Selling the Bailout: The Fear Factor

``For historians each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways. History is particular; economics is general." Charles Kindleberger, Manias, Panics and Crashes A History of Financial Crises (New York: Basic Books, 1989), p. 16.

Proponents of the bailout package have focused on two major concerns to advance their cause: fear and the allure of profits.

In marketing, sales pitches generally have to connect with emotions to create the necessary interests or conditions required to generate the desired outcome: sales. And what emotion could be easily trigger quick response or reaction than fear! According to marketing savant Seth Godin, ``Marketing with fear is a powerful tool. Fear is a universal emotion, it's viral and people will go to great lengths to make it go away.”

So when officials go to the extent of contriving Armageddon scenarios in order to secure the political capital required to pass their sponsored legislation as this…

From Federal Reserve Chairman Bernanke (quoted by New York Times) ``If we don’t do this…we may not have an economy on Monday.”

…we understand this as nothing but a hard sell meant to ram into throats of the Americans the notion that Wall Street and Main Street needs a “savior” by constant government intervention of the marketplace.

Think of it this way, it has been MORE than a year where the Bernanke-Paulson tandem have peddled this mirage in myriad ways to no avail: the $163 billion fiscal stimulus at the start of the year, various assorted alphabet soup of bridge financing facility some of which had been enabled by the rarely used legal authority under Section 13(3) of the Federal Reserve Act (Wall Street Journal), overseas swap lines, 325 basis points Federal interest rate cut, the takeover of Fannie Mae and Freddie Mac and AIG, the forced marriage of JP Morgan and Bear Stearns with the backstop from the Federal Reserve, tapping the $50-billion Exchange Stabilization Fund to offer insurance to money-market fund investors to stop a run on the funds (WSJ) and others…

Yet at the end of the week, global world financial markets remain under severe duress, see figure 1.

Figure 1: Danske Bank: Credit Stress and Liquidity Crunch

So even as the Bernanke-Paulson team (B&P) managed to secure the much needed mandate via Emergency Economic Stabilization Act (originally the Troubled Asset Relief Program-TARF) for the use of $700 billion at their discretion to support domestic markets (including foreign banks with domestic exposure), US equity markets fell sharply over the week: Dow Jones Industrials tumbled 7.34% (year to date down) 22.16%, S&P cratered 9.4% (down 25.14% y-t-d) and Nasdaq crashed 10.18% (down 26.58% year-to-date).

As a side comment, US markets appear to be fast catching up on the loss statistics of the Philippine equity benchmark the Phisix, whose decline has interestingly been mild (relatively speaking amidst this turmoil) and could have signified sympathy selling (down 1.19% this week and down 29.14% year-to-date) than a traditional rout.

The credit crisis seem to worsen with the apparent collapse in the US commercial paper market- (investopedia.com) “An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270 days” or market facilities which enables corporations to gain access or utilize short term financing (see right pane courtesy of Danske Bank). Aside the skyrocketing cost of funding seems to reinforce the indications of the ongoing stress on interbank lending or as some analysts insinuate a “silent bank run” (right pane).

According to Steen Bocian of Danske Bank, ``First, perceived counterparty risk went up as fears of other bankruptcies swept through the system. Banks therefore became even more reluctant to lend money to other banks. Second, the collapse of Lehman Brothers led to big losses for the oldest US money market fund, Reserve Primary MMF, which “broke the buck”. This means that investors experienced real losses on funds invested in the Reserve Primary MMF, as net asset value went below USD1. This was the first time since 1994 that a money market fund had broken the buck. The incident led to a flight of money out of money market funds in the US.” (underscore mine)

This is the critical link between Wall Street and Main Street. When the cost of funds shoot skyward, many ongoing or expansion projects are likely to grind to a halt and companies or institutions surviving on the margins end up filing for bankruptcy. Even states like California have quietly sought funding ($7billion) from the US Treasury.

Interventionism Doesn’t Seem To Work

So in spite of the so-called interventionist nostrums you have the markets generally rioting or becoming more dysfunctional.

This could mean one of three things:

one- measures have not been enough ($700 billion is not enough) or

two-measures don’t address the root problem but instead deal with the symptoms or

three-market could be reacting to the law of unintended consequences.

Economist and author of More Sex is Safer Sex Steven Landsburg in the Atlantic.com wrote a very eloquent poignant piece about the current banking crisis (emphasize mine),

``So what's special about banks? According to what I keep reading, it's that without banks, nobody can borrow, and the economy grinds to a halt.

``Well, let's think about that. Banks don't lend their own money; they lend other people's (their depositors' and their stockholders'). Just because the banks disappear doesn't mean the lenders will. Borrowers will still want to borrow and lenders will still want to lend. The only question is whether they'll be able to find each other.

``That's one reason I feel squeamish about the official pronouncements we've been getting. They tell us bank failures will make it hard to borrow but never that bank failures will make it hard to lend. But every borrower is paired with a lender, so it's odd to state the problem so asymmetrically. This makes me suspect that the official pronouncers have not entirely thought this thing through.

