulation, systemic risk can be short circuited while it appears to be dispersed. National and supranational regulators remained on the roadside on the superhighway of globalization. Regulators generally lack adequate mandate and expertise to keep pace with the supersonic speed of innovative financial products and processes that they are suppose to regulate.

AIG may be too big and too interconnected to fail. But governmental measures to date to save the failing company appear to have very limited effect on an escalating melt down of the global financial market.

On January 11, 2006, in Asia Times Online I pointed out the danger of credit-default swaps in Of debt, deflation and rotten apples:

In the US, where loan securitization is widespread, banks are tempted to push risky loans by passing on the long-term risk to non-bank investors through debt securitization. Credit-default swaps, a relatively novel form of derivative contract, allow investors to hedge against securitized mortgage pools. This type of contract, known as asset-back securities, has been limited to the corporate bond market, conventional home mortgages, and auto and credit-card loans. Last June [2005], a new standard contract began trading by hedge funds that bets on home-equity securities backed by adjustable-rate loans to sub-prime borrowers, not as a hedge strategy but as a profit center. When bearish trades are profitable, their bets can easily become self-fulfilling prophesies by kick-starting a downward vicious cycle.

On May 17, 2007, three months before the credit crisis first broke out in August, while establishment pundits were still in adamant denial, my article: Why the Subprime Bust will Spread remained a lonely voice; again in a January 26, 2008 article in AToL: THE ROAD TO HYPERINFLATION - Fed Helpless in its Own Crisis; and again in a June 22, 2008 article in AToL: Debt Capitalism Self-destructs.

Pointing this out is not to claim I was particularly astute or prescient, but to say that it is not possible that amid such clear signs of impending trouble that those in charge of billion of dollars of other people’s money, supported by high-priced research, were caught off guard. Criminal dishonesty with derelict of fiduciary duty is difficult to deny.

Too Big to Fail is the Cancer of Moral Hazard

“Too big to fail” is the cancer of moral hazard in the US finance system of magnifying profit through high leverage. Moral hazard is a term in banking circles that describes the tendency of bankers to make bad loan based on an expectation that the lender of last resort, either the Federal Reserve domestically, or the IMF globally, will bail out troubled multinational banks. The term also applies to bad loans made to borrowers that are considered “too big to fail” such as AIG, Countrywide, Citigroup, JPMorgan Chase, GE Capital, General Motors or borrowers such as inept Third World governments. In general, the principle of moral hazard states that bailouts encourage future recklessness. Brady bonds to bail out multinational banks with Latin American debts are labeled instruments of moral hazard in conservative financial circles.

Most bankers reject the moral hazard charge because they welcome government intervention when it comes to protecting their profits even as they oppose regulations as hampering innovation and competitiveness with foreign banks. Bankers only want to get government off their backs when government tries to help the financially helpless and the poor. Private bankers support privatization of profit and socialization of risks.

In global finance, the issue of moral hazard is more complex. Economic imperialism uses moral hazard as an argument to oppose debt forgiveness for the poorest economies. During the Asian financial crisis of 1997, the IMP imposed harsh “conditionalities” (namely high interest rates, corporate restructuring that results in lay off and massive unemployment, austere fiscal policies) justified by moral hazard arguments, punishing the poor in debtor nations for the sins of their wayward bankers.

Many, including myself, have observed that the shrinking intermediary role of banks in funding the economy, brought about by the rapid growth the non-bank credit and capital markets has increased system risk in recent decades.
See my September 5, 2007 AToL article: CREDIT BUST BYPASSES BANKS Part 1: The rise of the non-bank financial system

This risk manifests itself only in a bear market when price corrections dissipate phantom wealth. This systemic risk exposure is now building up to an unprecedented crisis in both complexity and scale. The repeal in 1999 of the Glass Steagall Act of 1933 that separated commercial banks and investment banks allows banks to compensate for their shrinking funding role by moving into securitization and propriety trading through their investment banking subsidiaries.

