Wednesday, 24 September 2008

Terminal Velocity

By Chan Akya

On the back of my last article on the undoing of the American/Western financial system (see Waiter, there's a banker in my soup, Asia Times Online, September 18, 2008) I had intended to write a follow-up on the implications for Asia. Events over the weekend though spell the very end of capitalism for the US and its European allies, pushing lifeboats on their decrepit financial sector even as the rest of the economies represented by the Group of Eight (G-8)leading industrialized countries come unstuck at breathtaking pace.

Perhaps the epitome of this decline was the coordinated support for the US dollar, combined with the provision of some US$200 billion of funds for the banking system last week. No matter all that, and the price of gold at the end of last week was still higher than at the end of the previous week.

US Treasury Secretary Henry Paulson seemed to have hidden his metaphorical bazooka for one weekend only (see Pareto's Bazooka, Asia Times Online, September 13, 2008) only to quickly unleash its fury in coordination with the Fed and the SEC last week once his favorite firms of Morgan Stanley and Goldman Sachs were threatened with bankruptcy.

Last week was quite far from the ordinary. The collapse of Lehman Brothers, the hastily arranged and seemingly shotgun marriage of Merrill Lynch with Bank of America as well as the breathtakingly immoral rescue of American International Group (AIG) by the Federal Reserve, which wasn't even that company's regulator, all point to the moral bankruptcy of Washington. The Securities and Exchange Commission (SEC) banned 799 stocks from being shorted for 10 days on Thursday night, in effect moving the goalposts once again (see A stone for Chris Cox, Asia Times Online, July 19, 2008) for my views on the sheer idiocy of banning short sales in financial markets).

In its defense the SEC, along with affected firms such as Morgan Stanley, pointed to the deep and serious risks being presented to the financial system by these unscrupulous short-sellers. Well, my heart bleeds for the investment banks but as it turns out, only 2.9% of Morgan Stanley was "on borrow", that is being used for short sales, at the beginning of last week. The rest of the decline in the company's share price - it fell 40% on one day for example - was basically good old genuine panic; the type that has not yet been banned by the SEC but is surely under consideration by some jobsworth or the other.

Just 10 years ago it was the very same luminaries from the US government, investment banks and the rest who pilloried the stock market intervention of the Hong Kong and Malaysian governments in 1998, arguing in favor of allowing the free market to establish itself. In editorial after editorial, these amazingly intelligent folks castigated the actions of Malaysia's then prime minister Mahathir Mohamad for banning short sales on the Kuala Lumpur Stock Exchange. The level of hypocrisy displayed by the US government - free-market professing Republican led, no less - in recent days brings to mind George Bernard Shaw's famous dictum that the "ordinary Britisher believes that God is an Englishman".

Much as Shaw foretold the end of the English empire, Paulson and his motley crew have brought forward the end of American and even Western economic power. As some wits remarked on television, there are even rumors that the Federal Reserve will guarantee personal happiness for the next few weeks, if so desired.

Call that triple-A?
Even away from the mumbo-jumbo of qualitative intervention, actual dollars being thrown around stack up nicely. There is firstly the $8.6 trillion in contingent liabilities that the US government has accepted within two weeks and without any apparent authority to do so - $5.2 trillion of liabilities guaranteed by Fannie Mae and Freddie Mac and $3.4 trillion outstanding at the country's money market funds that now enjoy a Federal guarantee.

For anyone keeping score, all that adds up to 160% of US government debt at the beginning of September. Add to these monstrosities the $700 billion that "Hank" Paulson now demands as new government funding to purchase every manner of decrepit mortgage-backed asset that US (and presumably European and Asian) banks wish to sell, and the total debt has increased by around 175%.

Against the gargantuan increase in total debt of the US, likely tax receipts will decline for many years to come as the combination of slower economic activity and historically built up tax-adjustable losses help individuals and companies to avoid paying taxes for many years to come. Indeed, one of the key tangible items for any bank to purchase its investment banking counterpart (Bank of America buying Merrill for example) is the billions in tax losses that can be absorbed in the event; these would more than pay for the purchase prices alone, leave aside the potential for revenue additions a few years down the line.

When debt increases and income declines, it is usual more difficult for the borrower to repay their debt. That is what creates a ratings event, ie for credit rating agencies to downgrade the borrower. The US government is now in the peculiar position wherein its debt is still rated at the triple-A level but there are very few quantifiable reasons for it remain so. While the overall situation is still better than that of the demographically-challenged European countries, I still cannot accept the notion that the US government is triple-A after last week's events.

A downgrade of the US government's debt will render much of its borrowings - Treasury bonds, agency bonds and the rest - unviable for holdings by the rest of the world. Alone, this could push up costs for the highly leveraged US economy at exactly the worst time in its cycle, and pummel growth for another couple of quarters by itself.

Of course, two of the three major credit rating agencies (Moody's, Standard & Poor's and Fitch) in the world are American while the third is European. Not to put too fine a point on it, I believe that it is quite unlikely that these agencies will proactively look to downgrade the US government - or indeed the governments of the UK, France, Italy et alia on the back of the most recent financial crisis. Whether the folks buying their bonds - Asian central banks and savers - will quite buy into that logic remains to be seen. Call me a cynic, but somehow I do not expect they will eat this "triple-A because we say so" nonsense twice. Then again, perhaps Asian central bankers ARE that stupid. We will find out soon enough.

