Tuesday, September 30, 2008

Congress decides it is worth risking depression

By Martin Wolf - Financial Times
Published: September 30 2008 19:22 | Last updated: September 30 2008 19:22

It is just over three score years and ten since the Great Depression. Judged by its rejection of the plan put forward by Hank Paulson, US Treasury secretary, Congress believes it is time to risk another one. That slump was, arguably, the greatest catastrophe of the 20th century: it was, among other things, responsible for the events that led to the second world war – not least Hitler’s rise. One can only imagine what horrors a depression might bring now?

Such forebodings must seem exaggerated. So, I expect, they will be. But that dire outcome is no longer impossible, not because a slump is inevitable, far from it, but because action is needed to prevent one.

We are watching the disintegration of the financial system. Finance is the web of intermediation binding economic agents to one another, across both space and time. Without it, no modern economy can survive. Yet that is now threatened, with the ongoing collapse in trust and flight to safety. We can indeed run this experiment. But why should we?

Even before Congress rejected the plan, the spread in dollars between the London interbank offered rate and expected official rates (as shown in overnight indexed swaps) had reached more than 200 basis points, for a period as short as three months. Prior to the start of the crisis in August 2007, the spread was negligible. (See chart.) Nor is this all: on Monday short-term yields on Treasury bills were below 1 per cent; credit default swap spreads on financial institutions reached exceptional levels and credit spreads on riskier bonds were widening rapidly. In the aftermath of the plan’s rejection, all this was likely to worsen. The S&P 500 also fell by 8.8 per cent on Monday, its worst day since October 19 1987. Nothing can better demonstrate how absurd it is to believe one can punish Wall Street without hurting Main Street. The two streets meet. That is what streets do.

If the financial system ceases to function properly and a range of financial institutions collapses, everybody will be hurt, as businesses and households are starved of credit. What is occurring now is a downward spiral of panic in which liquidity-starved financial institutions dump assets, weakening themselves and others, particularly now that their balance sheets are marked to market. This reduces their ability to lend and so undermines asset prices and the economy still more, thereby further damaging asset quality.

This, then, is “revulsion” – the final stage of a bubble when, as the late Hyman Minsky argued, investors are so scarred that they can no longer bring themselves to participate in the market. Unfortunately, among today’s panic-stricken investors are banks. These even wish to avoid lending to one another. As I noted last week (“Paulson’s plan was not a true solution to the crisis”, September 23), the gross liabilities of the US financial sector have soared from just 21 per cent of gross domestic product in 1980 to 116 per cent in 2007. A huge part of these massive liabilities must be from one financial firm to another. If credit is not extended, collapse will follow. This is why the investment-banking industry disappeared within weeks.

Against this dire background, what is one to make of the failure of Congress to ratify the plan? It is both understandable and a gross error.

It is understandable because the use of taxpayer money to buy so-called “toxic” mortgage-backed securities from the greedy fools who created the crisis is hard to tolerate. It is also understandable – even creditable – that those Republicans hostile to “socialism” do not want to bail out the undeserving rich, at least before an election. It is understandable, too, because, for reasons I put forward last week, the plan is not convincing. It is designed to deal with a problem of illiquidity in what seems certain to be a growing crisis of insolvency, particularly as house prices fall and the economy continues to weaken.

Yet the rejection is grossly mistaken because the resulting ruin will hurt the weak and destroy the legitimacy of the market economy. The plan is indeed flawed. But failure to ratify it is unlikely to convince anybody that something better will be forthcoming. It will convince them, instead, that the US is choosing to be impotent. At a time of such fragility, when the insurance offered by government is most indispensable, this is the worst possible message. It is a pity Mr Paulson did not choose another plan. It is a pity, too, that a former titan of high finance was charged with bailing out Wall Street. Yet it was still a mistake to reject the plan. It was necessary, instead, to build upon it.

What now? The first effort must be to find a plan that Congress can pass. It is quite possible to find one that protects the taxpayers’ interest better, by insisting on full reimbursement, after assisted companies return to health. Buying preference shares, as Warren Buffett did in Goldman Sachs, would be a good way to do this.

Second, it seems likely that a number of significant financial institutions will find it hard to fund themselves in coming days, as their share prices weaken and interbank lending is frozen. Central banks must make every imaginable effort – and a few unimaginable ones – to make sure liquidity needs are fully met during this period. The Federal Reserve may find itself having to rescue additional institutions. So, alas, be it.

Third, Europeans (among whom I include the British) must recognise they are in the same boat. In times of such peril, even a small cut in interest rates by the European Central Bank and the Bank of England would send a helpful signal. It is now most unlikely to prove inflationary.

