Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?

Today’s du jour word is “guarantee”.

The prevailing belief is that when deposits, loans, or debts are guaranteed by governments, they become fail-safe in absolute terms or the elixir to our financial and economic problems.

No one seem to ask, guarantees with what?

For instance when Iceland recently joined the policy stampede of guaranteeing its banking system, it has been earlier assumed that its government can settle with any calls made on such claims.

Unfortunately, mired with foreign liabilities in excess of $100 billion which dwarfs the country’s GDP of $14 billion and whose current account deficits is one of the highest in the region, it appears that government guarantees would depend from entirely either the kindness of foreigners or from its printing presses.

Courtesy of Danske Bank

Ultimately this means that guarantees need to be backstopped by hard currency which is something Iceland lacks at the moment…

Courtesy of Bloomberg

And because of the shortage of hard currency to pay for imports, Icelanders have begun to hoard on items. This panic buying will drive up consumer goods inflation already one of the highest in the region.

This from Bloomberg, ``After a four-year spending spree, Icelanders are flooding the supermarkets one last time, stocking up on food as the collapse of the banking system threatens to cut the island off from imports.

``Iceland's foreign currency market has seized up after the three largest banks collapsed and the government abandoned an attempt to peg the exchange rate. Many banks won't trade the krona and suppliers from abroad are demanding payment in advance. The government has asked banks to prioritize foreign currency transactions for essentials such as food, drugs and oil…

``There is absolutely no currency in the country today to import,'' said Andres Magnusson, chief executive officer of the Icelandic Federation of Trade and Services in Reykjavik. ``The only way we can solve this problem is to get the IMF into the country.''

Yes, the IMF and Iceland have reportedly been in discussion but have not reached any accord yet (guardian.co.uk).

The unfortunate part is that Iceland which used to be the top in terms of human development as measured by prosperity and “fulfilled life” could suffer immensely from the breakdown of its banking system.

Courtesy of Economist

According to the same report in Bloomberg, ``Icelanders, whose per capita gross domestic product is the fifth highest in the world, according to the United Nations 2007/2008 Human Development Index, will have to tighten their belts.”

Courtesy of Wall Street Journal

And this is unlikely to serve as a short term development as its 320,000 citizens will have to take the onus of bearing the angst from the losses incurred by its banking system. Yet the economy is faced with the immediate prospects of economic contraction, which compounds the dire scenario.

Courtesy of the Economist

Iceland’s agricultural subsidies, the largest among developed economies, could shrink as its government would likely require a sizeable share of its revenues to compensate for the losses.

For the moment, as external funding remains scarce, Iceland risk becoming the “Zimbabwe” of Europe as they would likely have to rely on the printing presses to finance its domestic financial system if foreign funding don’t emerge soon.

So aside from a recession, Icelanders risk facing a profound transformation of even higher taxes, a fall in per capita income, a decline in productivity and deterioration of living conditions.

In short, a potential regrettable “riches to rags” story.

Moreover aside from serving as an example of what happens when a banking system fails, the Iceland experience suggests that the probable next wave of crisis will be one of national solvency issues.

Guarantees can reflect more of political designs than of economic reality.

Some Prudent Advice from Dr John Hussman

Here are some important pointers from one of my favorite contrarians, the well-respected Dr. John Hussman on today’s market. BTW, Dr. John Hussman has been widely known as one the “perma bear” in the investment community. Excerpts From “Four Magic Words: "We Are Providing Capital"…

(all highlights mine)

1. ``Look, a few weeks ago, there was a $700 billion pile of money on the table, but the only way for Wall Street and bureaucrats to get their paws on it was to scare the public out of its collective gourd. They succeeded, but created the psychology that the U.S. was on the verge of depression if the bailout wasn't passed. Having created that psychology, the crisis took on a life of its own.”

Our Comment/Interpretation: The Power of suggestion took its own life; government engendered or prompted this panic!

2. ``Word to the wise - don't accept advice or analysis about this crisis from anyone who failed to anticipate it in the first place! The people warning about Depression now are the same reckless jackasses who told investors that stocks were cheap and “resilient” at the highs.

Our Comment/Interpretation: To Preach Doom Has NOW become MAINSTREAM! Halloween costumes are a fad. Beware of these false prophets.

3. ``Stocks are now measurably undervalued…Stocks are now at the same valuations that existed at the 1990 bear market low.”

Our Comment/Interpretation: From the valuation viewpoint, today’s market is a BUY.