There is no doubt that all of the nation’s biggest financial conglomerates, whose commercial paper is the bellwether for the dollar and euro commercial paper markets, will fall from borrower defaults and their interconnected size will be the “too big to fail” reason for Fed intervention. It is very clear that troubled debt-ridden corporations will now turn to the banks for help, not because bankers are friendlier than bondholders, but because banks have access to the Fed discount window. All through his long tenure at the Fed, Greenspan’s recurring message to banks to continue lending during the first sign of recession was a clear signal that the Fed would provide all the liquidity that is needed to prevent a systemic collapse. The trouble is that the inter-linkage through structured finance allows even tiny companies to trigger the demise of firms that are “too big to fail”.

The Nasdaq alone has made $3 trillion of market capitalization disappear in the last nine months of 2000 during the tech bubble bust which put many corporate bonds under water. Unless the Fed is prepared to inject trillions of reserves into the banking system, the debt crisis cannot be solved. And if the Fed does that, what will happen to inflation and the exchange rate of the dollar? Cash denominated in dollars is looking less a safe haven everyday. That is why the price of gold has jumped up.

It is an irony that at the very time when the US financial system is showing signs of structural failure, the global trend to adopt US business models and finance practices is reaching its peak. All over the world, governments are rushing to privatize public assets, securitize debts and deregulate their transitional economies away from socialism with the hope of reaping the enviable results that the US free market economy has enjoyed for decades. The bill of this enviable boom is now fast coming due and much of the world will to have pay without ever having enjoyed the benefits. The “race to the bottom” syndrome in wage competition has been enhanced by the “race toward risk” syndrome in finance competition.

The marketplace of ideas, not unlike financial and commodity marketplaces, often operates on mis-information until cruelly pulled back into reality by unforgiving facts. In countries around the world, much governmental and institutional aping of US deregulation practices is based on a misunderstanding of what a fatal virus US neoliberal market fundamentalism really is.

There is some truth in the popular myth that US ways are more flexible, more willing to innovate and to adopt to change. In the last two decades, US innovation and quick response to new business opportunities have produced a record setting long boom with only short recessions, with spectacular rise in profits and asset value. US household net worth, until the recent (and early wave) market crash, peaked at over $58.25 trillion in Q3 2007, doubling in a decade. It declined to $57.72 trillion in Q4.

The end of the Cold War and the global eclipse of socialist tenets have left US faith in market fundamentalism with the aura of a natural philosophy. The US calls her system capitalist democracy. In doing so, care is taken to distinguish democracy from equalitarianism. Conceptually, while the Declaration of Independence claims that “all men are created equal”, the nation that lives by it readily accepts the premise that men do not create wealth equally. The US system rejects social democracy which aims to reduce glaring economic disparity between people. The US system claims it promotes equality of opportunities rather than equality of rewards. It believes that the logic of the market is the most equitable arbitrage. Free-marketeers decry intimate relationships between government, finance and business and oppose even corporatism as an adjunct to the welfare state. They believe that the market’s unforgiving rules of selecting and rewarding winners and penalizing losers are inherently fair, efficient and necessary for maximizing overall economic growth. It is obscene that when they are punished by market forces for their wayward manipulation that they call for government help for themselves in the name of the common good.

The trouble with this view of free market capitalism is that it is a fallacy to assume that truly free markets can exist without regulation. Markets are always constrained by local customs and rules, unequal conditions and unequal information access by participants. In fact, markets come into existence through artificial construction by initial participants with rules that subsequent participants must observe as an admission price. These artificial rules generally favor the market founders and put later comers at a perpetual disadvantage. World Trade Organization (WTO) rules are the latest visible examples. Often the only option left to late comers is to start alternative markets hoping that they will enjoy the very privileges and advantages they oppose in existing markets.

Thus all markets require a wide range of regulations to check and balance their inherent march toward inequality and unfairness. Trade, by definition, is based on mutually balanced weaknesses. Mutual strength leads only to conflict, and unequal strength leads to conquest of the weak.