Psst ... want a bailout?
The demand for Congress to pass some $700 billion in new purchasing power for the US Treasury acting in its own capacity goes beyond the dictionary definition of chutzpah, by making the very people responsible for driving the US economy aground also most likely to benefit from its recovery. It seems that there is hardly enough time to man gravy boats one last time in Washington, every lobbyist has gotten something valuable in the past week.

My views on the agency bailouts were aired previously (see And now for Fannie and Freddie, Asia Times Online, July 12, 2008) so perhaps it is apt to look at the other beneficiaries of last week's actions. Firstly, money market funds, where trillions of US savings are deposited by individuals and companies. These funds invest in short-term assets with strict ratings guidelines, therefore the chances of losing money are seen as minuscule. Yet, that is precisely what happened when Lehman Brothers declared bankruptcy last weekend.

Some funds had been holding hundreds of millions in Lehman short-term paper, which promptly went from being valued at par to being worthless from Friday to Monday. This led aggregate losses to eat into total capital, that is after accounting for interest received, creating a situation called "breaking the buck" - when the fund will return less than par to its investors. Alarmed at the potential for money deposited in these funds disappearing and taking with it any chances of a financial system recovery, the Fed quickly stepped in last week to guarantee the deposits.

People putting their money into such funds aren't the sort that would bother with neighborhood banks; they are the very rich across America and the rest of the world. Thus, the bailout wasn't intended so much for the investors as the borrowers, that is US financial and other companies.

If even this made sense to you - and it doesn't to me - the second bit of moral hazard thrown out by Paulson boggles the mind a bit more so. His proposal for Congress to approve within a week a package of some $700 billion in funding for the US Treasury to directly purchase mortgage-backed securities (MBS) from financial firms has all kinds of danger signals popping up.

Paulson seems to believe that buying these securities and removing them from the public arena would create breathing room for the financial sector to re-emerge from the ashes of the financial crisis, but in so doing he will sow the seeds for the next few bubbles in the US and European financial systems.

These MBS that the Treasury intends to buy are the very same securities that private sector financial firms - investment banks, their commercial counterparts, insurers, credit rating agencies - all failed to properly understand or value. This wasn't a uniquely American problem either, as the rest of the world is also caught up in the same whirlpool of losses.

If profit-seeking folks couldn't understand these securities and figure out what they were worth, what possible hope is there for a government body to do so? The idea is to relieve the banks of these messy assets so that they can get back to their usual functioning, but it is more likely that the banks will simply sell all their dud assets to the Treasury and walk away with all the good stuff.

In any event, the Treasury initiative addresses only the parts of the leveraged market that have failed so far; these assets all based on mortgage lending were but the first to decline. Looking ahead, there are the hundreds of billions in leveraged loans made to companies buying other companies, billions of money lent to project finance for a global economy that is simply not likely to have the same kind of steam, and so on. If banks believe that they have put a couple of dud financial years behind them, the willingness to lend into the next bubble will increase.

This is the return of socialism with a vengeance. The very people who tut-tut the record of the Bank of Japan and the lost decade have implemented its rule book in double quick time. Japan continues to face a recessionary environment. Europe has gone back to its shell with poor economic data, mounting job losses, significant financial sector declines, widening pension deficits all helping to destroy its economic innards. The only part of G8 that was doing well - Russia - has also entered crisis mode due to its government's mishandling of corporate governance issues as well as the silly geopolitical maneuver in Georgia that helped to evaporate investor confidence in the country.

G-8 is thus a spent force, with the final chapters coming rather more quickly than I had predicted in a previous article (see Dear Dinosaurs, Asia Times Online, October 20, 2007). The icing on the cake is that when looking at the political landscape in these countries, no change appears imminent. European leaders all appear fairly secure in their jobs with even the UK's Brown postponing leadership challenges; so does the Russian dictatorship after all its recent misadventures. Japan faces the potential demise of the Liberal Democratic Party, but without any significant ideological change being espoused by the Democratic Party of Japan, I am at a loss to explain quite what will change for the country in enough time to pull out of its terminal economic decline.

Leaving the best for last, I am deeply entertained by polls showing that the Republican candidates are likely to win the US presidency once again. John McCain exhorted the strength of US fundamentals last week, clearly showing quite how in touch he was. When challenged, he praised the "fundamentals of US workers", presumably referring to the same folks who produce cars / machine tools / capital goods and the like at double the labor cost and triple the product faults of their Japanese and European counterparts.

As for his running-mate, Sarah Palin, her statement on the AIG rescue said it all:
Certainly AIG though, with the construction bonds that they're holding and with the insurance that they are holding (is) very, very impactful for Americans, so you know the shot that has been called by the Feds - it's understandable but very, very disappointing that taxpayers are called upon for another one.
Don't worry if that statement flummoxed you with its arcane references to construction bonds and insurance holdings; I couldn't understand it either. To think that Americans are willing to repose their confidence in these two characters after the level of economic destruction carried by the Bush-Cheney team points to their deeply forgiving and almost saintly nature.

For Asian countries looking to supplant the US as the pre-eminent economic engine of the world as well as muster up the occasional dance on the grave of the sole superpower, the return of the Republicans would truly be a godsend.

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