``The business cycle is brought about, not by any mysterious failings of the free market economy, but quite the opposite: By systematic intervention by government in the market process. Government intervention brings about bank expansion and inflation, and, when the inflation comes to an end, the subsequent depression-adjustment comes into play.” Murray N. Rothbard, Economic Depressions: Their Cause and Cure
While blood on the streets could essentially represent a once in a lifetime opportunity, one must understand too why it requires additional contemplation of the operational dynamics that lead markets to be consumed by fear.
Riots From Lehman’s CDS Settlement?
One of the stated reasons behind last week’s bloodbath has been attributed to the settlement of Credit Default Swaps contracts from the bankrupted Lehman Bros.
According to Wikipedia.org ``A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" makes periodic payments to the "seller" in exchange for the right to a payoff if there is a default or credit event in respect of a third party or "reference entity"” In essence, CDS contracts function like an insurance where bond or loans are insured by the underwriters “sellers” and paid for by those seeking shelter from potential defaults “the buyers”.
In Lehman’s case its $128 million bonds (Bloomberg) was reportedly priced at 8.625 cents to a dollar which meant that insurance sellers had to pay its counterparties or buyers at 91.375 on a US dollar or cough up an estimated $365 billion (washingtonpost.com) to settle for each of the contracts which covered more than 350 banks and investors worldwide.
Generally this won’t be a problem for banks that has direct access to the US Federal Reserve, except for its booking additional accounting losses. But for institutions without direct channels to the US Fed this implies raising cash by means liquidating assets, hence the consequent selloffs.
Figure 4: New York Times: CDS Market Shrinking But Still GargantuanAlthough the CDS market has been said to decline from more than $60 TRILLION to $54 TRILLION, the sum is staggering.
According to the New York Times, ``The 12 percent decline, to $54.6 trillion, still left the market vastly larger than the total amount of debt that can be insured. The huge total reflects the way the market is structured, as well as the fact that someone does not need to actually be owed money by a company to be able to buy a credit-default swap. In that case, the buyer is betting that the company will go broke.
``Within that huge market, many contracts offset one another — assuming that all parties honor their commitments. But if one major firm goes broke, the effect could snowball as others are unable to meet their commitments.”
In other words if the present crisis could worsen and lead to more bankruptcies of major institutions this could put the viability of CDS counterparties at risk. Hence, it’s not the issue of settlement but the issue of sellers of CDS of defaulted bonds having enough resources to pay for their liabilities.
For instance, while news focused on politicians bickering over $700 billion bailout, the US Congress passed $25 billion loan package (USA Today) to the US automakers. Yet despite this, the S&P raised the risks potential of bankruptcies for the big three; General Motors, Ford and Chrysler (Bloomberg). Presently these automakers have been pressuring the government to release the funds recently appropriated for by the US Congress (money.cnn.com).
Some analysts warn that CDS exposures to GM bonds are worth some $ 1 trillion even when GM’s market capitalization is today less than $3 billion. They suggest that a bankruptcy could entail another bout of market upheaval. Maybe.
While this week’s market riots can’t be directly attributed as having been caused by the Lehman CDS settlement, they may have contributed to it.
Spreading Credit Paralysis
What seems to be more convincing is what has been happening at the world credit markets. Remember this crisis began with the advent of the credit crunch in July of 2007. And after the Lehman bankruptcy, events seem to have rapidly deteriorated.
Credit stress indicators as seen in likes of LIBOR (London Interbank Offered Rate) and TED spread have sizably widened even as the US Federal Reserve introduced a new program aimed at surgically bypassing the commercial market by providing direct funding to affected financial companies by directly acquiring unsecured commercial papers and asset backed securities, called the Commercial Paper Funding Facility (CPFF)
Figure 5: Danske Bank: Commercial Paper and Asset Backed Securities PlungesAs you can see in Figure 5, the commercial paper (CP) market for financial institutions have effectively dried up (see redline) just recently. Aside from the Asset Backed Commercial paper (ABSP) which continues to fall from last year, the CP market’s decline has coincided with the recent crash in global equity markets.
Remember, the commercial paper market is a fundamental source of funding for working capital by corporations. Hence with the apparent difficulties to access capital, the alternative option for companies with no direct access to the Federal Reserve or for companies that have exhausted their revolving capital, is to sell into the markets their most liquid instrument regardless of the price.
This could be the reason why the VIX index has soared to UNPRECENDENTED levels simply because financial companies had NO CHOICE but to monetize all assets at whatever price to keep their businesses afloat!