4. ``The problem in the U.S. financial system amounts to roughly 5% of the mortgage assets outstanding. Virtually all of this panic can be traced to the wipeout of shareholder equity in highly leveraged institutions, but it's only a small percentage of the volume of loans in the financial system. Investors are now being quoted ridiculous dollar figures in the trillions and quadrillions (e.g. the total value of the U.S. housing stock, or the un-netted notional value of financial derivatives) as if these figures represent potential losses. The people spouting these figures are appealing to the worst impulses of a frightened public that doesn't fully understand the market mechanisms at work here.

Our Comment/Interpretation: Problems in the US economy should be seen in the right perspective. It’s easy to sell fear.

5. ``The proper way to address homeowner distress is not for the government to buy troubled mortgages and simply reduce the principal. That idea is utterly insane. If that policy was enacted, every homeowner in America would have an incentive to immediately go delinquent on their mortgage. Rather, Congress should provide for a relatively modest alteration in bankruptcy laws, allowing judges to write down mortgage principal but at the same time provide the mortgage lender with what I'd call a “Property Appreciation Right” (PAR) that would give the lender a claim on some amount of future price appreciation of property owned by the borrower. In that way, the mortgage lender would have the prospect of being made whole over time, homeowners who have faithfully made payments on their own mortgages would not be discriminated against, and homeowners in trouble would surrender some future price appreciation for immediate reduction in their monthly payment burden.

Our Comment/Interpretation: TARF is a bad idea. Infuse capital instead.

6. I recognize that all of this is very scary, particularly the rate at which the market has declined, which seems unprecedented. But it is important for investors to understand that the current selloff has all the quite standard markings of a “panic,” of the type that Charles Kindleberger described in Manias, Panics, and Crashes: a “seizure of credit in the system.” It is just mind-boggling to hear financial reporters and Wall Street “professionals” foaming at the mouth that the difficulties we are observing today are wholly new and unprecedented. We've seen these before.

``Economist Stephen Roach wrote weeks ago that “ The most important thing about financial panics is that they are all temporary. They either die of exhaustion or are overwhelmed by the heavy artillery of government policies.” That fact is worth remembering here.

Our Comment/Interpretation: Market panic has been PART of the cycle! See below…

7. ``In contrast, if your asset allocation is consistent with your risk tolerance, you're diversified, and you have a “full cycle” investment horizon, stick with your discipline. If your exposure to risk is small, a panic is a good time to increase it gradually on depressed prices. That is what good investors do. The bad investors are the ones that establish leverage at tops and are forced to sell at bottoms. Those investors unfortunately exist, and their behavior can amplify movements in both directions, but a disciplined, gradual, diversified strategy should allow for that.

Our Comment/Interpretation: Good Investors buy on Panic, Bad investors buy the fad. Always maintain discipline!

8. ``In a market economy, profits are the compensation that people earn for providing scarce resources. One of the scarcest resources here and now is the willingness to accept risk, the willingness to put a bid out at a low price so that someone can actually sell. You don't exhaust your whole risk budget, or even the majority of it, but you move gradually, in steps, the scarier and more volatile the market, the smaller the size of the trades and the bigger the discounts you require. In short, a good investor provides scarce resources, liquidity, risk bearing and (if you're a good investment analyst) information, when those resources are in furious demand.

Our Comment/Interpretation: It is the time to take risk, and be promptly paid for it.

Thank you, Dr. Hussman.

Deriviatives: Clear and Present Danger

From the New York Times

Global Market Crash: Accelerating The Mises Moment!

``Maybe only a friendly foreigner could say this. But America needs to realize that not everyone can own a home. The American Dream of home ownership for all is a fraud. Politicians who pimped this dream created an unsustainable mortgage industry whose collapse is only surprising because it didn't happen earlier. America's mortgage industry will not recover, nor deserve to recover, unless it is prepared to challenge this politically unpalatable reality.”-Janet Albrechtsen, Columnist The Australian, in Not Everyone Should Own a Home published at the Wall Street Journal

Let us leave the melodramatic chronicling of the market events to the media. Inane comments like “darkest days” and “no idea what will help the market” doesn’t take into account why this event ever occurred. The sun still shines and the market doesn’t need help. In fact, all the help thrown to the market has only worsened the situation by preventing the necessary adjustments.

A humorous depiction of today’s events was poignantly captured by Kal’s Cartoon of the Economist magazine via a caricature which I posted at my blog post Cartoon of the Day: Too Big To Rescue!

As we have repeatedly quoted the warnings of Ludwig von Mises who presciently wrote in 1940s in his magnum opus the Human Action, ``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.”

This has never changed and will be an ongoing dynamic.

Yet it’s not the end of the world as we know it.