``In the 1930s, a wave of bank failures did make it hard for borrowers and lenders to find each other, and the consequences were drastic. But times have changed in at least two relevant ways. First, the disaster of the 1930s was caused not just by bank failures, but by a 30% contraction of the money supply, which is something today's Fed can easily prevent. Second, as any user of match.com can tell you, the technology for finding partners has improved since then. When a firm wants to raise capital, why can't it just sell bonds over the web? Or issue new stock? Or approach one of the hedge funds that seem to be swimming in cash? Or borrow abroad?

``I know, I know, the rest of the world is in crisis too. But surely in the vast global economy, it should be possible to find someone capable of introducing a lender to a borrower. (Note that I'm not talking about going to foreign lenders, though that's another option. I'm just talking about the same American borrower and American lender who would have found each other through Bear Stearns finding each other through Barclays instead.)

``In other words, I'm not sure these big Wall Street banks are really necessary, and I'm not sure we'd miss them much if they were gone. Maybe there's something I'm missing, but if so, I think it should be incumbent on Messrs. Bernanke, Paulson and above all Bush to explain what it is.”

Or a similar thought from Bill King (hat tip Barry Ritholtz), ``The cause of our current financial morass is Big Government + Big Business = Crony Capitalism + Funny Money = concentration of wealth and risk + declining US living standards.”

``The solution is decentralization of the financial system, like the tech industry, which will lower systemic risk, foster competition and yield better ideas, services and companies.”

Like us, Mr. Landsburg and Bill King acknowledges that the banking system is no less than one huge cartel organized and operated by a network of central banks led by the US Federal Reserve living off under the platform of US dollar standard fractional reserve banking system whose basic premise is one of institutionalized leverage (legally required to keep only a fraction of deposits relative to lending). And whose boom bust policies foster banking oligopolies and crony capitalism.

The Opportunity Cost of A Wal-Mart Bank

Proof? In 1999 Wal-Mart’s attempt to buy a savings bank in Oklahoma was foiled by the Gramm-Leach-Bliley Act. In 2002 Wal-Mart was again interdicted from acquiring the California ILC by the California legislature. In 2005, community and regional banks closed ranks to defeat Wal-Mart’s application banking license on fears that it might grab away their businesses (sfgate.com).

The point is not to defend Wal-Mart attempted entry in the banking industry, but to accentuate the example of the use of laws to prevent entry of new competition.

And this has been the essence of the Wall Street bailout: to sustain the clique on the premise of the sustenance of systemic concentration-“too big or too interconnected to fail” whose functionality has been “too embedded in the economy” which requires today the poor and mid class Americans to pay for the sins of a flawed currency system based on the rule of elite.

A financial and economic model where the poor subsidizes the rich, very much in resemblance to today’s global current account imbalances paradigm (poor emerging countries with current account surpluses subsidizing rich current account deficit countries). Free market failure anyone?

Conditions That Pave Way For Greed

The fact that the essence of today’s bust is one which stemmed from excessive leverage has been principally reflected on the operating principles of fractional reserve banking system. Where one can get away with piling on more leverage to gain additional profits why then stop? “As long as the music keeps playing we keep dancing”.

Is it all about greed? Think of it, when borrowing rates offered you is at ZERO rates or money for “free” what would you do? Take up the money and speculate. You chase for yields. You lever up. You lengthen your time preference based on false signals that the credit offered have been backed by real savings. And since everybody seemed to doing the same, why not seek the “comfort of the crowds”? You chase momentum on assets that have been popularly boosted by inflation or speculation. You flip stocks or houses. That’s exactly what the public did upon the implicit prodding from government policies.

US Banks which has signified as the main pillar of the fractional reserve bank system, has essentially transmitted the same principles to the society by: overextended gearing, overspeculation, adopted computerized quant risk models, went around regulatory loop holes as the net capital rule (New York Times), morphed into a new business model of “originate and distribute” which passed the credit and repayment risks to end-users freeing up more capital to lever, utilized innovative “hedge” instruments (structured finance and derivatives) to accrue incremental gains, relaxed lending standards to produce economies of scale, and moved out of the regulated sphere to establish the Shadow Banking System.

As for government policies, responsible for twisting incentives that led to these boom: Fed policies (aside from monetary policy, remember Greenspan’s advanced the idea of Americans moving to ARMs?), the implicit guarantee of the Government Sponsored Enterprises, Mark to Market Accounting Rules and the Community Reinvestment Act (which forced lending to less qualified candidates based on the concept of expanding homeownership or protecting the American dream).

Moreover, regulatory oversight became lax when the boom flourished! This very insightful quote from Robert Arvanitis Risk Finance Advisers, Institutional Risks Analystics, Seeking Beta: Interview with Robert Arvanitis (highlight mine)``Being mortal, the bureaucrats desire to avoid pain is as dear to them as the desire by their counterparts in private industry to seek gain. And it is far more profitable to game the rules, for example, than to enforce them. And any system can be gamed.” Yes indeed why get blamed for stopping the music while everybody is dancing? (hat tip: Craig McCarty)

In other words, Wall Street under the backstop of US Federal Reserve inflated the system until it became evidently unsustainable and thus collapsed.