Adam Smith advocated "free trade" in the mercantilist context as an activist government policy to breakdown the protectionist policies of other nations while subsidizing national industries to compete in a tariff-free and open world market. “Free enterprise” was first developed by royal charters and grants from the sovereign for business operations and for land development within the royal domain, and for trading rights and command of the high seas to “freely” exploit colonies and foreign locations. In other words, free enterprise was launched and fostered with government aid and grants that private investors found too risky or whose potential rewards too remote. Royal charters, letters patent and copyrights are all instruments of government for the privilege of exploiting the resources in the sovereign’s domain. Government and free enterprise have always worked in concert. Modern free enterprise manages to prevent the monopolistic or oligarchic control of markets only by government action. Business always wants government help before the market is mature and after the market is saturated. It only wants “free” markets to gain easy profit. Business by nature abhors competition and social responsibilty.

The notion of “too big to fail” is sacred in US regulatory philosophy. This remains true even as the anti-monopolistic “restraint of trade” regulatory regime of the New Deal was steadily modified in recent decades to permit mergers and acquisition toward increased size and market share to achieve strategic advantage. The scenario of the ideal free market is that there should be only five entities in every sector: two market leaders and three window-dressing market followers to keep regulators at bay. The US economy has always been organized along oligarchic lines in its core industries, allowing a high degree of centralization while preserving only a token degree of competition. The rules of competition are generally set by market leaders of every industry. Self-regulation is the mantra. Responding to the current crisis, US regulators are seeking to change rules to ease bank mergers, by further loosening rules. The Fed has announced an easing of restrictions that had forbidden regulated companies to transfer funds to less regulated and more risky affiliates, such as from commercial banks to their investment bank subsidiaries.

While the US promotes globalization, US attitude on foreign ownership of US assets remains schizophrenic. Furthermore, there is an inherent contradiction in globalization in that while capital is allowed to move freely across political borders, labor is not. It is now conveniently forgotten, when the IMF was established by the Bretton Woods Conference, its Articles of Agreement specifically sanctioned restriction on movements of capital across national borders. Until labor can also move freely, the lopsided globalization is nothing but economic neo-imperialism. It is not a march toward one world, it is a march towards an hierarchical world of structural inequality.

Another defining characteristic of modern US finance is the broad access to credit. US businesses have long enjoyed access to open credit markets. In recent years, until the current developing credit crunch, no US corporations of any size is effectively shut out of the highly developed credit market, regardless of credit rating. Low credit ratings only affect the interest rate rather than credit market accessibility. In fact, debt securitization has brought virtual security to credit unworthiness on a massive scale. The commercial paper market first burgeoned in the 1960s and for four decades, collateralized debt obligations (CDO) dominated the global credit market, until the credit crisis of 2007. Securitization is a process of turning non-marketable credit instruments into marketable ones through pooling. Securitization creates credit worthiness out of the theory of large numbers and the theory of averaging to manage the risk of default by spreading it to a large pool. When a lender lends to a risky company, he bears the full risk of default. But if he invests in a collateral debt obligation instrument, he is lending to a pool of companies whose default rate may be reduced to a risk level coverable by the interest rate spread. The fatal enemy of securitization is a liquidity crisis when all exits from purportedly open markets will be suddenly closed, when all participants move to the sell side, leaving the buy side empty at any price. Today (September 16, 2008), Fed funds rate target is 2% and prime rate posted by two-thirds of the nation’s 30 largest banks is 5%, while commercial paper rate is 2.7% for 211-270 days, and dealers CP (high grade unsecured notes sold through dealers by major corporations) is 2.75% for 90 days. The spread is not abnormal, but few deals are closed. There is no shortage of funds or shortage of borrowers, just shortage of willing lenders. It is clear evidence that it is not a liquidity crisis. It is a confidence crisis.

