'Cracks' in credit - By Chan Akya

"...the global financial system is for all intent and purposes broken...

...Government officials including US Treasury Secretary Hank Paulson have reportedly made dozens of calls to Asian central banks this week demanding support for their markets, to be provided through emergency issues of loans for banks in Europe and North America."


'Cracks' in credit

By Chan Akya
Aug 25, 2007
Source

Not a day goes by without a major European or US bank announcing some kind of financial complication or the other. While much of the problem lies with exposures to the US subprime market, it is perhaps no exaggeration to point out that when banks cannot or will not lend to one another, the global financial system is for all intent and purposes broken.

There are multiple facets of this problem, as I described in recent articles: first, [1] the penchant of Asian countries to preserve fixed currency values against the US dollar, which has caused the massive and unnecessary reserves buildup that underpins the whole deck of cards that the financial system is today. The second issue is the repackaging of billions of dollars of US housing (mortgage) debt, the defaults on which threaten to wipe out many years of already meager investment returns for Asian central and commercial banks. [2] Third, we have the reactions from the Western central banks such as the US Federal Reserve and the European Central Bank that are aimed at stabilizing the financial system but draw much on the implicit support of Asian savers. [3]

Caveat venditor
Since the mid-1980s, the United States has waged an undeclared war against Colombian drug suppliers. Reeling from a mounting problem of substance abuse in urban America and the inevitable decay this caused across the productive landscape, US lawmakers in essence took international law into their own hands and authorized their military and Central Intelligence Agency to attack the various Colombian drug cartels (such as those based in Medellin, Cali et al).

I have no sympathy with drug pushers, but the attacks on Colombia, which included precision air strikes deep within sovereign territory, did raise two important questions: first on the right international protocols that must be observed and, perhaps more important, the second consideration of why the United States wasn't tackling its end of the problem with equal fervor or aggression.

I will leave the first issue for diplomats to consider and address, especially as the pattern has repeated since then, with the most recent examples being the invasion of Afghanistan and Iraq, ostensibly under the guise of killing terrorists based there.

The second issue raised above, though, goes much deeper, into the moral values that the United States upholds. The principle of caveat emptor or "buyer beware" has held for centuries. It in essence implies that anyone purchasing a product must bear the consequences of subsequent performance. In the case of illegal drugs, though, the US government changed this core principle to caveat venditor or "seller beware", in other words transferring the onus of the problem to the sellers and indeed their countries.

Attempts at destroying supply lines without changing the demand situation, as more and more American youngsters and their parents get stoned, obviously runs counter to good economic principles. Prices simply go up and, when they do, suppliers become increasingly desperate and therefore ruthless. Within the "community" of US drug pushers, the "war on drugs" thus caused the gentlemanly Italian mobsters rapidly to give way to the ruthless Latin American gangs who left a much greater trail of carnage behind.

The lack of a comprehensive program to reduce drug usage by youngsters and nip the demand problem in the bud remains an extremely relevant one even today, well after the "war on drugs" started some 30 years ago. The biggest weakness in the US armory is thus its own inability to cut demand. Without such ability the country can pursue drug pushers to the moon (which is not a function of how "high" they can get) and still fail to curb the problem.

Credit is addictive too
Much like the supposed highs from using illegal drugs, borrowing outside of one's means provides the opportunity for people to make more than their fair share of income. This leveraging effect has been at the heart of much of the value that the United States supposedly created for itself in the past 20 years. Take it away and suddenly the famed finance-based economy simply falls apart like a house of cards.

A typical person would carefully examine what he can afford before taking out a loan, especially on an asset as important as a house. He would then find something that fits his budget, move in and hope for the best. This is not without risk, but at least the basic process of taking only risks acceptable to everyone is indeed followed. The process also has an advantage in that when someone makes a choice of, say, a mortgage that cannot be afforded, the banking counter-party typically turns him down, forcing him to reduce his expectations.

During the 1990s, though, the US basically discarded every basic principle of banking. First, a central banker intent on protecting Wall Street bonuses jumped the gun on cutting interest rates sharply, in essence creating negative interest rates that presaged rampant asset inflation. The moves were already quite controversial because of what had happened in Hong Kong during the early 1990s, when the currency peg to the US dollar kept interest rates below the local inflation rate, in essence fueling a massive asset bubble that popped painfully in the late '90s and caused house prices to fall some 50%. Despite the wealth of historical and recent examples, then-Federal Reserve chairman Alan Greenspan and his cohorts chose to keep interest rates too low.

