The new Brahmins

By Chan Akya

Imagine if you fancied the roulette tables in Macau, but had a nasty habit of losing US$10,000 every time you landed there. Most sane people would get some kind of psychiatric treatment that prevented them from ever getting to Macau under those circumstances. Supposing though that a rich uncle compensated you for all your losses in Macau and also paid for your travel and hotel stay. Are you likely to return to Macau after losing a whopper this week, or not?

Sitting back and absorbing the sheer scale of fraud that was perpetuated on the global financial system last week in the name of a putative rescue of Bear Stearns, I wrote "When trust goes down the drain", which laid out the sound principles of central banking as enunciated by Walter Bagehot that have been serially violated in this crisis. Even as most left-leaning commentators brush off the concerns of the so-called "moral hazard" crowd of which this author is a card-carrying member, the fact of the matter is that we are now in the middle of a transformation.

Ruminating a bit more in the morass though, especially after the eager buyer upped his price fivefold this week, it became apparent that the Ben Bernanke Fed has merely emulated its alleged bete noire, namely the Bank of Japan, whose failed policies in the 1990s caused a lost decade of growth for the country and more importantly ensured that its demographic nightmare simply accelerated.

So "kudos" indeed to the Fed for achieving in a couple of months what the Soviet Union could not muster in its seven decades of existence - namely to destroy global market capitalism, chiefly through the demise of the Anglo-Saxon system.

In rescuing Bear Stearns, the Fed was in good company, following the Bank of England and the European Central Bank (ECB) in bailing out large financial institution using taxpayers' money that they strictly did not have to account for to anyone. Yes, the details are somewhat different, namely that shareholders got different outcomes in each case and the level of oversight responsibility was different, but the inescapable conclusion from all this is that Group of Seven (G7)central bankers are utterly corrupt besides being terrifyingly incompetent.

As I wrote in a previous article ("Euro-trash, Asia Times Online, March 11, 2008), the ECB sowed the seeds for its own policy inflexibility by blithely rescuing every bank that came begging on its knees. The fractured nature of the European economy, its lack of service and system integration and mind-numbing political details all allowed the mandarins of the ECB to quietly pass favors to their constituent banks.

While on the above-referenced article, a reader wrote in to complain that I had merely misunderstood the superiority of Europe, and invited me to Sweden, which is apparently the Mecca of something called market socialism. As it turns out, the region boasts the worst record of banking losses and subsequent taxpayer rescues, with an average of 18% of gross domestic product following the 1991-92 bust.

Since the government provided assistance without taking over equity capital, tax burdens needed to be higher for longer for these countries to pay for the mess. Thus, people's natural tendency to grow and become richer was sacrificed at the altar of this demon called market socialism. The net result is that Scandinavia boasts the highest incidence of suicides in the Western world - yes, I am sure to tell the Asia Times Online reader to expect me to begin living in this paradise soon enough.

To think that the original models for the Fed actions from the middle of last year were set in the Scandinavian and Japanese crises of the last decade only makes us more puzzled, rather than less. The aftermath of those crises was to stunt the economic growth of both regions (Scandinavia and Japan) once specific extraneous influences are removed from the picture - for example, the rise in oil prices that benefited Norway and the technology bubble that helped a part of the Japanese economy in the 1990s.

The Japanese merged a bunch of banks together but refused to take the necessary steps that could have made the combined banks more efficient in terms of utilizing scarce resources such as capital and good people. Scandinavian banks attempted to split the "good" and "bad" banks, but eventually put everything back together without any serious change in industrial structure.

Meanwhile, to absorb the costs of the rescues, the governments had to issue billions in new debt, which had to be bought by the rescued banks at artificially low yields because the governments would have themselves been bankrupted by higher charges.

As the system's decline was arrested with the strong government backing, banks found themselves in new problem areas - namely that they did not know what to do with the billions in deposits that were sitting in their books. In the case of Japan, this proved to be the main reason for a slew of misadventures ranging from copper trading to the current bout of CDO (collateralized debt obligations) investment losses.

Super-caste
For all the protests of the Fed and its lackeys on what was done last week, it seems unavoidable that banks will not emerge as protected species, a super-caste of companies, in the new economic environment. The Fed, along with other G7 central banks, has clearly demonstrated that it will not allow any financial company to go bust.