Derivatives are financial instruments whose values are derived from the value of another instrument. Among other effects, derivatives tend to lower the systemic credit standard of the markets by manipulating the assignment of risk to commensurate return. Highly-rated corporations can now arbitrage their high credit standing to further lower their cost of funds by issuing long-term fixed rate debt and then swapping the proceeds against the obligation to pay a floating rate. In other words, they monetize their high rating by taking on more risk. Simultaneously, lower-rated corporations that otherwise would be frozen out of the credit markets as the credit cycles mature can use derivatives to lock in long-term yields by borrowing short and swapping into long-term maturity obligations. In other words, they pay more interest to buy higher credit ratings, not withstanding the fact that high interest cost would actually further lower their credit ratings. The intermediaries, banks and other financial institutions that make credit markets and trade these obligations enjoy the illusion of being relatively risk free by linking their risks system wide. The credit ratings of these banks appear relatively strong, but in fact they appear strong only because the overall credit rating of the system has declined.

When individual risks are passed on to systemic risk, individual creditors are comforted by the safety of the "too big to fail" syndrome, because they become part of the big system.

The growth of pension and retirement funds can be viewed as a process in the socialization of capital formation. This process has brought about a corresponding growth in professional asset management based on competitive performance measured by short term market value, placing distorted emphasis on technical trends investing rather than fundamentals investing. The quest to socialize risk has led to indexation which works better in rising market to capture optimal systemic returns, but can also cause the categorical downgrade of entire families of debt instruments and their issuers without regard for individual strength. This can cause unnecessary and violent systemic damage, as it did in Asia in 1997 and now in the US since 2007. This socialization of risk associated with the socialization of capital formation means that a financial collapse will affect not merely the rich investors who may be able to afford the loss, but the entire population who can ill afford to lose their pension.

The “too big to fail” notion then comes directly into play and government is forced to step in, putting an end to the myth of the free market. Moral hazard will be in full bloom as the nature of the beast. The Fed has been repeatedly held hostage to the “too big to fail” syndrome since 1930 and will again and again until it becomes the main agent to herald socialism to the US, as Schumpeter predicted. Creative Destruction, of which Greenspan is so fond, will eventually destroy capitalism with creativity.

Leverage is another development that not only magnifies volatility, but the abnormally high rates of leveraged return distort market judgment, making normally respectable returns look unattractive. Greed becomes standardized. Derivatives and hedging techniques have created the illusion of safety by risk management, while they merely reshuffle risks system wide and heighten exponentially the penalty of misjudgment.

Litigiousness is a byword of the US notion of the rule of law. Innovative contracts and financial and business relationship are often inadequately defined to meet rapidly changing conditions, and disputes are settled in courts whose judgments can have drastic consequences to the litigating parties as well as the system. Major bankruptcies have been routinely caused by court decisions. The tobacco legal time bomb is a good example. It is a matter of time that a court decision will drive a major tabacco company into bankruptcy. Texaco was forced into bankruptcy when faced with a judgment that exceeded its entire market cap value, based on the legal definition of what constituted a valid offer in a merger.

The list of potential bankrupts is long. The stabilizing value of legal precedents is greatly discounted in a world of constant unprecedented judicial developments. Courts are frequently confronted with controversies that the judges and their law clerks are grossly unqualified to comprehend. Court decisions often hark back to symbolic posturing based on dated concepts. The anti-trust cases against Microsoft are a classic example: the issues raised in the case have become operationally obsolete as the legal process drags on, yet the courts are asked to make determinations based on them that will affect the future of software monopoly.

The most fundamental flaw in US financial market system is its inherent drive towards excess. A market boom will only end with a market crash unless government intervenes in mid course. The quest for the short term maximization of returns leads inevitably a speculative bubble. The traditional demand/supply business cycle has been genetically modified into a debt-propelled cycle that requires more debt to prolong. And the speed of the expansion dictates that more debt can only be added by a lowering credit quality. The end result is always systemic implosion.

This is what Greenspan means when he refers to unbalances in the system, that physical expansion of productivity cannot possible keep pace with credit expansion associated with the sudden wealth effect. In the Greenspan era, stocks were valued at 181% of GDP at their peak in March 2000, while at the beginning of the decade they were 60% of GDP. One of the characteristics of a bubble economy is the de-coupling of the equity markets from the actual performance of the economy.