And this has spread about to every financial center from Hong Kong, Singapore, Japan and others, including the Philippines. According to a report from Bloomberg, ``Rising Libor, set each day in the center of international finance, means higher payments on financial contracts valued at $360 trillion -- or $53,500 for each person worldwide --including mortgages in Britain, student loans in the U.S. and the debt of companies like CIIF in Makati City, the Philippines.”
And this difficulty of raising money today has equally led to hedge funds redemptions especially by institutional investors which may have contributed to the carnage, from Wall Street Journal,
``Larger investors, like pension funds, which had in some instances borrowed money to invest in hedge funds, are pulling out because the credit crunch makes it difficult to raise money.
``Investors can't redeem their money from hedge funds at will; often they have quarterly windows when they can do so. Many investors had until Sept. 30 to tell hedge funds they wanted out. While the funds are typically not required to redeem the money until the end of the year, the redemptions were greater than some funds expected. That caused a scramble to raise cash to pay the investors back. And one quick way to raise cash is often to sell holdings of stock.
Some of these hedge fund liquidations have been even traced to the collapse in Hong Kong’s market (the Hang Seng Index lost 16% week on week), according to Xinhua.net, ``In a sign of redemption pressures on the investment funds, the Hong Kong unit of Atlantis Investment Management said it has suspended redemptions in its Atlantis China Fortune Fund -- a hedge fund with outstanding performance -- due to market volatility.”
Institutional Bank Run
As you can see banks refusing to lend to each other, deterioration in money market, collapse in the commercial paper market, massive hedge fund redemptions and fears of credit derivative counterparty viability could be diagnosed as an institutional bank run.
Honorary Professor at the Frankfurt School of Finance & Management Thorsten Polleit makes our day to come up with a lucid explanation at the Mises.org,
``What spells trouble, however, is an institutional bank run: banks lose confidence in each other. Most banks rely heavily on interbank refinancing. And if interbank lending dries up, banks find it increasingly difficult, if not impossible, to obtain refinancing (at an acceptable level of interest rates).
``An institutional bank run is particularly painful for banks involved in maturity transformation. Most banks borrow funds with short- and medium-term maturities and invest them longer-term. As short- and medium-term interest rates are typically lower than longer-term yields, maturity transformation is a profitable.
``However, in such a business, banks are exposed to rollover risk. If short- and medium-term interest rates rise relative to (fixed) longer-term yields, maturity transformation leads to losses — and in the extreme case, banks can go bankrupt if they fail to obtain refinancing funds for liabilities falling due.
``Growing investor concern about rollover risks has the potential to make a bank default on its payment obligations: interest rates for bank refinancing go up, so that loans falling due would have to be refinanced at (considerably) higher interest rates.
While banks are protected from depositors run by deposit insurance, what protects banks from an institutional run?
The European Experience
Ireland broke the proverbial ice in declaring a blanket guarantee on a wide-ranging arrangement that covered deposits and debts of its six financial institutions aimed at ``easing the banks’ short-term funding’ (Financial Times) among European countries.
This created a furor among its neighbors which contended that the ‘Beggar-thy-neighbor’ policies risks fomenting destabilization of capital flows. The reason is that the public would naturally tend to gravitate on the countries or institutions that issue a guarantee on their deposits, hence lost business opportunities for those that don’t do so.
Instinctively the radical policy adopted by Ireland evolved into a domino effect; despite the protests, every EU nations followed to jointly increase their savers to €50,000 (breakingnews.ie).
The problem is according to the Economist (with reference to Ireland or to those who initially went on a blanket deposit guarantee), ``it is not entirely clear how governments would pay these bills, if they ever came due. The chances of governments having to make good on all deposits seems remote, but the figures involved are eye-popping. In Ireland, for instance, national debt would jump from about 25% of GDP to about 325% if the value of its banks’ deposits and debts were taken on to the government’s books, according to analysts at Morgan Stanley, an investment bank. Similarly in Germany, national debt would jump to almost 200% of GDP if it included bank deposits (and about 250% if it included all the debts of its banking system). This may explain why interest rates on Irish government bonds have been rising in recent days.” (emphasis mine)
In other words, should losses consume a substantial portion of the resources of Ireland’s banking system, taxpayers will be on the hook and bear the onus for such unwarranted policy actions. As you can see, desperate times call for desperate measures regardless of the consequences. Nonetheless, Ireland expanded its deposit guarantees to cover 5 foreign owned banks (Economic Times India) presumably to avoid the Iceland experience, again despite the objection of most its neighbors.
Yet, strong pressures to guarantee the domestic banking system at all costs have taken a strain on the solvency of its neighbor Iceland.
