Page 1 of 2 A risk-free
revolution By Julian
Delasantellis
In Ten Days That Shook
the World, American socialist John Reed’s
account of Vladimir Lenin’s November 1917 armed
insurrection against the Provisional Government of
Alexander Kerensky (later made into the Warren
Beatty movie Reds in 1981), it is described
how the new government of Bolshevik
revolutionaries issued its first edicts on
financial system reform.
"It [the new
government] will suppress immediately the great
landed property, and transfer land to the
peasants. It will establish workmen's control over
production and distribution of manufactured
products, and will set up a general control over
the banks, which it will transform into a state
monopoly."
As March 2008 draws to a close,
it is obvious how a more modern
age’s customs have acted
to speed up previously plodding processes. Last
month, from March 11 to March 17, the world
financial system witnessed Six Days That Shook the
World. No, the government did not "set up a
general control over the banks" and transfer them
into state monopolies; but what the US government,
in the form of the bearded, bald revolutionary
personage of not Lenin, but of Federal Reserve
chairman Ben Bernanke, did during this period, is,
in the context of US banking and financial system
regulatory history, just about as revolutionary.
The Fed’s actions are also far more
significant than US Treasury Secretary Henry
Paulson’s March 31 initiative on financial system
regulatory reform, which, in mixing and remixing
the current alphabet soup regulatory structure,
sounds a lot more like jumbling a Scrabble board
than real reform.
You might say that the
metaphor is hopelessly stretched, in that, at
least not yet, no royal families have been shot to
death in a root cellar, as happened to the
Romanovs in 1918. However, if you happened to have
started the month as a stockholder of the US
brokerage house Bear Stearns, it may feel just
about the same.
Last August, as the first
serious waves of the subprime crisis started
slamming against the shores of the financial
markets, an earnest young woman interviewed me
about what was then going on. She was a reporter
for, as she put it, "the Economic Observer, which
is one of the most influential business newspapers
based in Beijing China" - I can imagine my old
professor of Chinese Communist studies spinning in
his grave at the prospect of not just one, but
many business newspapers in modern day Beijing.
I told her I thought that the US Fed was
going to start cutting short-term interest
rates-soon and in quantity. (It was the day after
I said this that the Bernanke Fed made its first
cut, the 50-point cut in the Discount Rate of
August 17; they’ve cut seven further times since.)
What about "moral hazard" the young woman
asked. Wouldn’t cutting interest rates to bail out
US financial institutions that had made risky bets
on subprime mortgage bonds be a prime example of
this?
I chuckled a bit at this question.
This young woman sounded like one of those earnest
and hardworking economics students (and I’ve had
so few of these that I sure know one when I
encounter one), who sat there in the front row of
the lecture hall and dutifully took notes on every
single inflection of every single syllable that
her professor uttered.
With the economic
changes in China over the last quarter century,
especially the concept of a free-market economy as
something to be emulated and not looked down upon
with contempt, I wonder about what it was like
when the professor was standing up in front of her
class. Surely, with the change in direction of the
political winds, Western free market capitalism
must now be put up high on a pedestal, in the same
way that Mao’s Great Leap Forward was sanctified
50 years ago.
In this, I wonder if her
professor, or his department head, got his hands
on some old Western business and economics
textbook - without, of course, paying royalties to
the author, just like I didn’t for my $10
made-in-China Rolex .
The text talked
about moral hazard. This is the phenomenon where
one economic actor working to his own benefit
jeopardizes the health and solvency of the whole
system - an example would be a government-insured
bank making extra risky loans, knowing that, if
the loans fail, the government insurance will pay
off the depositors.
The aforementioned
purloined text undoubtedly said that moral hazard
is bad, that it should be avoided, that Western
economies, and those who manage them, are wise
enough not to set up situations where moral hazard
comes into play. Since everything connected to
Western capitalism and Western markets is now
idolized in China, the professor read the text to
the students, the students heard and accepted this
revealed wisdom (my earnest interlocutor taking
copious notes) and out they emerge from college
believing every word of it.
And then, for
the Chinese students, just like for Western
economics students, comes the bracing shock of
frigid air that is the real world, the way things
really work.