None of what is happening is easily palatable. The need for a rescue is hard to swallow. The emergence of bigger and even more complex financial behemoths – all too big to fail – is a harbinger of crises to come. Yet, while one must consider the long-run implications of how a crisis is resolved, one must resolve it first.

Franklin Delano Roosevelt famously said that “the only thing we have to fear is fear itself”. In truth, the economic processes unleashed by the bursting of the housing and credit bubbles are real. But fear is also a danger. When confidence collapses, a market economy cannot function. It must now be restored.

The problem is not lack of knowledge of how to do this: we know how to recapitalise and restructure damaged financial systems. The problem is lack of will. Government must start to show it is in control of events. In the twilight of a failed US administration, that may seem far too much to ask. Winston Churchill, Roosevelt’s partner, said: “The United States invariably does the right thing, after having exhausted every other alternative.” The alternatives are now exhausted. It is time for politicians to do the right thing.


Friday, September 19, 2008

Capitalism in convulsion: Toxic assets head towards the public balance sheet

By John Plender

Published: September 19 2008 19:25 | Last updated: September 19 2008 19:25

In the space of just two momentous weeks, the landscape of global finance has been dramatically transformed. President George W. Bush’s administration has mounted a multi-billion-dollar rescue of the financial system at the cost of inflicting severe damage on the US model of free- market capitalism.

Heavy costs will be inflicted on the American taxpayer, who is now subsidising Wall Street – and indeed financial institutions around the world – in a bail-out of unprecedented size.

The sequence of events that led to this extraordinary socialisation of finance began with the de facto nationalisation of Fannie Mae and Freddie Mac, the bankrupt government-sponsored mortgage lenders at the heart of the US housing finance system. There followed a rise in the cost of insuring against default in the world’s most powerful economy. On some independent estimates, the overall response to crisis could take the outstanding US public sector debt from readily manageable status to a level comparable with such fiscally stretched countries as Italy and Japan.

Concern about the creditworthiness of the US is nonsensical, according to Charles Goodhart of the London School of Economics. It has nonetheless surfaced, along with worried punditry about the dollar’s role as a reserve currency.

Then came the absorption of Merrill Lynch by Bank of America and a bold decision by Hank Paulson, US Treasury secretary, to allow Lehman Brothers, the fourth largest US investment bank, to go to the wall. This constrasted with the government orchestrated rescue of the smaller Bear Stearns by JPMorgan Chase earlier this year.

The disappearance of these two Wall Street securities giants raised questions about the durability of the independent model of investment banking. Shares in the two independent survivors, Morgan Stanley and Goldman Sachs, were quickly savaged by short-sellers. In the UK, such short-selling is alleged to have been what pushed HBOS, the country’s biggest mortgage lender, into its shotgun marriage with Lloyds TSB.

Still more startling was news that the Federal Reserve was advancing $85bn (€59bn, £47bn) of taxpayers’ money to AIG, the world’s biggest private insurer. Thanks to its role in the global market for credit insurance, AIG was so interconnected with other financial institutions that its bankruptcy would have been catastrophic for the whole system.

Yet despite the rescue, the festering lack of trust that has dogged the banking system since August last year worsened after this move. On Wednesday, the interest rate on one-month US Treasury bills turned negative, bearing the astonishing message that investors would rather lose money on government paper where repayment was certain than invest in money market funds. The climactic point had been reached where nobody trusted any credit other than the government’s.

In such circumstances, experience teaches that central banks have to lend freely. In the event, the Federal Reserve injected $180bn into the markets, while other leading central banks said they were taking co-ordinated measures to help short-term dollar markets.

To round off the week, Mr Paulson announced discussions with political leaders to create a government-sponsored vehicle to take on toxic assets created during the bubble, prompting a manic stock market bounce.

The paradox in this remarkable tale is that extreme illiquidity exists in a world awash with the excess savings of Asia and the petro-economies. Russia illustrates the point. Thanks to the oil windfall, it sports high economic growth, the third largest foreign exchange reserves in the world and low public sector debt. Yet Moscow stocks are collapsing and trust in the financial system has eroded to the point where overstretched Russian investment banks are starved of funds and threatened with bankruptcy.

This is what happens when an overleveraged global financial system unwinds. Borrowing is being forcibly reduced across the world after the greatest credit bubble in history. It amounts, says David Roche of Independent Strategy, a research boutique, to a “tectonic shift from leverage to thrift as the means of financing growth and the concomitant dramatic reduction in global imbalances such as the US current account deficit”.