Having rescued a financial institution that was not even under its regulatory purview, it seems only a matter of time before global central banks start rescuing other frontiers of capitalism, namely finance companies, insurance firms and investment management outfits. Thus, everything in the financial world becomes superior to all else in the system, for the sake of national cohesion or any other communist-era slogan that you care to mumble.

The banks are in turn likely to take more risk with their capital going forward, not less, now that they know that the central banks can be counted on to write them checks in perpetuity. Indeed, as Bear was merged into a commercial bank, it stands to reason that the biggest risk-takers will feel emboldened to trade their way out of billions in losses by putting on exotic bets. Like the gambler in the first paragraph, today's banks know that central banks are too afraid to call their bluff.

This super-caste of bankers get to lord it over the rest of Western capitalism for the foreseeable future. Companies will have to accept higher borrowing costs, individuals will see their credit cards shredded, all in order for society to continue paying for the sins of bankers.

In ancient India, a bunch of people pulled off very nearly the same trick. While the Brahmins of today's India face wrenching socio-political changes that have helped to turn the clock back on their dominance and allowed greater opportunities to emerge for other groups, the very opposite event has taken place in G7 countries over the course of the past 12 months. Welcome then to the new caste system that appears set to take over the global economy, led by its new Brahmins - namely the bankers.

Trust goes down the drain
By Chan Akya

Conversation from 10 years ago: relating to John Meriwether of Long Term Capital Management (LTCM) calling his friend at Bear Stearns:
Bear Stearns - How much are you down by, John?
John - Half.
Bear Stearns - You are finished.
John - But I have billions in cash, more fund raising to come, etc. Bear Stearns - John, when you are down by half, people figure you can go all the way. You are finished.

My article published on Friday (see Forget Spitzer, fire Bernanke, Asia Times Online, March 15, 2008) touched upon the unconventional rescue of a large securities firm by the Fed last Monday when it announced a new refinancing tool to help Wall Street. It appears that the firm in question was Bear Stearns, an ironic throwback to the advice given to LTCM that I quoted above.

Over the weekend, JPMorgan Chase agreed to buy Bear Stearns for US$2 per share, a fraction of the $30 or so that the company closed at on Friday, itself about 50% down for the day. The infamous rule of "down by half, finished" appears to have struck none other than the very firm that used it to measure its risk outstanding with other funds. Full credit for what happened over the weekend though must go to what the Fed did on Friday.

On Friday, the Fed announced a more direct rescue of Bear Stearns, by providing back-to-back financing through JPMorgan wherein the latter would hand over all eligible securities held by Bear Stearns to the Fed, and would pass along all Fed credit to the investment bank. Essentially, JPMorgan had the role of a middleman with the ultimate risk being held by the Fed as all financing to Bear Stearns was "without recourse" - a legal term that essentially means, once you make a loan against something, you are pretty much on your own, pal.

Glass Steagall
Following from the near collapse of the US financial system in the earlier part of the 20th century, authorities moved to separate normal banking activities from those of investment banks. The separation has become increasingly blurred in recent times, but in effect while the Fed is responsible for commercial banks, it does not have a direct role in the financing and operations of the investment banks. Each of the regional Fed banks (for example the Federal Reserve of New York, or NY Fed as its more commonly known) has responsibility for all commercial banks registered in New York, and so on. Thus, if any of these banks had a problem such as bank run, the NY Fed would step in to help that institution.

Bear Stearns, being an investment bank, did not have direct access to the Fed "window", leaving it at a competitive disadvantage to commercial banks such as Citigroup, JPMorgan and Bank of America when it came to the process of accessing liquidity. Therefore, on Monday as a first step the Fed made a concession to the very kind of collateral that investment banks were holding in large volumes, such as residential mortgage backed securities (RMBS). This kind of collateral is not a big problem for commercial banks to hold - indeed it can be argued that making mortgages to individuals is their main business - therefore there isn’t much of an issue keeping these securities on their books funded by cheap deposits left by increasingly scared individuals across the US.

Investment banks on the other hand saw their cost of funding more than triple since last year and more importantly, found that many tools for refinancing were completely shut. The process of selling mortgage-backed securities had already ground to a complete halt, even as defaults were rising on the underlying home loans - essentially a dual hit for the investment banks.