So what is the basic problem? Inflation, overspeculation, overvaluation, oversupply and excess leverage or having taken on too much debt more than one can afford to pay. Essentially the ongoing bust represents market forces unraveling the massive distortions imposed on it or the reassertion of the universality of economic laws.

And $700 billion would seem like a spare change relative to the degree of market distortions that need to be cleansed from the system or the current high level of debt needs to be reduced to the level where the US economy can afford to pay them.

Markets have simply been telling Wall Street and the US, particularly Bernanke and Paulson and the US leadership, that it won’t be cowered by threats, and that market forces have been revealing the truth and realities about the untenableness of the imbalances within the system.

Perhaps it is about time to reconsider accepting the non-traditional non-cartelized sources of financing.

Global Markets: From “Minksy Moment” To The “Mises Moment”

``In their haste to be wiser and nobler than others, the anointed have misconceived two basic issues. They seem to assume: (1) that they have more knowledge than the average member of the benighted, and (2) that this is the relevant comparison. The real comparison, however, is not between the knowledge possessed by the average member of the educated elite versus the average member of the general public, but rather the total direct knowledge brought to bear though social processes (the competition of the marketplace, social sorting, etc.), involving millions of people, versus the secondhand knowledge of generalities possessed by a smaller elite group.-Thomas Sowell, "The Vision Of The Anointed: Self-Congratulation as a Basis for Social Policy"

It has been a most eventful week! Looking at the end numbers won’t do justice to the drama that had unfolded. And we should expect this to continue. And for the first time, even Philippine broadsheets highlighted the ruckus in the global financial sphere on its headlines, giving the oblivious public the opportunity to attest of the ongoing dynamics at the “macro” framework of global finance. Unfortunately, many of these reports only focused on the “surface” than of the “genuine” pressures which has been rattling the “core” of the system.

None of these have been new to us. We’ve dealt with the risks of evolving finance (structured products, derivatives, etc…), since we became bullish in GOLD in 2003 (The Rip Van Winkle in Gold series.)

Warren Buffett’s Philosophical Victory

We even subscribed to the views of Mr. Warren Buffett, the world’s premier investor, on his advocacy against the menace of newfangled exotic financial products or as Mr. Buffett has repeatedly warned, the “financial weapons of mass destruction” (see Figure 1) and of the follies of “squanderville” economics or conspicuous debt driven consumption as manifested by US current account deficits in November 2003 Fortune Magazine “America's Growing Trade Deficit Is Selling the Nation Out From Under Us”.

Figure 1: US Global: Derivatives In Perspective

And as always and contrary to the mainstream, in the fullness of time, Mr. Buffett has once again been utterly validated. As a reminder, Mr. Buffett’s themes have almost always materialized from a LONG term and NOT ticker (short term) based perspectives, as commonly espoused by the public.

And recent events only have only reinforced such theme where market forces have been wracking at the pillars of the much maligned world’s monetary (financial) system.

And this has not just been foretold by Mr. Buffett but also by the Austrian School of Economics.

The “Minksy Moment” At its Finest

“Minsky Moment” has been coined by the distinguished UBS Economist George Magnus. It refers to the illustrious American economist Hyman Minsky (1919-1996) who is known as the father of Financial Instability Hypothesis, from which he gained popularity over the theory of “stability leads to instability”.

In our August 2007 article, Global Markets: An Advent to the Minsky Moment and the Kindleberger Paradigm?, we described Minsky’s credit cycle as,

``Minsky’s model actually basically depicts of the credit cycle underpinning the business cycle, where credit transforms from a function of HEDGE financing (ability to pay principal and interest) to SPECULATIVE financing (ability to pay interest only, which needs a liquid market to enable refinancing and debt rollovers) and finally to PONZI Financing (basic operations cannot service both interest and principal and strictly relies on rising asset prices to service outstanding liabilities).”

Or said differently, complacency tends to foster greed, via the transition mechanisms of the credit cycle where people imbue more risks by adopting unsustainable arcane credit instruments, which eventually culminates to a break point known as the “Minsky Moment”.

So the perturbation you have been witnessing from today’s financial sphere is exactly how the late Minsky described all these to be; the diverse alphabet soups of highly leveraged complex instruments-slice, diced and repackaged, stamped with investment grade ratings by credit rating agencies and sold to investors all over the world.

Banks and Investment Banks which traditionally held on the mortgages they underwrote and took the underlying credit risks morphed into “originate and distribute” models from which disseminated credit risk to investors, who instead of conducting their own credit scrutiny to establish the viability of these products, almost entirely depended on the seal of approval from credit rating agencies. For global investors faced with a “savings glut” and institutional requirements to match investments with liabilities, in behaving like lemmings, it became an “in” thing to get into these papers on the assumption they were safe as determined by the Credit Rating Gods.

