The Great Unwind
Friday, October 10, 2008 at 6:00 am
In “The Arabian Nights,” the beautiful princess Scheherazade buys one day of life at a time by recounting fantastic fables that entrance the king, who has condemned her to die. Investors and traders are currently telling each other fairy tales to buy one day at a time to stave off the inevitable.
The worldwide economic drama and tumult are not symptoms of the disease but the cure. The “disease” is the excessive debt and leverage in the financial system — especially in the United States, Britain, Spain and Australia. The “cure” is the reduction of the level of debt — the great “de-leveraging.”
In 1931, Treasury Sec. Andrew Mellon explained this process to President Herbert Hoover: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down. … Enterprising people will pick up the wrecks from less competent people.”
The first phase of this cure is reduction of debt throughout the financial system. So far, overall losses to financial institutions are $400 billion to $600 billion, and that may well go higher. This requires cutting balance sheets — assuming banks are levered around 10 to 1 — of around $4 trillion to $6 trillion in in lending and asset sales.
For example, the bankruptcy of Lehman Bros. meant about $600 billion of debt was eliminated. This inflicted losses on holders of Lehman debt, and that flows through the chain of capital. The destruction of Lehman Bros.’ capital (around $20 billion) also permanently diminishes the capacity for further credit creation in the future.
The second phase of the cure is the higher cost and lower availability of credit. This forces corporations to sell assets, reduce investment and raise equity — for example, as General Electric has done. It also forces consumers to cut debt by reducing consumption or selling assets.
Reducing investment and consumption lowers economic activity. That puts stress on corporations and individuals that may result defaults that trigger losses in the financial system, which further reduces lending. De-leveraging continues until overall debt levels reach a sustainable level, set by lower asset prices and available cash flows.
This process of destruction echoes W.B. Yeats’ words: “All changed, changed utterly: A terrible beauty is born.”
Within the financial sector, de-leveraging is well advanced. In the real economy, however, it is still in the early stages. Fairy tales in financial markets focus on the “superhuman” abilities of regulators and governments to avoid this de-leveraging.
Central banks and governments, accepting an increasing range of collateral, have aggressively supplied liquidity to the money markets. Central banks may soon accept items akin to baseball cards — maybe, for example, Lehman, Bear Stearns and Fortis memorabilia, like mugs and tote bags.
Central banks are acting as “buyers of last resort” rather than “lenders of last resort.” They are providing cheap funding. The loans will have to be rolled over, as the banks cannot repay them. They will only be repaid from the underlying cash flows of the assets counted as collateral.
Government and central banks have also “bailed out” a number of financial institutions using a variety of strategies. Lower interest rates and increased government spending have been used to reduce the effects of the financial crisis.
The U.S. government’s $700-billion bailout package is the latest magic potion. It is puzzling why this initiative is seen as the “silver bullet” that can “fix” the problems.
A look at the Troubled Asset Relief Program, or TARP, reveals confusion about what problem it is addressing. The plan to purchase up to $700 billion in “troubled” assets is not dissimilar to existing support provisions. If assets are correctly valued on the books of the banks, then purchase at fair value only provides funding to the bank. The difference is that the risk of the securities is now transferred to the government — but so is any potential recovery in price.
There are different views about how much the government should pay. Under one approach, the government would pay a “hold-to-maturity” price that may be, perhaps significantly, higher than the “market” price, or the value on the bank’s book. This would give the bank liquidity as well as capital.
The alternative approach would be to pay “market” values. This would provide liquidity to the banks but no capital. It could even trigger additional losses where the assets are carried at higher values — creating incentives against participation.
There is also a small problem in that nobody has a clear idea what these securities are worth.
Purchases of troubled assets are also conditional on (correctly) protecting the taxpayers against losses. This requires banks to provide the government with equity, or equity-like interests, in exchange for participating in the program.
Alternatively, the institutions selling the assets will need contingent arrangements to minimize the risk of loss to the taxpayer. Commentators have gone into rhapsodies about the ability of the taxpayer to “profit” from the program. This creates potential conflicts for financial institutions, whose fiduciary duties require maximization of returns for shareholders.