There is clear evidence that the wealth effect does not reflect the performance of the economy. One of the few valid points made by Greenspan was that the wealth effect created imbalances that were more than conventional time lag. The Clinton budget surplus resulting from credit-induced extended long boom was merely a false signal of the illusionary soundness of the US economy. GDP was measuring the size of the debt bubble rather than the size of the real economy. Some economists had been vocal that the Clinton budget surplus was in fact an indicator of economic trouble ahead. Those who proudly pointed to the budget surplus as the Clinton administration greatest achievement have come to look extremely foolish in 2008. Private debt, both consumer and corporate, has been growing at record pace in the US for the past two decades, drawing funds from lenders all over the globe. Much of this debt was taken on by telecom companies whose revenues fell as much as 90% through deregulation. Asecond wave of debt went into the housing bubble.

As the equity markets collapse from earnings shortfalls caused by an expanding market capitalization outpacing slower earnings growth, the political pressure for the Fed to inject more debt into the system by lower interest rates always becomes irresistible.

The emergence of an unregulated open credit market diminishes significantly, though not totally, the ability of central banks to manage the economy through conventional monetary policy measures, because of the banks’ shrinking intermediary role in the credit market. A credit binge in which loose lending to borrowers of dubious credit worthiness is always followed by a credit crunch, as surely as gluttony leads to obesity that will outgrow the wardrobe.

Bad loans are made in good times, as Greenspan is fond of quoting. A credit crunch is an interruption in the supply of credit which can be caused by destruction of the lenders' incentive through a decline in regulatory protection, or massive defaults by borrowers on loans taken out during a credit binge. When that happens, the central bank’s only option is to alter the financial structure to reconnect credit supply in a timely manner. And in the current markets of electronic trading, timeliness is a matter of hours, not weeks. The futility of the Fed’s traditional time lag response is exacerbated by speed of oncoming danger.

Yet Greenspan told Congress in his July 1999 Humphrey-Hawkins testimony: “But identifying a bubble in the process of inflating may be among the most formidable challenges confronting a central bank, putting its own assessment of fundamentals against the combined judgment of millions of investors.” Investor judgments are now mostly based on technical analysis while the Fed is still looking at fundamentals.

This explains why the record of the Fed’s recognition of market trends has been consistently six months late. Yet the Fed cannot afford to wait for market discipline to correct a credit crunch. And because of the recognition time lag, coupled with the diminished ability of the Fed to affect market decisions, and the compressed chain reaction time of collapse, each subsequent intervention would need to be escalated or overshot to achieve comparable effect, which in turn increases moral hazard to fuel the next abuse. It is intervention inflation, similar to the narcotic syndrome of pushing towards the edge to reach new highs which always leads to fatal overdosing.

The global financial upheavals since 1997 have damaged not only financial markets, but national economies along their paths. The Mexican crisis of 1994, the South Korean crisis of 1997-98 (the only one in Asian the US intervened because Brazilian investors were holding Korean bonds), and the Brazilian crisis of 1998, the Russian bond crisis of 1998, Argentina and Turkey in 2000, are all victims who have become permanent patients in the critical care unit of the IMF. Yet the US economy has been immune mostly because the Fed, taking advantage of dollar hegemony, which is the unique position of the dollar as the anchor currency in the existing international finance architecture, and its ability to print dollars unimpeded, applied a bailout standard on the US economy much less demanding than what the US required of the IMF for other economies. In recent decades, the Treasury and the White House have effectively usurped much of the Fed's alleged independence through the back door of foreign exchange rate policy which narrows domestic interest rates options. A strong dollar policy is part of US financial hegemony. It is a national security position of the White House that the Fed must support. Now the Treasury is again ordering the Fed around in the nation of national economic security.

The credit bubble has been largely responsible for the spectacular growth of the financial infrastructure. The narrow focus on rising market capitalization value has obscured the high leverage in the US economy and to a lesser degree in the global economy. Global equity markets rebound within months out of the debris of sequential financial crises while the local economies stay depressed for years. Recovery is proclaimed all over Asia while people remain jobless and desperately poor. Stock options became currency not only for management compensation and corporate mergers, but for the general working population in the so-called New Economy and for seeding new enterprises. Loans collateralized by inflated market capitalization are preferred to liquidation as a devise to skirt capital gain taxes. These loans magnify growth in a rising market and they magnify contraction in a falling market.

