Fifteen months have passed since the ongoing financial crisis exploded onto the US scene with the implosion of two hedge funds managed by Bear Stearns.

Since then Bear Stearns has been bought over by JP Morgan Chase; two other veritable investment banks - Lehman Brothers which declared bankruptcy and Merrill Lynch which was acquired by Bank of America - have also disappeared.

This leaves only Morgan Stanley and Goldman Sachs, both of which have given up their status as stand-alone investment banks to become bank holding companies in order to access funding from the Federal Reserve Bank (the Fed).

This is indeed a fall from high for Masters of the Universe - Wall Street bankers who once commanded the heights of the financial industry and thought they were invincible.

What went wrong and why has the turmoil continue unabated, lunging from one crisis to another?

bank us federal reserve 141008 02All the industry players including the Fed have under-estimated the risks and severity of the crisis. In October last year, four months into the crisis, Lehman Brothers prematurely bought Archston and made a US$3.9 billion loss, and itself is out of business today.

Several sovereign funds have also suffered huge book losses by buying into the shares of the US investment and commercial banks. Early this year, AIG, the largest US insurance company thought that in the worst case scenario, the exposure from its credit default swaps was $2.5 billion. (Credit default swaps are contracts written by a financial institution such a bank or insurance company to guarantee the underlying bonds of another issuer.)

It turned out later, the Fed had to pump in $85 billion to keep AIG afloat. In other words, even the financial institutions that peddle and hold these innovative financial products like collateralised debt obligations (CDOs) and credit default swaps (CDSs) do not know what they are worth and to how much risks they are exposed.

Are these products marked-to-market, marked-to-model, or marked-to-myth? (Marked-to-market is the accounting term for valuing assets at market price rather than historical costs. Marked-to-model refers to valuing assets based on financial models.)

Because these products have been widely distributed and often sit as off-balance sheet items, no one knows for sure how much is being held by whom and which financial institutions are creditworthy. This has resulted in a freezing of the money market and the inter-bank credit market - the lifeline of the financial system.

Despite the Fed maintaining the Fed Fund rate at 2 percent, the 3-month inter-bank lending rate is now trading between 80-160 basis point above the OIS (Overnight Index Swap) indicating banks are averse to lend to or even to trade with one another for two reasons.

First, banks may need the liquidity themselves and hence hoard the cash to meet rainy days. Second, because they don’t trust each other, even banks with excess cash would rather invest in the 3-month Treasury bills at 0.05 percent and make a loss than lend to other financial institutions at over 3 percent. Hence the Fed and other central banks in Europe had to pump in over $200 billion of extra liquidity to keep the financial system flowing.

Lending by the Fed to banks and to broker-dealers reached over $400 billion in early October. This means the normal credit markets are not functioning any more. Since private sector financial institutions do not dare to take the credit risks of other institutions, the risks of lending is borne by the central banks.

Lender and investor of last resort

This is a role that the Fed has not taken on before. But since the Fed has run out of monetary bullets, it started intervening in the capital markets on a piece-meal basis: first, the rescue of Bear Stearns, followed by the bailout of Fannie Mae, Freddie Mac and AIG.

The initial costs of Bear Stearns and AIG are easier to quantify at $29 billion and $85 billion; that of Fannie and Freddie are much bigger and could cost one hundred to two hundred billion.

The Fed did not bail out Lehman Brothers because it figured Lehman’s collapse would not threaten the whole financial system. However, the market did not like the piecemeal measures of the Fed and the Treasury, and the stock market nosedived; more worrying was the capital strike by banks and financial institutions.

Even money market funds that are supposed to be as safe as cash fell below their net asset value and the drying up of the $3 trillion money market would have serious repercussions on financing of the financial and corporate sectors.

Clearly there was a total lack of confidence in the financial system. This prompted the Fed and Treasury to resort to a comprehensive bailout programme by proposing the establishment of a Troubled Assets Relief Program (TARP) similar to the Resolution Trust Corporation set up in the late 1980s to bailout the failed savings and loans associations.

The TARP that was finally passed by the House will try to clean up the balance sheet of financial institutions by buying up the toxic assets such as the CDO, CDS and mortgage-backed securities so that they can hopefully return to the business of lending.

currency peg 240105This was what the governments did in South Korea, Indonesia, Thailand and Malaysia during the 1997 Asian financial crisis at great costs to taxpayers, ranging from 13-55 percent of GDP.

However, this time around, the issues are not as simple because the assets are more complicated and harder to value. At what price would the government buy the assets? At market price? In which case there are vulture funds and private equity funds that would be willing to snap them up at bargain prices.