With capital freed up from warehousing credit risk, these institutions worked to assume more risk by the extension of credit facilities to a wider scope of the population who were less creditworthy or “subprime” on ultra-favorable loan terms in order to generate additional returns via the economies of scale.

Moreover, these institutions piled into more dubious loans from the real economy (real estate mortgages) which were recycled with more leverage and wrapped into complex financial labels into the financial economy underpinned by the creation of off balance sheets vehicles (SUV) from banking institutions from which emerged the Shadow Banking system. Aside, derivative instruments as credit default swaps (CDS), originally meant as an insurance against company defaults was likewise utilized as another tool for obtaining leverage (CDS issuance vastly greater than underlying bonds), whose mind boggling size further enhanced counterparty risks.

Thus, the full scale transition towards the Ponzi structure.

Who can forget the infamous quote from Citibank’s Charles Prince, ``But as long as the music is playing, you've got to get up and dance. We're still dancing.” Yes, almost every participant knew this was bound to happen, but assumed that they could get out ahead of the others. Unfortunately like cartoon character Wily E. Coyote, who runs off the cliff and keeps going on until he looks down and realizes that he’s been running on air, the industry plunges to the ground!

Nonetheless when the Minsky Moment emerged, the risk distribution on an international scale revealed that risk weren’t really reduced but instead, as vividly shown last week, had been spread and became the source of the tremors which rippled throughout global markets.

From the effects side, Minsky was absolutely correct. Stability created conditions for greed which allowed for more risk taking appetite backed by a pyramid of unsustainable gearing.

The Emergence of Mises Moment?

We have been saying for so long that the entire premise of today’s suspenseful episode has been centered on the structure of the prevailing monetary system- the Paper Money US dollar standard operating on the fractional banking reserve platform as defined by wikipedia.org as ``only a fraction of their deposits in reserve with the choice of lending out the remainder while maintaining the obligation to redeem all deposits upon demand.”

It means that it is the intrinsic nature of global central banks to foist boom conditions derived from leveraging (modeled after the banking system) or by means of expanding money and credit to the point that it becomes unsustainable. From which the ensuing bust will tend to prompt liberals or interventionists to unjustly brand such cyclical inflection as “market failure”, when market forces had been repeatedly tweaked and distorted to the extremes by constant policy based interventionism.

Besides, had there been automatic adjustment mechanisms meant to curb excesses by allowing market forces to determine the resource allocation process (e.g. gold standard), boom bust scenarios would have greatly been reduced.

Unfortunately while many articulate voices cite the lack of regulation or its ineffectualness, a large part of this laissez faire blaming has not been consistent with reality; this noteworthy quote from George Mason University Professor Tyler Cowen from the New York Times (highlight mine),

``But the reality has been very different: continuing heavy regulation, with a growing loss of accountability and effectiveness. That’s dysfunctional governance, not laissez-faire.

``When it comes to financial regulation, for example, until the crisis of the last few months, the administration did little to alter a regulatory structure that was built over many decades. Banks continue to be governed by a hodgepodge of rules and agencies including the Office of the Comptroller of the Currency, the international Basel accords on capital standards, state authorities, the Federal Reserve and the Federal Deposit Insurance Corporation. Publicly traded banks, like other corporations, are subject to the Sarbanes-Oxley Act.

``And legislation that has been on the books for years — like the Home Mortgage Disclosure Act and the Community Reinvestment Act — helped to encourage the proliferation of high-risk mortgage loans. Perhaps the biggest long-term distortion in the housing market came from the tax code: the longstanding deduction for mortgage interest, which encouraged overinvestment in real estate.

``In short, there was plenty of regulation — yet much of it made the problem worse. These laws and institutions should have reined in bank risk while encouraging financial transparency, but did not. This deficiency — not a conscientious laissez-faire policy — is where the Bush administration went wrong.”

We’d like to add the implicit guarantees of Fannie & Freddie Mac and Community Reinvestment Act of 1977-forcible lending to minorities as additional unintended consequences to the present boom bust scenario. Of course as we earlier brought up, the most compelling dynamics of the recent tragedy arose out of the policies to expand credit or money.

At this point, events are proving to be strongly in transition towards our “Mises moment”,

From Ludwig von Mises’ Human Action (highlight mine), ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

Our “Mises moment” assumes that governments faced with a crisis will run the printing presses to reflate the system at the expense of its currency system.

Why?

Because for governments, credit is the only panacea for any economic or market ailment. This from Ludwig von Mises from Human Action, ``Credit expansion is the governments' foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make everybody prosperous.”

“Too big to fail or too interconnected to fail” has been the overwhelming justification for recent government actions to inject massive doses of credit into the global financial system for the implicit aim to stave off a financial meltdown. Of course, with it comes the unintended consequences which will reveal itself overtime.

As for “inflationary” credit expansion, here is a list of the recent activities…

-The US took the Fannie Mae and Freddie Mac into conservatorship ($200 billion).

-The US rescued its largest insurer AIG with an $85 billion in loan package (three-month Libor plus 850bp) collateralized by its assets with the US government assuming 79.99% in equity through warrants and has the right to veto payment of dividends and preferred shareholders in condition that it pay the loans by orderly liquidation of its assets.