In fact, this crisis will unmask the illusions and charades of Keynesian Capitalism-the consumption and paper shuffling economy, -consuming what you don’t produce, spending more than you can afford, taking on debt more than you can pay for, “current account deficits are good” -prompted for by loose monetary policies, the overconfidence from the invincibility of central bank printing press, exports of financial claims in return for real goods or services (paper money standard), government pump priming policies, government’s tweaking with the public’s incentives via the cartelization of the banking system which has led to cronyism and its oligarchic structure which only concentrated risks, the fractional reserve banking system which became paradigm for profiting from credit expansion, and all forms of price control measures to the point of suggesting to suspend the markets. Oh yes, we might not see markets operating next week as this is being discussed as part of the measures to “rescue” the market.

If the ban on short selling only intensified the market’s unraveling, no amount of suspending the market will correct the fundamental imbalances generated by policies meant to perpetuate an eternal boom. Besides, since most of the academe and liberal authorities has pinned the blame on market’s alleged “Greed” (who he/she?), we should then ask our leaders to legislate on controlling human emotions. (e.g. thou shalt not greed!) (hahaha!)

To quote Warren Buffett, ``It's only when the tide goes out that you learn who's been swimming naked." Yes sir, the Emperor has no clothes!

On the hand, we shall see how distinct economies survive this ordeal or the validation or falsification of the new paradigms of: an emerging multipolar world anchored on Emerging Markets (BRIC) and Asia-Emerging Asia (via support from reserve foreign exchange surpluses held or by the shift in demand-supply and saving-investment structures-perhaps via exchange rate policies or by the development phase of financial markets or by increasing regional trade and financial integration and or collaboration)

And this should also test how monetary policy based instruments as interest rates used to cushion today’s market stress will impact distinct economies from which will define each nation’s cost structures as Arthur Middleton Hughes, The recession of 1990: An Austrian explanation of the Austrian School of Economics posits,

``Because of these dissimilarities, changes in the cost of capital result in very different investment patterns. For a lower-stage industry (such as a retailer, wholesaler, or food producer), the cost of capital is not as important, because the interest charges do not have to be carried very long before the payout begins. For a higher-stage industry, increases in the cost of capital often mean the difference between undertaking a new project or not doing it at all… [p.108]

``What this tells us is that the market rate of interest means different things to different segments of the structure of production. When rates go down, a great many higher stage projects that were uneconomic at high interest rates become at once feasible. When rates go up, many higher-stage long-term projects have to be scrapped. These simple rules do not apply to lower-stages of production, simply because their payoff times are much shorter. They don't have to pay as much interest on their typical project. A lower stage producer is less likely to embark on an investment project.” [p110]

Given today’s massive interest rate cutting action conducted jointly by major central banks; particularly the US, ECB, UK, Canada, Sweden, UK, Switzerland, China, Hong Kong and Taiwan, South Korea, what this means is that manufacturing economies stand to benefit from lower interest rates than “consumer related” economies.

So while today’s market has almost gutted most of the global financial markets (equities, commodities, bonds and currencies-yes newspapers focus on stocks but contagion has been across the board) as a result of massive deleveraging and stress in the global banking system, once such policies sink in or diffuse, we are likely to see divergent economic performances that should be reflected on the markets once the panic subsides.

The Bullish Case: It’s Blood On The Streets!

``Many momentous historical developments occur without the participants fully realizing what is happening.” George Soros

It’s been reported that losses in Wall Street has hit $2.4 trillion this week and $8.4 trillion for the year (Forbes) while the Phisix lost some P 554 billion or about or about $11 billion over the week (inquirer.net). On percentage basis, the Phisix lost almost the same as Wall Street down by over 18% and is down 45% year to date against the US bellwether Dow Jones Industrials at 39% and S & P 500 at 42%.

As we have pointed last week, the US seems fast catching up on the Phisix on an apparent race to the bottom. But the optimistic angle for the Phisix, which used to be high beta or “high risk-high return” seem to have transformed into “low beta”. In short, US markets appear to be underperforming the Phisix on the downside as well as the upside.

Yes admittedly the overwhelming power of the global bears eventually did catch up with my “divergence” view from which the Phisix struggled to maintain but eventually succumbed. But nonetheless, if such outperformance manages to hold then come the time when the global markets begin to stabilize or consolidate we should see a faster recovery for the Philippine benchmark.

True, the technical breach from support levels signals the return of the bear market, but it is unclear if we could go deeper.