The Fed eased in 1998 after the Russian default. History would decided whether the Fed did the right thing by allowing Russia to default. But there is now cleared evidence that the Fed panicked and eased excessively after the Russian default and after the LTCM bailout, thus exacerbating the post 1998 bubble, foreclosing the prospect of a soft landing.

A bubble is formed when there is aggregate overstating of financial value. Its existence saps real growth because profit can then be earned more easily from speculation than from increased productivity. That was the virus that seriously wounded the Japanese economy and kept it depressed for over a decade. It is now killing the US economy.

The phenomenon that turned the dollar into the base currency for world trade is oil related. The US abandoned the Bretton Woods regime of gold-backed fixed exchange rates in 1971 but the dollar remained the anchor currency for world trade. The 1973 oil embargo gave APEC control of the oil market and pricing power. But oil is transacted with dollars. The black gold trade reinforced the dollar as the international trade currency, despite the fact that it has not been backed by US monetary and fiscal discipline for decades.

Gold everybody wants but nobody needs. But oil, everybody needs in the modern world. The pricing of oil then becomes the true anchor for the value of the dollar, not the Fed's monetary measures. When the price of oil rises, the dollar depreciates in real terms. When it falls, the dollar appreciates. For most of last decade, the US has managed to keep oil prices low, around $10/barrel, reaping the benefit of a strong dollar with low inflation. But cheap oil price discourages conservation and exploration which eventually will cause oil prices to rise. $90 oil is expensive only in relative terms to recent historical prices, but its impact on the economic bubble is significant.

The rise in oil prices in 1973 was handled by the recycling of oil dollars into US assets. It was the same strategy used to finance the US trade deficit in a decade of globalization, until 1997. By the 1980s, as oil dollars accumulated, the US economy, beset by the burst of a credit bubble which produced stagflation, was unable to absorb further investment at expected returns. The transnational financial institutions then discovered Third World lending which produced high returns commensurate with high risk. But as Walter Wriston proclaimed: "Banks go bankrupt, but countries don't." Thus oil money can earn high returns without commensurate risk in Third World loans, as governments will always bailout such loans. As history recorded, Third World borrowers defaulted en mass. By 1982, nine US banks had lent Mexico alone $13.4 billion, representing 50% of their combined capital. To handle the impact of sovereign default, Mexico temporarily closed its foreign exchange window and converted all foreign currency accounts into pesos and demanded a debt restructuring which the banks reluctantly complied. The US banking system was seriously weaken as a result of Third World debt.

U.S. Treasury Secretary Nicholas Brady, in the 1980s in association with the IMF and World Bank sponsored the effort to permanently restructure outstanding sovereign loans and interest arrears into liquid debt instruments. Brady Bonds represent the restructured bank debt of Latin American and other emerging nations that over-borrowed from U.S. institutions. Designed to prevent financial meltdown for lenders and borrowers alike, Bradys are normally collateralized by US zero-coupon bonds of various maturities. That means principal is guaranteed, but most bonds' coupons are not. If a country can't make its interest payments, investors can collect 100% of their principal when the bonds come due. But they lose out on interest, and they have tied up their money for years instead of putting it into a paying investment. And because the bonds no longer pay interest, their value in the secondary market plummets to only a fraction of their face value. This market is extremely volatile, reacting to moves in US bond prices and especially to bad news from emerging nations, such as the Mexican peso devaluation of 1994.

Hedge funds, insurance companies, and other institutional investors have been willing to take that chance lately. Meanwhile, the managers of US open-end mutual funds dedicated to emerging-market debt are insisting that Brady bonds have gone main stream. Countries involved in the Brady Plan restructuring: Argentina, Brazil, Bulgaria, Costa Rica, Dominican Republic, Ecuador, Mexico, Morocco, Nigeria, Philippines, Poland, Uruguay.