-The US through in coordination with global central banks have made available nearly $300 billion ($180 initial and $100 additional) for short term loans (New York Times) see figure 2.

Figure2: Wall Street Journal: US Running the Printing Press To Save the System

-U.S. will insure money-market funds from a backstop of $50 billion from an emergency pool (Exchange Stabilization Fund) against losses for the next year as it seeks to prevent a run on $3.35 trillion of assets that average investors and institutions rely on as a safe alternative to bank deposits. (Bloomberg and Wall Street Journal)

Other prospective courses of actions include the following (From Danske Bank):

“-Setting up an entity that would take bad assets off financial companies’ balance sheets: As in past financial crises the plan is to set up a fund that could take over troubled assets from the balance sheet of financial companies. This is in many ways similar to the RTC fund set up during the savings and loans crisis.

“Such fund would create an investor of last resort in troubled assets and remove the significant black box element from balance sheets of banks. In turn, this should increase downside visibility and thereby confidence among banks.

“-The creation of federal insurance for investors in money market mutual funds: As investors have become increasingly worried about money market mutual funds, otherwise thought off as one of the safest investments, insurance akin to the one currently safeguarding bank deposits could hinder a massive outflow from the money market funds currently under scrutiny

As of this writing, the US Treasury has appealed to its Congress to be granted with $700 billion to buy on a carte blanche basis ``bad mortgage investments from financial companies in what would be an unprecedented government intrusion into the markets.” (Bloomberg)

Will Systemic Socialization Be Successful?

With the US Federal Reserves finally opting to expand its balance sheets, the response from the gold market has been breathtaking as it has been with global equity markets, see figure 3, but to a lesser extent.

Figure3: stockcharts.com: Gold Smells Bloody Inflation!

The extraordinary run up in gold prices comes even in the face of the raising of margin requirements on Comex gold and contracts by 47% and 20% respectively. (Bloomberg) This is another sign of government intervention to halt spiraling precious metals. Notice that the turn in the US dollar index could mark an inflection point.

Again this hasn’t been unexpected since we noted in our June article, Global Financial Markets: US Sneezes, World Catches Cold!, “Maybe if all the above measures cease to work then the last ace for Mr. Bernanke would be to expand the Fed’s balance sheets by printing money or otherwise the US economy could succumb to deflationary recession!”

Obviously with the recent accentuated downside volatility in the equity markets, aside from the freezing of the credit markets, Mr. Bernanke’s (aside from Treasury Secretary Paulson) actions reflected the aura of desperation enough to utilize their last ace; the shifting role of the US Federal Reserve from a lender of last resort to a BUYER of last resort or the socialization of the important aspects of the US financial markets, which was once the embodiment of modern capitalism!

Many have argued that the socialization of the financial sector is needed to save the system. We aren’t so sure.

Why?

-Prohibition of short sales has temporal effects. As we argued in our recent post Will The Proposed Ban of Short Sales Support Global Markets?, a ban of short sales is a form of price control which inhibits price discovery and leads to even more inefficient and volatile markets. Instead, since socialization seems to be the thrust why not simply ban the stock market altogether?

-It is unlikely for the US to save the entire banking industry or let alone the $47 trillion debt markets.

-Government will essentially compete with private funds for financing affected or bailed out or “nationalized” institutions. Aside from the risk of driving up interest rates, it could lead to more inefficiency in capital allocation within the economy resulting to a loss of productivity.

-Since the US government is entirely reliant on foreign financing (about $2 billion per day), it may be at the risk of having difficulty to borrow or raise money for its funding requirements.

As an example, just last week even when US treasury yields where at historic lows from the credit seizure, credit default swaps (CDS) on US treasuries rose to its highest level! From Reuters, ``Credit default swaps on 10-year Treasury debt widened to a fresh high of 27.9 basis points from 27.7 basis points late on Thursday, according to CMA, a specialised data provider.”

Figure 4: Casey Research: Foreigners Pull Plug on Dollar Recycling?

The Fannie and Freddie debacle led to an outflow or significant sales in agency holdings by major foreign public and private institutions last July (CBS marketwatch). Although some portion of the sales had been offset by inflows into US treasuries, which seemed as the only asset the foreigners were willing to buy, aside from the reduced net purchases of foreign assets by US residents, which equally reflected the forcible liquidations abroad, it wasn’t enough to account for to reverse the net outflows.

Overall, in times of heightened risk aversion, state owned Sovereign Wealth Funds or central banks don’t seem to be totally immune to the previous conventional pursuit of the acquiring US dollar assets (or recycling dollars) for political objectives as seen in Figure 4.

What this means?

It raises the risk of the skepticism over the viability of the “full faith and credit” upon which the US dollar and the world’s monetary system has been founded upon.

While we are seeing some participation of forex currency reserve rich countries as China in the ongoing negotiation to acquire distressed US financial companies as the brewing CIC-Wachovia- Morgan Stanley deal (newsdaily.com), it isn’t clear that the previous incentives for foreign financing will always remain the same.