Of course, one shouldn't judge Greenspan too harshly either. He found himself presiding over an economy that had lost all of its productive capabilities (this was partly to blame for the drug problem cited above). The US could no longer make stuff, ranging from refrigerators to cars, that could compete with the offerings from Japan and Europe on either price or quality. In that context, creating a nation of software developers (the Internet boom and bust) and then property developers (real-estate boom and bust) seems a logical choice.

As borrowers expanded their appetite for loans and depended increasingly on house-price appreciation to repay mortgage debt, US banks of course felt the need to sell down their risks increasingly, in turn spawning the financial innovations that I wrote about in previous articles. Selling down the risk to hapless Asian savers seeking higher returns than Treasury bonds also freed up the banks to make more loans.

Therein lay the crux of the current crisis - as banks originated ways to distribute risk, they did not care about underlying credit quality to the same extent that they would have if the loans had sat in their own books. Investors buying into securitized transactions relied on data that had been gathered during periods when the banks did care about underlying credit quality. Removal of this crucial factor was to cause a massive increase in underlying problems soon enough.

Implications
Dealing with all these issues holistically requires us to examine the primary causal factor, which inevitably is the excessive consumption of the US consumer. In another article, [4] I described the United States as a corpulent feline that threatens the world with its firepower even as its own economy dies from within. This will come back to haunt both East Asia and the Middle East in coming weeks and months.

The collapse of market confidence has hit the North American and European financial systems hard. Banks fear the simple activity of lending to one another in the overnight market, necessitating that central banks cut rates for emergency funding (known as the discount window) and the Fed being pushed to cut rates next month, which now appears a dead certainty. However, neither rate cuts nor central-bank intervention will work without the crucial ingredient of the US getting more support from the rest of the world.

This is where the principle of caveat venditor that I described above will come into operation. In essence, US legislators have already started blaming lenders for the problems being faced by borrowers. The country's most famous bond manager, Bill Gross at PIMCO, has gone to the extraordinary length of suggesting direct government assistance for affected mortgage borrowers. I don't know if he plans to run for election as the next governor of California, but this is among the silliest things said by pretty much anyone in the markets recently.

Thus lenders will be asked to pony up for further restructuring payments in one way or the other - either by accepting lower interest rates or by facing the dreaded haircuts that I wrote about previously. They wouldn't be given the option to sell down risk, though, as the financial system has frozen up. Government officials including US Treasury Secretary Hank Paulson have reportedly made dozens of calls to Asian central banks this week demanding support for their markets, to be provided through emergency issues of loans for banks in Europe and North America.

A lack of cooperation would inevitably increase the chances for more nasty outcomes - including trade sanctions of the sort that the US is now mulling on China ostensibly for quality-control reasons but more likely for the ones stated above. This is eerily similar to the treatment meted out to Colombia in the 1990s, albeit for entirely different matters. Once again, the United States rides to the rescue of its citizens at the expense of all else.

It remains an unmitigated principle of banking that if one owes a million dollars to a bank and cannot pay, one is in trouble, but if one owes a billion dollars to a bank and cannot pay, the bank is in trouble. By lending to inept bankers in North America and Europe, Asian savers will now realize how true that principle is.

There is always another choice open for Asian policymakers. That would be to examine the system as it stands now and decide that ultimately the United States can simply never repay its debts. This would mean calling the greatest bluff in history, that of US financial strength, and letting the system collapse under its own weight. Doing this would cause significant short-term pain to the global economy, but eventually the removal of excessive US consumption cannot but be a good thing for the rest of the world.

Pushing that process through, though, requires both vision and popular legitimacy, and Asia's tragedy is that I cannot think of a single policymaker around the region who has both. Despise it if you will, but Asian savers will remain under the thumb of their biggest borrower for a long time yet.

Notes
1. Deja-Wu: Why China must revalue, Asia Times Online, June 30, 2007.
2. Robbery of the century, ATol, July 14, 2007.
3. Asia and the vicious cycle of bank bailouts, ATol August 11, 2007.
4. Garfield with guns, ATol September 2, 2006.

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