As I wrote in the above article, there was clearly a break in the system wherein many of these commercial banks refused to accept securities as collateral from investment banks even if the onward refinancing with the Fed was made available. This is potentially due to two concerns: 1. Firstly, some commercial banks would have exceeded their specific credit limits to various investment banks having provided them with ever increasing lines of credit against difficult-to-value collateral over the past 12 months. 2. Secondly, while these securities could be refinanced with the Fed, they were all "with recourse", ie if there was a problem with the quality of collateral for example through a ratings downgrade, the Fed could demand its money back from the commercial bank while the latter could possibly not hope to make a successful claim against a failing investment bank.

Matters seemed to have proceeded far faster than even I had expected since Wednesday last week when I wrote the above article. In effect, one or more commercial banks had refused to lend to the likes of Bear Stearns under "any circumstances", and even refused to accept a modicum of risk that exists in all market transactions such as buying and selling foreign exchange, settling interest rate contracts and credit derivative contracts.

Thus, on Friday, the Fed was forced to act directly to help Bear Stearns by providing it with unprecedented access to liquidity. The initial reaction to the announcement was a sharp jump in the share price of Bear Stearns in pre-market trading.

However, even equity investors are not that stupid these days. While they still can be accused of living in aerial castles with respect to the rest of the stock market, at least their view of the risks of holding stock in securities firms has matured over the past few months.

Last year at one point, Bear Stearns’ stock was trading close to $180. At the beginning of last week, it was trading around $60, falling from $80 at the beginning of March. On Friday, after first rising a few dollars, around 10% in pre-market, the stock opened more than 10% lower and continued to fall.

Even the most gullible equity investor could no longer be fooled about the turn of events. Bear Stearns needed a rescue because it was going bust, and that was all there was to the positive spin on the story from the NY Fed, and all discussions from the company about its real book value were hollow.

Financial institutions survive purely on the confidence of investors, who after all trust them to hold significantly more assets than their capital bases would allow. A typical investment bank with a market value of $10 billion would typically have assets of over $200 billion, to give you an idea of the kind of leverage we are talking about here. I would hate to analyze the figures of Bear Stearns on these counts because many of those assets were impaired, and partially that was already reflected in the reduced stock capitalization.

Going forward
Much like a financial game of whack-the-mole, the rescue of Bear Stearns puts in question the next potential victim. As I noted in the Friday article, other investment banks may be better off for the immediate future, but all have similar existential crises in front. Why should any investor trust them to manage assets far in excess of their capital bases?

Their financial results for the first quarter ended February, due over the course of this week, will inevitably raise issues of potential downside and worst-case scenarios. No bank prepares for all its depositors to turn up on the same day to demand their money back, and neither does any investment bank.

A few weeks back, I wrote Mr Paulson, Tear Down This Wall (Street) (Asia Times Online, February 16, 2008) purely because of a deeply held personal belief that a major investment bank would go bust in 2008. I certainly did not know that it would be Bear Stearns nor that it would happen by the first quarter itself. In any event, the reason for that article was to implore US authorities not to expand the circle of trouble by bailing out investment banks because that would only make problems worse for the entire global financial system.

It appears that US financial authorities have been overly influenced by their European counterparts and have chosen to effectively nationalize troubled companies. That process did not work in Japan where banks remain moribund more than a decade after these efforts began in earnest, nor in countries like France where banks seem to lurch from one crisis to the next. Thankfully, market circuit-breakers in the US still work wherein the firms being asked to buy troubled investment banks are exerting their own pressure on price - as JPMorgan showed by offering a price of $2 per share rather than the $30 closing price (or even the $20 that the weekend press indicated).

All commercial banks accepting to purchase investment banks would put their own existence in jeopardy, not the least because of the sheer size of these companies as well as their complexity. Accounting standards and regulations are vastly different between these companies due to many decades of Glass Steagall.

The acquisition of Bear by JPMorgan means that investors cannot trust the reported book value of US financial firms anymore. If they cannot trust investment banks, can the trust of commercial banks be really all that higher? The discount to book value should tell the Fed and all other central banks an important truth namely that the bailers themselves may need to be bailed out in time.