Besides, it would necessitate a substantial portion of the US assets to be acquired by foreign investors, if the present system is to be maintained, which implies a shift in the balance of geopolitical power.

Yet, we appear to be seeing some signs of cracks on the seemingly inexorable faith over the US dollar system…

From the New York Times (highlight mine),

``The nonstop deluge of bad publicity for American investments seems to be seeping into the consciousnesses of the rich and middle class across Asia.

“I do not believe in U.S. financial institutions anymore; I don’t think any U.S. bank is safe anymore,” said Wang Xiao-ning, a Hong Kong homemaker. Even after the Federal Reserve had taken control of A.I.G., she waited in line with dozens of other anxious policyholders at one of the insurer’s customer service centers for the chance to close her investment account….

``Changing Asian sentiments have not yet eroded the value of the dollar — although market reaction to the A.I.G. bailout seemed to be doing that Wednesday. Asian skittishness has coincided with heavy selling by Americans of their holdings of stocks and bonds in foreign markets.

``“It’s almost a case of everyone bringing money back home,” Americans and Asians, said Ben Simpfendorfer, an economist in the Hong Kong office of Royal Bank of Scotland.”

This implies that the US has been more at the urgency to bring home its currency enough to have prompted for the recent US dollar rally, which evidently had been indications of the deleveraging process.

However, as Asians may become more skeptical, they could begin entertain the idea of possibly reallocating more of their investments to ex-US dollar denominated investments or tangible assets, albeit the alternatives aren’t large and liquid enough.

For Asians to withhold if not abandon the US markets in exchange for other potential markets would be a disaster for the US.

And it is not just in the financial world but also seen in migration flows.

From AsianInvestor.net, “We are seeing not only ethnic Asians seeking to return to Asia from Europe and the US, but also professionals without any personal link to Asia,” says Executive Access’ Eisenbeiss. “Asian markets still offer more opportunities than elsewhere for selected, experienced professionals.”

Does this represent an unwarranted concern? Not if you ask New York Mayor Michael Bloomberg, from Hedgeco.net, ``"Who’s buying our debt? It’s these overseas funds, these sovereign-wealth funds, these overseas hedge funds. They are in trouble now. So it’s not clear who is going to be buying" US Treasury bills, he said.”

Some Mises Moment Scenario

So what do we see from the Mises moment?

More US assets will probably be acquired by foreign institutions unless the US government resorts to increased financial protectionism. Yet there is could be a political policy dilemma over the prospective crossborder acquisitions of key US industries, as Brad Setser rightly points out ``Bailing out US banks is one thing. Bailout out a Chinese-government-owned US bank is another.” With more of the foreign buying of US distressed assets, the balance of geopolitical power would have clearly shifted. Yet if state owned institutions were to take such a lead role then, we could be seeing nationalization of US assets from governments abroad.

It is likely too that on the account of massive dosages of central bank money for rescue programs, the prospects of “higher inflation” could be signaled by the continued rise in gold and precious metals.

Furthermore, the US dollar may be pressured from government instituted policies that is likely to weigh on the fiscal equation. We cannot compare the past experience of nationalizations simply because the scale of government intervention will likely be the largest the world has ever seen.

With government weighing in heavily on the markets, the rules have been changing almost daily to the point of triggering credit events for CDS, which means even more losses.

Now, if the degree of US financials systemic losses are much more than anticipated by the regulators, then I think the appropriate question to ask is, who will then bail out the US treasury and the US Federal Reserve?

Fannie And Freddie Bailout Designed To Save The US Dollar Standard System

``Over the past few years, the Agencies were central to the process that brought the emerging world’s savings to the US housing market. And governments were involved every step of the way. When the world’s central banks (and other big bond investors) decided that the implicit US government backing for the Agencies wasn’t enough, the US government had to make the backing explicit.”-Brad Setser, Council of Foreign Relations, So true …

 

It was a highly volatile market out there this week.

 

The initial salvo was wild cheering from global equity markets on the recent action by the US Treasury to take its Government Sponsored Enterprise (GSE)-Fannie Mae and Freddie Mac- into “convervatorship” (quasi-nationalization). However, the festiveness quickly dissipated when the realities of “a weakening global economy”, the ramifications from the credit event of the F&F takeover on the Credit Default Swap Market and concerns over the persistent deterioration of US financial conditions as manifested by the lackluster capital raising quandary by Lehman Bros, which until recently, was the 4^th largest investment bank in the US, sunk into the consciousness of global investors which resulted to a retreat from most of the earlier gains.

 

The conservatorship program includes the taking over of management control of Fannie and Freddie (F&F) by its regulator the Federal Housing Finance Agency (FHFA), where common and preferred stock would be diluted and not eliminated. The takeover now alters the corporate objective of the GSEs to “improving mortgage financing conditions” from “maximizing common shareholder returns”.