It is not clear what securities will be eligible for purchase and who will be allowed to participate. Amusingly, the recent short-selling ban on financial institution stocks saw a curious array of companies claim that they were financial institutions! Gaming the system will be practically difficult to control.
In fairness, the final form of the bailout plan is not yet settled and may provide greater clarity. But the bailout could merely transfer the problem onto the U.S. government and taxpayer balance sheet.
Government support for financial institutions in this crisis is already approaching 6 percent of gross domestic product — compared to less than 4 percent in the savings and loan crisis. This could ultimately place increasing pressure on the U.S. sovereign debt rating and undermine Washington’s ability to finance its requirements from foreign creditors.
Government and central bank initiatives to date have been ineffective. Money markets remain dysfunctional and inter-bank lending rates have reached record levels relative to government rates. But the failures are unsurprising.
At the height of the boom, banks used various techniques to increase the velocity of money. Now, as the system de-leverages, the velocity of money has sharply decreased.
Money being supplied to the banks is not being lent through. Banks are parking the money in short-dated government securities, in anticipation of their own funding requirements. Around $2 trillion to $3 trillion of assets are returning to bank balance sheets from the “shadow” banking system that can no longer finance itself.
In addition, banks have large amounts of maturing debt — estimates suggest $1.5 trillion by the end of 2008 — that they must fund. Fear of bank failure, especially after the Lehman bankruptcy, and shortages of capital also limit the banks’ ability to lend.
Ultimately, nothing can prevent the de-leveraging of the financial system now in progress. At best, actions can smooth the transition and reduce disruption of the economy.
The risk is that well-intentioned steps would prevent the required adjustments from taking place, delay recognition of big problems and discourage action that must be taken by financial institutions, corporations and consumers.
The extent of de-leveraging is substantial and likely to take time. For all asset prices must adjust significantly. The key issues are availability of capital and liquidity. The perceived abundance of liquidity was, in reality, an illusion. As the system de-leverages, it seems clear that available capital is more limited than previously estimated.
Central bank reserves and sovereign wealth funds are often cited as evidence of the amount of available capital. These reserves are invested in U.S. Treasury bonds, GSE paper and AAA rated asset-backed securities. It will be difficult to convert them into the home currencies of investors without large losses.
Government and central bank actions, meanwhile, need to be focused on managing the transition to a lower debt world. Actions should be directed to three areas.
First, banks must be forced to write off bad loans without delay — even if this means breaching minimum solvency capital requirements. Second, bank capital needs must be addressed by forced mergers and restructuring, new equity issues and even nationalization or liquidation. Third, central banks need to guarantee (for a fee) all major bank transactions, enabling normal transactions between banks and other parties in the financial markets to resume.
On Wednesday, Oct. 8, Britain announced a program that addressed some of the above issues. However, coordinated global action is needed so that people do not merely move money from one country to another to take advantage of superior government protection.
A global conference along the lines of Bretton Woods, under a respected chairman — Paul Volcker is the obvious choice – should be convened. It could bring together all major players — including vital creditor nations, like China, Japan, Russia -– to develop a framework for the major economic reforms in areas like currency policy and fiscal disciplines, to work toward resolving the crisis.
A principal objective could be ensuring supply of funding for the U.S. in the transition period. Recent comments by China about Washington’s responsibility for the crisis and its resolution miss the point. As China’s Premier Wen Jiabao observed the U.S. financial may “affect the whole world.” All creditors have much to lose if the de-leveraging process becomes disorderly.
Like a giant forest fire, the de-leveraging process cannot be extinguished. Thoughtful actions can create firebreaks that limit damage to the U.S. economy and the international financial system until the fire burns itself out.
“The Arabian Nights” had a happy ending. The king, after 1,001 night of enchantment and three sons, pardons the beautiful Scheherazade — who becomes his queen. Despite the fairy tales that investors are now putting their faith in, the de-leveraging at the heart of the current financial crisis may not have such a happy ending.
Satyajit Das is a risk consultant and author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.”
At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.
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