The optimistic case:

Figure1 BBC: Market Crashes Through The Ages

In Figure 1 from BBC which we have shown in August 2007 and August 2008 highlights the worst performance of the Dow Jones Industrials in terms of one day falls and worst bear markets relative to the scale of losses.

Since each crisis has its own tale, this week’s drop 18.2% is one for the history books (marketwatch.com). Nonetheless, the 7.3% drop last Thursday will be as included as part of the largest one day loss and where the weekly loss looks like the extended variant (instead of one day, it became a one week) of Black Monday Crash of October 19^th 1987.

But from the technical, sentiment, valuation point of view these events are starting to look better.

One, the Dow Jones Industrial’s historical bear markets suggest that the biggest loss EXCLUDING the GREAT Depression has been around 40-50% (right pane) which means unless you believe that the US is faced with the prospects of a great depression, this record loss could herald a near, if not an interim, or even a major bottom.

The Dow Jones Industrials has already exceeded the degree of losses incurred from its 2000-2002 bear market (36%).

Figure 2: stockcharts.com: Fear Index and Capitulation Signals

Next, technical indicators point to severely oversold conditions to the point of ‘capitulation’ (see figure 2) or as per investopedia.com, ``capitulation is associated with "giving up" any previous gains in stock price as investors sell equities in an effort to get out of the market and into less risky investments. True capitulation involves extremely high volume and sharp declines. It usually is indicated by panic selling.” (highlight mine)

Meanwhile the Fear index (topmost pane), as measured by the VIX is at confounding record highs. In previous occasions, the normal highs recorded were at over 30s (red vertical lines) which coincided with interim bottoms. This extraordinary fear is worth taking note of. Likewise the oversold conditions seem to be corroborated by the Relative Strength Index (RSI), seen at bottom pane, which is at below 30.

Figure 3: US Global Investors: Valuations Halved!

Nevertheless market actions appear to be pricing in a significant slowdown in global economies, according to Frank Holmes of US Global Investors (highlight mine), ``Trailing price-earnings ratios for global equities have been slashed in half since last year, as seen in the chart below. This is true regardless of whether financials are included in the calculation. In October 2007, the Factset Work Equity Index (10) generated a trailing P/E ratio of 18; that has now fallen to nine times earnings.

``Barclays made another important observation: The de-rating has been in response to the deteriorating economic climate. Basically, there’s been a traffic jam of inflation and credit shocks that has generated a global financial panic.”

So from the above perspective, we remember the famous contrarian advise of Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family, who reaped a fortune from the ensuing panic during the Napoleon’s Battle of Waterloo as saying ``Buy when there's blood in the streets, even if the blood is your own!” (investopedia.com)

Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?

``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 Gargantuan

Although 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 Plunges

As 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 6^th 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’.

Figure 7: yardeni.com: Falling reserve growth

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.

Ron Paul: We Have No Understanding of How Capitalism Is Supposed to Work

Chart of the Day: US Dow Jones: Worst Annual Decline in History

From Chartoftheday.com:

``Continued concerns regarding the credit crisis, a slowdown in consumer spending, and a further weakening of the US economy sent the Dow down more than 7% on the day. Today also marks the one-year anniversary of the current correction. The Dow put in its record high of 14,164.53 back on October 9, 2007. Today, the Dow closed at 8,579.19 -- down 39.4% from its one year old peak. For some perspective on the magnitude of the current decline, today's chart illustrates how the Dow performed during the first year of all major corrections since 1900. As today's chart illustrates, the first year of the current correction has been more severe than the first year of any correction since 1900 -- and that includes the correction that began in 1929."

Two points of thought:

1. Could the collapse in US stocks signify more than just deleveraging and its economic spillover such that losses have topped 1929?

2. Relative to the Phisix which is down by 45% from the peak as of Friday's close, it used to be far worst, e.g. when US markets fell by 1% we dropped by 2-3%. Have we become low beta? Nonetheless despite the market's rout, the Phisix has held up well. So far so good.

Cartoon of the Day: Too Big To Rescue!

From the Kal's Cartoon of the Economist

Hilarious depiction of markets versus governments.

Great Stuff, Kal!

Japan’s Nikkei 225: Back to the Future

In 2003 Japan’s benchmark the Nikkei 225 fell to a 14 year low at about the 7,800 level…

Courtesy of chartrus.com

Nikkei has been on a free fall…

As of this writing the Nikkei is being bludgeoned at 8,300

4 years of gains gone to naught.

Global Central Banks Cut Rates Simultaneously To Cushion Markets!

As we expected, markets under heavy pounding, has prompted SIX central banks to coordinate rate cuts.

chart courtesy of BBC

According to the BBC,

``Six central banks - including the Bank of England - have cut their interest rates by 50 basis points.