Once graduated from college,
those earnest economics students, now employed in
the banking, brokerage or financial services
industry, learn that the world is a lot different
from the textbooks. The system is infused,
permeated, saturated, soaked through and through
with reward and acceptance of moral hazard; trying
to avoid it is like expecting an alcoholic to stay
on the wagon after getting a job at the beer
warehouse.
Part of it is the fact that the
core disciplinary tactic of the moral hazard
paradigm, letting imprudently acting financial
institutions bear the full penalty of their folly
and thus go bankrupt, with their directors
suffering penury, the poorhouse, or prison, sounds
a lot better in theory than it works in practice.
Yes, the foolish, those who lent or invested
unwisely, might suffer, and that, like the
miscreant undergoing humiliation or worse chained
in the public stocks, may be a tempering lesson to
those who may be tempted to act similarly in the
future.
But a lot of others, namely,
anyone who had any type of financial relationship
with the miscreant institution, will suffer as
well. The chastened institution that had gambled
and lost, now bankrupt, will in no way be able to
meet its obligations, to pay back any debts it has
with any other institutions. That will, if only by
raising doubts about the soundness of these other
institutions, put in question their continued
operations and existence as well.
These
institutions will be in dire straits enough in not
getting their money back from the insolvent, moral
hazard bank; when the word gets out that this is
so a panic, a "run" on the bank, could occur that
might drain the bank’s deposits, its capital
reserve, in but a few hours - much as what
happened to Northern Rock bank in England late
last summer. Financial regulators have learned
that, although it probably would be salutary to
allow the imprudent to suffer the foolishness of
their folly every once in a while, it’s just not
worth it if the rest of the system goes down the
drain as well.
In addition to what they
don’t teach in the economics textbooks, moral
hazard is tolerated for what they don’t teach in
the political science textbooks either. In
exploiting the system’s implicit guarantee of
rescue to make outsized profits, the moral hazard
bank garners more than enough financial resources
to easily fund substantial purchases of the
relatively cheap political system, in order to get
their desired message reliably and persuasively
transmitted to the levers of power. (In the manner
in which the financial system’s heavy hitters
browbeat Bernanke into commencing the rate cuts
last August - see Vox populi - Why the Fed did
a U-turn, Asia Times Online, October
17, 2007) To paraphrase what a more modern Ernest
Hemingway might say to a contemporaneous F Scott
Fitzgerald - "The rich are different from you and
I - they can repeatedly call Ben Bernanke’s
private number and not be charged with phone
harassment."
So, all during the final
four-and-a-half months of 2007, and well before
there was any real indication that the problems
with the banks were causing any actual damage to
the general economy, the Bernanke Fed cut rates
and cut them again - solely to resuscitate a
financial system floundering under its highly
leveraged and ill-advised exposure to the subprime
mortgage phenomenon. As the new year broke and
then there did seem to be indicators of the crisis
inhibiting growth outside the financial sector,
the Fed’s cutting became more and more frenetic,
taking off 1.25%, 125 basis points, in two
separate rounds of cuts, in late January alone.
But then a problem arose. The rate cuts
did not seem to be doing much good - indeed, the
financial system’s woes seemed to be ever
increasing, as more and more subprime mortgage
holder defaults and repossessions were leading to
the souring of more and more highly leveraged
subprime mortgage paper in the portfolios of the
financial system. Indeed, the problem seemed to be
spreading from out of just mortgage finance. As I
have explained previously (Wealth destruction gathers
pace, Asia Times Online, February 20,
2008), the damage being done to banks and other
financial institutions balance sheets was
inhibiting lending, and thus leading to a
contraction of liquidity, in sectors of the
financial system far removed from housing finance.
And so, like the starving peasants of St
Petersburg whose desperation lit the match for the
November Russian Revolution of 1917, a financial
system starved of capital ignited the great
financial system revolution of March 2008.
As Japanese economic officials have
learned to their misfortune during their now
almost 20-year economic malaise, countering an
economic contraction that originates as a credit
crisis solely through interest rate cuts can be a
chancy preposition at best. Interest rate
reductions act to increase the general supply of
money to the overall economy, but, in financial
system crises, the supply of money in the general
economy is not really the problem. The Bank of
Japan lowered short-term rates to just above 0%
and held them there for almost a decade, and still
it could not get its banks and other financial
system institutions to lend freely to the general
economy. Then in Japan, and currently in the US,
the financial system was just not all that
enthused about making new loans when it wasn’t
sure that its old loans were going to get paid
back. With this fear abounding, it’s not
surprising that much of the US Fed’s recent
largesse has gone into purchases of risk-free
short-term US Treasury securities, and tangible
commodities such as oil, gold, and food products
futures contracts.