Some countries like Mexico, Venezuela, and Nigeria have attached to their Par and Discount bonds rights or warrants which grant bondholders the right to recover a portion of debt or debt service reduction as stated in the Exchange Agreements, should their debt servicing capacity improve. In effect, some are known as Oil Warrants because they are linked to oil export prices and thus to the oil export receipts. The collateral consists of funds maintained in a cash account usually at the Federal Reserve Bank in New York and typically invested in AA- or better securities, for the purpose of paying the interest should a debtor country not honor an interest payment. A rolling interest guarantee (usually 12 to 18 months or 2 to 3 coupon payments) remains in effect as each successive coupon payment is made. The collateral continues to guarantee payment for the next successive unsecured coupon. In the event the collateral is used, there is no obligation to replace it.

In the 1987 crash, Greenspan, merely nine weeks as Chairman, flooded the system with reserves by having the FOMC buy massive quantities of government securities from the market, and announced the next day that the Fed would "serve as liquidity to support the economic and financial system." Some accuse Greenspan for bringing on the crash by raising the discount rate 50 basis points to 6%. Portfolio insurance has been identified as having exacerbating the crash. The technique involves selling stock futures when stock prices fall to limit or insure a portfolio against large losses. This gives index arbitrageurs the opportunity to benefit from lower future prices by buying futures in Chicago and selling the stock market in New York, adding selling pressure in the market. But the fundamental cause of the 1987 crash was the trend of corporation moving to debt from equity financing. Corporate new debt tripled in a decade, with debt service taking up 22% of internal cash flow. Total non-financial debt was 225.5% of GDP in 2007, compared to 182.9% in 1987, and 139.2% in 1977. Corporate credit ratings deteriorated but the lending did not cease because funds were being raised in the non-bank credit markets. Home mortgages were 80.4% of GDP in 2007 compared to 40.8% in 1987. GSE mortgage pool was 53.1% of GDP in 2007 compared to 40.6% in 1987. It is clearly show a housing bubble of debt.

Historians have identified the causes of the 1930 Depression as:
1) Too much savings in relation to consumer power due to income disparity;
2) Over capacity due to excessive investment from surplus capital;
3) Over stimulation through the growth of debt through new intricate system of inter linked debt obligations;
4) Legalized price fixing through mergers and acquisitions; big corporations maintain price and cut production instead of lowering prices, resulting in massive unemployment;
5) Economic growth too heavily dependent of big ticket durable goods that cannot sell in a depression thus slowing recovery;
6) Exhaustion of public confidence and optimism; and
7) The collapse of international trade (Smoot-Hawley Tariff Act).
8) Irresponsible foreign lending (the US was a creditor nation with a credit balance about twice the size of the total foreign investment in the US.)

All of these causes are still present today at a larger scale and faster reaction time, with the exception that the US is now the world’s biggest debtor nation.

Greenspan testified in 1998: “We should note that were banks required by the market, or their regulator, to hold 40 percent capital against assets as they did after the Civil War, there would, of course, be far less moral hazard and far fewer instances of fire-sale market disruptions. At the same time, far fewer banks would be profitable, the degree of financial intermediation less, capital would be more costly, and the level of output and standards of living decidedly lower. Our current economy, with its wide financial safety net, fiat money, and highly leveraged financial institutions, has been a conscious choice of the American people since the 1930s. We do not have the choice of accepting the benefits of the current system without its costs.”

Well, the costs are coming headlong like a runaway freight train.

Whole testimony:
http://www.bog.frb.fed.us/boarddocs/testimony/1998/19981001.htm

Experts note that each financial crisis is unique, which probably is true in detail. These experts also seek comfort in the observation that the identified excesses of past crashes have been dealt with through new regulatory measures, which is also undeniable. Yet financial crisis have persistent common threads in that they seem to defy precise anticipation and that their occurrence leave serious structural damage. Thus the requirement of a conservative debt to equity ratio is needed to protect the system from policy misjudgment. Yet the US system prospers on living on the edge through maximization and socialization of risk, thus building in failure or collapse that hurts no just the willing risk takers, but the general public who has been put into risky situations they cannot afford by the sales talks of sophisticated risk management.

Will history compare Clinton to Coolidge and Bush II to Hoover?

September 19, 2008