``The UK rate move - which had not been expected until Thursday - puts interest rates at 4.5% from 5%.

``The US Federal Reserve has cut rates from 2% to 1.5% and the European Central Bank trimmed its rate from 4.25% to 3.75%.

``The central banks of Canada, Sweden and Switzerland all took similar action in the co-ordinated move.

``The unprecedented step is aimed at steadying a faltering global economy and slumping stock markets.

``The Fed said that it had acted "in light of evidence pointing to a weakening of economic activity and a reduction in inflationary pressures".

Separately, China lowered its key rate by .27%. Japan didn't participate but supported the move. (Bloomberg)

Earlier today Hong Kong took the lead when it announced interest rates cuts....

``The base rate for banks will drop to 2.5 percent from 3.5 percent tomorrow, based on the U.S. benchmark target rate plus 50 basis points, down from 150 basis points, Chief Executive Joseph Yam said today. The HKMA tracks the Fed Funds rate, which is now at 2 percent, because Hong Kong's currency is pegged to the dollar.(Bloomberg)

Australia likewise took a surprising 1% cut yesterday.

So central banks are using unparalleled modern ways to deal with the unprecedented scale of deflation by using a combination of various tools, aside from tight collaboration and synchronized efforts among themselves. This seems like their version of "globalization" of central bank policies. Although we really doubt if they can be successful in trying to contain the market process of unwinding the excesses of the past. Maybe they can buy some time.

Nevertheless, since rate cuts are effectively growth stimulus, the impact should be different in national boundaries depending on their capital and production structure.

As an aside, central banks today look increasingly desperate and captive to the political demands of Wall Street.

News from The 1990s Foretold of this Crisis

Debating who had been responsible for this crisis can take lots of academic vernacular to support or debunk the premises.

But we don’t need it.

By looking at the past, we can note that some news reports during the ‘90s appear to have actually “sensed” or predicted today’s fateful occurrence.

This excerpt from an LA TIMES article…

Minorities’ Home Ownership Booms Under Clinton but Still Lags Whites’

By Ronald Brownstein May 31, 1999

``All of this suggests that Clinton’s efforts to increase minority access to loans and capital also have spurred this decade’s gains. Under Clinton, bank regulators have breathed the first real life into enforcement of the Community Reinvestment Act, a 20-year-old statute meant to combat “redlining” by requiring banks to serve their low-income communities. The administration also has sent a clear message by stiffening enforcement of the fair housing and fair lending laws. The bottom line: Between 1993 and 1997, home loans grew by 72% to blacks and by 45% to Latinos, far faster than the total growth rate.

``Lenders also have opened the door wider to minorities because of new initiatives at Fannie Mae and Freddie Mac–the giant federally chartered corporations that play critical, if obscure, roles in the home finance system. Fannie Mae and Freddie Mac buy mortgages from lenders and bundle them into securities; that provides lenders the funds to lend more.

``In 1992, Congress mandated that Fannie and Freddie increase their purchases of mortgages for low-income and medium-income borrowers. Operating under that requirement, Fannie Mae, in particular, has been aggressive and creative in stimulating minority gains. It has aimed extensive advertising campaigns at minorities that explain how to buy a home and opened three dozen local offices to encourage lenders to serve these markets.

``Most importantly, Fannie Mae has agreed to buy more loans with very low down payments–or with mortgage payments that represent an unusually high percentage of a buyer’s income. That’s made banks willing to lend to lower-income families they once might have rejected…

``The top priority may be to ask more of Fannie Mae and Freddie Mac. The two companies are now required to devote 42% of their portfolios to loans for low- and moderate-income borrowers; HUD, which has the authority to set the targets, is poised to propose an increase this summer. Although Fannie Mae actually has exceeded its target since 1994, it is resisting any hike. It argues that a higher target would only produce more loan defaults by pressuring banks to accept unsafe borrowers. HUD says Fannie Mae is resisting more low-income loans because they are less profitable."

From the New York Times article by Steven Holmes Fannie Mae Eases Credit To Aid Mortgage Lending, September 30, 1999

``Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

“In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the saving and loan industry in the 1980’s.

“‘From the perspective of many people, including me, this is another thrift industry growing up around us,’ said Peter Wallison a resident fellow at the American Enterprise Institute. ‘If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.’”

Hat tip Prieur Du Plessis

As author Steven Landsburg reminds us, ``Most of economics can be summarized in just four words: People respond to incentives. The rest is commentary." (Hat tip Mark Perry )