 

The program also includes capital injection into the GSEs by US Treasury and FHFA to maintain the positive net worth of these agencies in order to fulfill its financial obligations, where in exchange the US Treasury receives “senior” preferred equity shares and warrants aimed at securing solvency.

 

Aside, a new credit facility designed to secure liquidity concerns will be introduced to backstop F&F and Federal Home Loan Banks, and which is set to expire on December 2009. Lastly, a temporary program will also be put in place to acquire GSE Mortgages in order to secure market liquidity of mortgage securities also slated to expire on December of 2009.

 

For starters, Agency securities are one of the world’s most widely held securities by both private and the public sectors (Sovereign Wealth Funds and Central banks).

 

Morgan Stanley’s Stephen Jen has a great breakdown on these (highlight mine),

 

`` Total foreign holdings of long-term USD securities increased from US$7.8 trillion in 2006 to US$9.8 trillion in 2007, with US$1.3 trillion of this annual increase from increased foreign holdings of US long-term debt securities, including US Treasuries, agencies, agency ABS and corporate bonds.  Foreigners are dominant in some of these markets.  For example, some 57% of the marketable Treasury securities are held by foreign investors. 

 

``Foreign investors’ appetite for US agencies – both straight agency debt and agency-backed ABS (also called agency pass-throughs) – has risen sharply.  (Fannie Mae and Freddie Mac (F&F) are government-sponsored enterprises (GSEs) with two main activities.  First, they securitise mortgages by converting conforming mortgage loans into tradable mortgage-backed securities (MBS).  Second, they have an ‘investment portfolio’ business, whereby they issue AAA rated agency debt to finance the holding of MBS or other assets.  The latter is a ‘carry trade’, capitalising on the then-implicit government guarantee.  One key part of the policy discussion regarding F&F is whether their second activity is justified.)   Of close to US$7.5 trillion in outstanding US agency debt and agency-backed ABS, some US$1.54 trillion (according to Fed flow of funds data, June 2008) is held outside the US, with China, Japan and AXJ being the largest holders of these securities, with US$985 billion of this latter figure held by foreign central banks. (The share of total US long-term securities held by foreign investors has more than doubled since 1994 (from 7.9% of the US$16 trillion in securities back then to 18.8% of the US$49 trillion outstanding as of 2007).” 

 

We featured a chart on the composition of foreign holdings of the F&F in Inflation: Myths And Beneficiaries. Nonetheless, private ownership of Agency backed papers appears to have stagnated since 2005 while foreign public ownership has steadily increased as shown in Figure 2.

Figure 2: Northern Trust: Foreign Public-Private Exposure On F&F

 

In perspective, aside from foreign holdings GSE debt securities are likewise owned by US households and institutions or financial entities as commercial banks, savings banks, credit unions, pension funds, life insurance companies mutual funds, brokers, ABS issuers and REITs.

 

However, as % of total outstanding debt, in 2007 ownership of GSE debt in pecking order: foreigners comprise 19.92%, followed by commercial banks 13.87%, households 12.06%, mutual funds 7.67% and ABS 5.13% (Northern Trust).

 

So when US Secretary Paulson was asked of the US government’s takeover of F&F, his reply as quoted by the Washington Post,

 

``"The U.S. government had no choice," he said.

 

``Mr. Paulson, in an interview with CNBC on Monday, said foreign pressure was not the "major driver" of the takeover, but acknowledged that "there's no doubt that there's fragility in the capital markets."

 

``"These companies are so big, and they are owned by investors all around the world. You are obviously going to get concerns," Mr. Paulson said. "It was definitely concerning overseas, but there was concern in this country. I tell you, my phone is ringing the most from investors here." 

 

This means the US financial system have reached a near calamity. 

 

However many had been quick to lash at the “conservatorship” program as virtually a bailout of foreign owners of agency securities.

 

While this perception seems partly correct, I think most of these critics ignore the fact that these actions basically signify a remedial patchwork to the emerging cracks at the Fiat Paper Money “US Dollar” standard system. The massive current account imbalances a common feature in today’s world tends to amplify on the systemic flaws especially amidst today’s heightened volatility.

 

At present, countries with current account surpluses at one side of the ledger need to be offset by countries with current account deficits at the opposite side. As an example, deficits of the US have been more than sufficiently covered for by capital flows from mostly emerging markets paving way for the unorthodox pattern of “Poor countries Financing The Rich”.

 

Yes, while various politicians and experts from around the world have boisterously decried about “social inequality”, unknowing to most is that such inflationary “inequality” mechanism appears to be the imbedded on the US dollar standard platform. Think of it, while profits are privatized, losses are socialized! Wall Street’s politically connected gets rescued, while the masses pay for the mess created by the former. The failed F&F model was demonstrative of the Keynesian brand of capitalism and not of the laissez faire genre. (Please don’t associate the fiat paper money standard as epitomizing laissez faire or free markets too. Same with currency markets, interest rate markets or even oil markets! These markets are controlled heavily by governments notably on the supply side. As an aside, the “anarchy” in the Shadow Banking System wasn’t symptomatic of a free market mess, but one of going around banking regulations or taking advantage of “regulatory loopholes” in order to take on added leverage by assuming more risk to magnify returns by the establishment of off-balance sheet Structured Investment Vehicles (SIV). Going around loopholes do not signify free market paradigms).