What was needed was
thinking outside of the box. What was needed was
the Revolution. In my review last month of the
first year of the subprime crisis (And the band played on,
Asia Times Online, March 6, 2008), I explained why
interest rate cuts alone were not going to get to
the core of these current difficulties:
The core issue here is that every
subprime property foreclosed upon and then
thrown back onto the market with a foreclosure
auction adds real estate supply and thus
depresses prices, which makes it impossible for
the next subprime borrower to re-finance, so he
defaults and his property gets thrown onto the
already sodden market - on it
goes.
And with every succeeding
mortgage default and foreclosure, somewhere, in
some commercial bank, investment bank, hedge fund
or some other portfolio, that default means that
the mortgage-backed security containing that
mortgage is losing more and more value, meaning
that it no longer can be used as extensively as
collateral for more borrowing and lending. Like a
malignancy spreading and consuming the financial
system it contains, every successive organ the
cancer consumes just makes it stronger, its
appetite more voracious, for the next.
The
answer? Take the subprime paper out of the
portfolios - cut the cancer out. As I put it on
March 6:
Various proposals are
floating around the public policy wonk world that
call for a far greater role by the US government
in saving the subprime/structured finance world.
Most of these call for some branch of the
government to, in effect, take the subprimes out
of the hands of the private sector, by buying
these mortgage securities from the banks. Since it
would take these rapidly declining in value
securities off their hands, in exchange for cold,
hard, rock-solid (as long as you’re not comparing
its value to that of the surging euro) American
cash, the banks would love this.
Starting on March 11, the
Fed seemed to get the message. The first gates
were stormed.
It was on that day that the
Fed announced that, as collateral for banks
borrowing at its new, longer-term Term Securities
Lending Facility (TSLF), it would then start
accepting mortgage-backed securities, the cancers
in the banks’ portfolios. This was a very
significant change from the standard practice of
accepting only government-backed securities as
collateral.
This wasn’t the complete
exchange of subprimes for cash that I referenced
above, but you can see here that the Fed was at
least somewhat thinking along these lines. By
accepting the subprime paper as collateral, if
even just for the duration of the loan (TSLF loans
are for a period of up to six months, as opposed
to traditional Fed overnight or three-day
repurchase agreements) the Fed was, in effect,
taking it off the banks’ hands, so its continued
decline in value would not so greatly inhibit new
lending.
Then came the weekend of March
14-17. The Revolution.
In retrospect, the
insolvency of Bear Stearns should not have come as
that much of a surprise. Like attending a 10th
high school reunion and finding out that the class
troublemaker was now doing hard time, Bear’s
reputation for sharp-elbowed, full-speed tackling
business practices had well preceded it. It was
last summer’s insolvency of two Bear hedge funds,
the High-Grade Structured Credit Fund and the
High-Grade Structured Credit Enhanced Leveraged
Fund, that really set the alarm bells ringing in
the finance ministries and central banks of the
world. No one was all that surprised to see Bear
flounder and fail, and, apart from the
stockholders, no one was all that disappointed,
either.
On Thursday, March 13, the US
financial system saw an event that, like some
tropical disease thought to be eradicated through
proper hygiene and sanitation, it thought it would
never see again - a run on the bank. Bear Stearns
had finally played its last card from its sleeve,
and it was time to face its destiny.
However, unlike the Great Depression-era
bank runs exemplified by the scene in It’s a
Wonderful Life, this did not involve
hardscrabble men standing in the rain, waiting for
the bank to open so they could pull their deposits
out. Twenty-first century bank runs are much more
high tech.
To meet its short-term
financing needs, Bear was relying on the
continuous rollover of short-term lines of credit
from hedge funds, wealthy investors and other
private banks. This was all done electronically,
through electronic funds transfer. That Thursday,
a modern bank run was seen; in effect, a stampede
of computer mice moving away from the icons on
financial traders’ computer
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