This would require the selling financial institutions to take huge losses and seek for fresh recapitalisation which is uncertain as the sovereign funds that were the early white knights and have taken huge book losses, are taking a more cautious stance now. If the government bought it at above market price, then it is effectively asking taxpayers to subsidise the losses of the financial institutions.

This Republican government that has always preached the superiority of the free market system, and railed against government intervention and social welfare, is doing just the opposite. By socialising all the risks and costs while privatising all the gains, it is practising social welfare for the rich.

While it is averse to giving a few billion dollars for social welfare programmes, it is quick to bailout Wall Street that could cost upwards of $1 trillion. Treasury secretary Henry Paulson, an ex-chairperson of Goldman Sachs is now hailed as the saviour of Wall Street. Without subscribing to a conspiracy theory, we cannot overlook the close connection between Wall Street leaders and the highest ranking officials in the Treasury and the Fed.

Revolving door

There is a revolving door between Wall Street, Capitol and Pennsylvania Streets. Many past Treasury and Fed officials join Wall Street after they leave their jobs and vice versa. They all share the same paradigm and values. In fact Wall Street has overshadowed Detroit and the manufacturing industry in its influence over Congress and the Executive branch.

us dollar currency 040105While Detroit struggles to get $25 billion soft loans from the government, Wall Street had little difficulty in obtaining $1 trillion to prop up the financial system. The power of finance capital has overshadowed productive capital; proverbially, the tail (the financial system) is now wagging the dog (the real economy).

According to David Roach of Independent Strategy, the liquidity system of the financial system resembles an inverted pyramid - with deposit money (M1 to M3) forming only 10 percent at the base; above that is securitised debt (20 percent); and on top are derivatives (70 percent).

For example, the notional principal in the CDS market alone rose from $15 trillion to $62 trillion between 2005 and 2008. (The world’s GDP in 2006 is slightly under $50 trillion.)
This high leverage and capacity of banks and the shadow banking system to create money is at the root cause of financial fragility and instability.

The average Wall Street bank is leveraged 30 times (from 12 times in 2004), while the average commercial bank (without investment banking activities) is leveraged 10 times. If off-balance sheet items are included, the leverage is much higher.

Leveraging and deleveraging

Leveraging and playing the maturity mismatch (i.e. funding long-term, higher-yielding assets with cheaper short-term funds) are the stuff that make money for financial institutions. Prudently managed they are acceptable; recklessly mismanaged they are lethal.

Minksy 20 years ago predicted that the financial system is increasingly more fragile as it moves away from hedge financing to speculative and Ponzi financing. Hedge financing is where the debtor is able to pay principal and interest; in speculative financing, the debtor is able to service interest but principal is rolled over; in Ponzi financing, the debtor has difficulty doing both.

Bankers lent based not on the cash flow ability of the debtor to repay debt, but on the expectation that rising value of collateral (land, houses, stocks, etc) will enable the debtor to service part of its debt. This happened with subprime mortgages and leveraged buy-out loans.

Leveraging is a wonderful ride when the markets are rising, but is fatal in declining markets. What we are witnessing today is the deleveraging process where asset values are falling, individuals and institutions are forced to sell assets to cover their liabilities. This in turn sends prices spiraling downwards with each wave of selling.

This deleveraging process has not stopped both for consumers and for financial institutions. Price of houses and shares are still falling and have not reached bottom. US consumers with negative savings rate are struggling to keep afloat and cannot take on any more debt.

us dollar currency 060105For financial institutions, there is a great multiplier effect to deleveraging. For every dollar of capital lost, banks have to reduce their lending by $10; for Wall Street firms the deleveraging is 30 times.

The equity markets cheered and skyrocketed for two days after the announcement of the proposed bailout plan and the Senate passed the proposed bill. But as they digested the news, they became more sober and the markets have tanked after Congress passed the bill on Oct 3, 2008.

The markets finally accepted the fact that the real economy that was temporarily propped up by the fiscal and monetary stimulus of the government has lost steam and will head into a recession, the severity of which is still uncertain.

Morever, this bail out will add to the another trillion to the government’s huge budget deficit which stands at about $10 trillion. This combined with the current account deficit could threaten the AAA credit rating of the US.

The government has a few options - to raise tax which is deflationary and/or to inflate its way out of the debt which will cause the dollar to tumble further. Already, the US is the largest debtor in the world.

How much more and longer is the rest of the world, particularly Asia and the Middle East, continuing to finance the US and at what price? This will determine the fate of the US economy. Meanwhile, the financial turmoil has not run its full course yet.


MICHAEL LIM MAH HUI, PhD is a senior fellow of the Nippon Foundation’s Asian Public Intellectuals Programme. He has worked for over 20 years in various international and investment banks and has also taught Political Economy and Sociology in various US and Malaysian universities.