From the same Economist magazine article, ``While governments on mainland Europe were trying to save their banks, Iceland was trying to save the country after it had overextended itself trying to bail-out its banking system. Its economy had been doing well, but its banks had expanded rapidly abroad, amassing foreign liabilities some ten times larger than the country’s economy, many funded in fickle money markets. Since the country nationalised Glitnir, its third-largest bank, last week the whole Icelandic economy has come under threat. Its currency is tumbling and the cost of insuring its national debt against default is soaring. As of Monday it was desperately calling for help from other central banks and was considering radical actions including using the foreign assets of pension funds to bolster the central bank’s reserves. These stand at a meagre €4 billion or so, according to Fitch, a rating agency, and in effect are now pledged to back more than a €100 billion in foreign liabilities owed by its banks.”
Iceland, a country of about 300,000 population and the 6th richest in per capita GDP (nationmaster.com), behaved like a hedge fund whose banking system immersed on the carry trade during the boom days. They borrowed short and invested long (overseas) or the maturity transformation (see Polleit) and additionally took on currency risk. In fact many of their home mortgages have been pegged to foreign currencies which has aggravated both the conditions of bankers and borrowers, from the New York Times,
``Some Icelanders with recently acquired mortgages face a double threat. Home prices have been falling, and analysts expect them to decline further. But many of these mortgages were taken out in foreign currencies — marketed by the banks as a way to benefit from lower interest rates abroad, as rates in Iceland rose into the double digits over the last year.
``Now, with the Icelandic krona plunging, homeowners have to pay back suddenly far more expensive euro- or dollar-value of their mortgages — a kind of negative equity, squared.”
Figure 6: Ino.com: Iceland’s Krona Plunge Against the US dollar (left) and the Euro (right)In addition, Iceland’s guarantees initially extended to only local depositors and did not to cover overseas investors many of which came from UK, hence ensuing threats of lawsuits. But as of this writing Iceland seems to have reached a deposit accord with UK and Netherlands (Bloomberg).
Moreover, another critical problem is that Iceland found no aid from its Western allies even as a NATO member and had to rush into the arms of political rival Russia which promised a loan for €4 billion (US $5.43 billion)! This is a dangerous precedent for central banks. Of course while this might seem like isolated case- in Asia Japan earlier rushed to offer loans to South Korea when the latter’s currency got pounded, aside from eyeing to create a scheme under the IMF to assist EM countries (Japan Times) and the urgency to revive the Asian counterpart of IMF (AFP)- such risks could worsen if the crisis deepens.
With the nationalization of Iceland’s top banks, taxpayers will also be responsible for the realized losses from the outsized liabilities, from which we agree with London School of Economics Professor Willem Buiter who says, ``The acquisition by the government of a 75 percent stake in Glitnir and the recent nationalisation of Landsbanki were therefore a mistake. Rather than hammering its tax payers and the beneficiaries of its public spending programmes, rather than squeezing the living standards of its households through a sustained masstive real exchange rate depreciation and terms of trade deterioration, and rather than creating a massive domestic recession/depression to try and keep its banks afloat, it should now let Glitnir, Landsbanki and Kaupthing float or swim on their own. The interests of domestic tax payers and workers should weigh more heavily than the interests of the creditors of these banks.”
Here are some lessons:
-Iceland through its nationalization of banks now suffers from the risks of currency, market, rollover and payment losses having to overextend themselves overseas and whose policies will eventually take a heavy toll on its citizenry.
-It’s not about the interest of taxpayers but of the interest of a few who control and become too entrenched into the system and whose risks has now become systemic.
-The Iceland experience of isolation in times of need reveals that central banks can’t always guarantee assistance to one another.
-In times of turmoil, national policies such as the action taken by Ireland can have negative externality effects- incur immediate political and future economic and financial costs.
-The risks of an institutional bank run which threatens the entire global banking system is clearly a top concern for European banks who seem to be acting out of desperation.
-Blanket guarantees (which had been limited to some countries so far) and nationalization of the banking industry will most likely be the ultimate tool used by central banks when pushed to the wall.
Global Liquidity Shortages and Falling Forex Reserves
In today’s turmoil, foreign currency reserves held by emerging markets appear to have been used as defense mechanism against a shortage of US dollar in the present environment in order to defend local currencies.
As affected US and European banks continue to raise capital and shrink balance sheets by selling assets and hoarding and conserving cash resulting to a lack of liquidity into the system, despite the massive infusion in the system by the global central banks led by the US Federal Reserve, this may also be construed as a symptom of the ongoing ‘institutional bank run’.