 

Going back to the unorthodox pattern of “Poor countries Financing The Rich”, during the gold standard, current account imbalances had effectively been curtailed by the shifts in the gold reserves by nation states engaged in trade. This essentially accounted for as an automatic adjustment mechanism, which is absent today under the digitalized and unlimited printing capabilities of central banks to churn out money “from thin air”.

 

And as we noted above, current account imbalances today need to be offset. During the recent past, the nations with current account surpluses signified as subsidies to domestic export-oriented industries but came at the expense of domestic consumers, i.e. China, Asia and other emerging markets. On the other hand, current account deficit nations run subsidies on domestic consumers via expanding domestic debt (financed by current account surplus countries) at the expense of domestic production. From which the transmission mechanism had been mainly via currency pegs or dollar links.

 

The foreign buying of agency papers or US debts were meant to sustain mercantilists’ policies by frontloading currency and interest rate risks in order to keep the exchange rate undervalued and thus promote domestic export oriented industries in order to expand employment. Hence, the currency manipulation policies that led to the current account imbalances had primarily been meant as a tool to manage domestic political risks.

 

In other words, the US dollar standard system paved way for political imperatives over economic goals, see figure 3.

Figure 3: Asianbondsonline.com: China-US yield curve

 

What sense would it make for a current account surplus country as China to buy or load up on assets of a depreciating currency, thereby suffer from currency loss? What sense too for current account country as China to buy assets whose yield is less than what is offered domestically, thereby suffer from opportunity cost of low interest rate spreads (assuming holding bonds until maturity)? And this has been going on for years!

 

The same for deficit countries, domestic consumers had been financed to go into a debt driven asset buying binge which resulted to overleveraged driven massive speculation, again for political goal of sustaining finance driven economic booms, where the demand from domestic consumption boom has greased the industries of current account surplus countries as China and emerging countries.

 

The US dollar, functioning as the world’s de facto currency reserve currency, has fundamentally been used by the US government to freely load up on debt, given its special privilege to underwrite from its own currency, by selling almost unlimited financial claims to international investors to finance such speculative unsustainable booms.

 

And as the US real estate and financial boom has basically unraveled, all these seem to be in a transition.

 

Recently there had been some signs of reluctance of nations with current account surpluses to stack up into agency papers. Of course, the recent actions by the US Treasury may seem to have assuaged the concerns of repayment by buying more into US treasuries instead of agency papers.

 

So what can we see from all these?

 

One, current account surpluses nations or foreign central banks seem to have the tolerance bandwidth, given their accrued currency reserves, to suffer from the risks of currency and interest rate losses provided they get repaid for holding these securities until maturity. I guess the actions by the US treasury may have answered such “repayment” concerns.

 

Two, foreigners which have been formerly financing the US real estate securitization boom appears to be bailing out, if not help tacitly ‘nationalize’ the structurally beleaguered industries by buying into agency papers until recently.

 

It also reveals of the extent of overdependence or vulnerability of the US on relying on foreign financing. The risk seems such that if foreign central banks or state owned Sovereign Wealth Funds or affiliated institutions would deem to have accumulated more US dollar reserves than what they might think is required, and change their priorities by reducing finance exposure to the US, which can even lead to more volatility in the US. Political factors can also hold sway to the appetite of foreign financing of US deficits.

 

In addition, understanding its present predicament and limitations, the “capital short” US government seems to be working feverishly to attract or to intermediate for foreign capital participation into buying out its besieged financial institutions. Example, a syndicate led by UK’s 3^rd largest bank, Barclay’s along with a “club rescue” team of “Temasek of Singapore and China Development Bank, was reportedly have shown willingness to back a deal that would put Barclays in the top tier of financial institutions.” (timesonline.co.uk)

 

Three, it’s all about the increasing integration of geopolitics or the decreasing hegemony of the US, as seen in the “Poor financing the Rich” aside from “Autocratic and non-democratic states financing democratic countries”!

 

Some Poor but Autocratic/non democratic nations that have been a beneficiary to the ongoing wealth transfer appear to have accumulated enough political clout as to weigh on the internal political policymaking of the US. 

 

Remember this quote from Yu Yongding, a former adviser to China's central bank quoted last in our Will King Dollar Reign Amidst Global Deflation? ``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic, if it is not the end of the world, it is the end of the current international financial system.” The recent political actions employed by the US government appeared to underscore such circumstances and Mr. Yu’s prayers seems to have been answered.

 

Or how about Russia’s recent military offensive against Georgia (as discussed in Toynbee’s Generational War Cycle: In Mindanao or In Georgia/South Ossetia?) which has practically left the US as a political nonparticipant to a besieged ally?

 

This only goes to show how the US looks to be losing its imperial edge over the global geopolitical economy and how the US dollar standard system appears to be in greater jeopardy.