The chart courtesy of yardeni.com shows the declining growth rate of forex accumulation from developing and industrial countries. Since September, the growth rate is likely to have turned negative as more economies use their spare reserves to cushion the fall of their currencies.
From Bloomberg, ``Latin American central banks are being forced to draw on record foreign reserves built up during the six-year commodities rally to stop their currencies from sinking in the worst financial crisis since the Great Depression..
``The worst currency meltdown in Latin America since the emerging-market economic crises of the 1990s is causing companies' dollar debts to swell as well as sparking derivatives losses, and may stoke inflation. The decision to intervene came after central banks in the U.S., Europe and Canada cut interest rates in a coordinated effort to boost confidence…
``Brazil and Mexico join Argentina and Peru in selling dollars. Central banks in Chile and Colombia have so far used derivatives contracts to arrest the decline of their currencies, without touching reserves.
So it’s not just Latin Americans selling their US dollar surpluses but likewise in India ($8 billion in one week-hindubusinessline.com) and South Korea (estimated $25 billion since March).
Moreover current deficit economies including the US are likely to be at greater risks since it would need surpluses from foreign investors to fund the imbalances.
While the US continues to see strong inflows from central banks into US treasuries, our favorite fund flow analyst Brad Setser says that Central banks have either been shifting into US dollars from the euro or their reserve managers have also lost confidence in the international banking system or is moving into the safest and most liquid assets via the treasuries.
As per Mr. Setser. ``I would bet that this is more a flight away from risky dollar assets toward Treasuries than a flight into the dollar.”
Conclusion
I don’t like to sound alarmist, but all the present actions seem to indicate of the genuine risk of a failure in the global banking system. And this probably could be the reason behind why the recent turmoil in the financial markets has been quite intensive and amplified.
So the most likely steps being undertaken by global regulators in the realization of such risks (why do you think global central banks cut rates together?) will be to rapidly absorb or nationalize troubled banks (if not the entire industry) and continue to inject massive liquidity and lower interest rates aside from outright guarantees on deposits and loans in the hope to restore confidence to a faltering Paper Money system. In short, they intend to reinflate the impaired banking system.
Yet even under such conditions we can’t be sure if governments can provide sufficient shelter for the depositors and users of the system if conditions should deteriorate further. Present capital in the domestic system won’t probably be enough when the economic functions (clearing and settlement, payment processing, credit intermediation, currency exchange, etc.) of external banking system becomes dysfunctional, even under the context of our government guarantees (which will largely depend on its balance sheet and the ability for the citizenry to carry more public liabilities). Moreover, the international division of labor will likely be curtailed, leading to societal hardships and risks of political destabilization.
The key is to watch the conditions of the credit spreads, commercial paper and money market. Any material improvement in the major credit spread indicators will likely ease the pressure on regulators and relieve the pressure on most markets. Thus, while the potential for a rebound in the stockmarket seems likely given the severely oversold conditions, the vigor and sustainability will greatly depend on the clearing of the flow of global credit.
But on the optimistic part, the markets have already painfully reflected on the necessary adjustments of prices. While it is doubtful if we have reached the level of market clearing enough for the economic system to be able to pay for its outstanding liabilities given the amount of leverage embedded, it may have relieved additional pressures for a repeat performance of this week’s gore.
Of course, any action that government does which may coincide with a recovery is likely to be deemed as government’s success by liberals, it is not. The markets have already violently reacted.
Next, global depressions are aggravated by protectionism. This means that for as long as globalization in trade and finance can be given the opportunity to work, it may be able to accrue real savings to enough to recuperate the system. Besides, technology can vastly aid such process.
Another, this crisis episode is likely to generate a massive shift in productivity and wealth. The losses absorbed by crisis affected nations will impact their economies by reduced productivity on greater tax obligations. Thus, we are likely to see a faster recovery on economies that survived the ordeal with less baggage from government intervention. That is why we believe that some emerging markets including most of Asia should recover faster.
Moreover it isn’t true that if the banking industry goes the entire economy goes. As example, the Philippines has a large informal economy which is largely a cash economy. True, a dysfunctional international banking system abroad can create economic dislocations which may result to hardships but markets can be innovative.
As a final note, don’t forget that historical experiments over paper money have repeatedly flunked. We don’t know if this is signifies as 1) a mere jolt to the system or 2) the start of the end of the Paper money system or 3) the critical mass that would spur a major shift in the present form of monetary standard.
To quote our favorite departed icon Sir John Templeton in 1994, ``Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell."