The reality is that the financial system has been operating as if it were an off-balance-sheet vehicle of the government. Private-sector companies and individual bankers have been making huge profits in the bubble. Their risk appetite has been enhanced by previous bail-outs and, in the case of Fannie and Freddie, by the government’s implicit guarantee. Yet their market pricing does not reflect the potential cost to the system of their own collapse.

This inability to handle externalities has again been apparent in the markets over the past two weeks as speculators have engaged in short-selling strategies against AIG and the investment banks in the US and HBOS in the UK. This threatens the financial system because the rating agencies respond to the consequent falls in share prices by cutting credit ratings, so jeopardising the victims’ ability to fund the business.

Once again, property has been at the heart of a financial debacle, in spite of the assurances of central bankers that a nationwide fall in US house prices was an impossibility. Yet the peculiarity this time lies in property being wrapped in complex financial products that few could understand.

When investors go outside their areas of competence, trouble follows. Walter Bagehot, the 19th-century economist who defined the rules for central bank management of financial crises in his book Lombard Street, said: “Common sense teaches that booksellers should not speculate in hops, or bankers in turpentine; that railways should not be promoted by maiden ladies, or canals by beneficed clergymen . . . in the name of common sense, let there be common sense.”

The twist in the current decade is that even bank boards and bank executives have failed to understand complex mortgage-backed banking products, as have central bankers, regulators and credit rating agencies.

In this off-balance sheet Alice in Wonderland world, the most absurd feature has been a reward system that has granted huge bonuses to those who peddled toxic mortgage-related products and does not permit much of the money to be clawed back now that the going is bad. Almost as absurd has been the degree of leverage racked up by investment banks.

As Michael Lewitt, the Florida-based money manager, puts it: “Allowing investment banks to be leveraged to the tune of 30 to 1 is the equivalent of playing Russian roulette with five of the six chambers of the gun loaded. If one adds the off-balance-sheet liabilities to this leverage, you might as well fill the sixth chamber with a bullet and pull the trigger.”

So what stage in the the crisis have we reached? Bagehot quoted the banker Lord Overstone’s description of the progress of an unstable cycle thus: “quiescence, improvement, confidence, prosperity, excitement, overtrading, CONVULSION [Bagehot’s capitals], pressure, stagnation, ending again in quiescence”.

Over the past two weeks we have experienced convulsion. Yet it ought to be possible to avoid stagnation, because the authorities are following the prescriptions of Hyman Minsky, the economist whose work Stabilizing An Unstable Economy best explains the dynamics of this crisis.

Minsky saw fiscal activism by big government, alongside last-resort lending by central banks, as the modern way of coping with financial distress. That is now taking place. In effect, the US government is replicating what happened in the private banking system earlier in the crisis, when institutions were obliged to take entities they had created, such as structured investment vehicles and conduits, back on to their balance sheets as funding dried up.

Having implicitly guaranteed Fannie and Freddie and underpinned the operations of irresponsible bankers at AIG and elsewhere, the US government is putting bankrupt institutions back on to the public sector balance sheet via nationalisation. Now, Mr Paulson’s proposal for the system’s toxic assets has the makings of a turning point.

What will the banking landscape look like after this saga? Much depends on the regulatory response. At the very least, tougher capital requirements will be imposed, which could mean the banking system reverts to a lower-risk, utility-like function. Yet one of the most important questions concerns the independence of central banks.

If central banks have to be recapitalised, as seems likely, politicians may want to extract a price that diminishes their operational independence. That could have damaging consequences. For a central point of Minsky’s thesis is that fiscal activism and last-resort lending set the stage for serious inflation.

That, together with an increased burden on future generations of taxpayers, could be the cost of the last two weeks’ frantic efforts to stave off deflation and keep some semblance of the Anglo-American model of capitalism afloat.

The writer is an FT columnist and chairman of Quintain

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Thursday, September 18, 2008

Gridlock and panic follow loss of compass

By Gillian Tett

Published: September 18 2008 20:52 | Last updated: September 18 2008 20:52

As markets trembled on Thursday, Standard & Poor’s, the US rating agency, detonated another small grenade. After announcing in March that it expected banks to write off $285bn of mortgage assets, it casually raised that estimate by $100bn-odd, owing to falling asset values.

Compared with recent dramas, that $100bn might not look so disastrous (Nouriel Roubini, the American economist, expects $2,000bn total credit losses before the end.)

However, the S&P revision highlights a problem that explains much about the current storm: namely that recent events have left investors and financial institutions so utterly disorientated, that there is widespread confusion about what anything might now be worth. The financial world, in a sense, has lost its compass.

And that has left investors so disorientated they are either rushing for safety, or simply refusing to trade at all. The result is gridlock and panic.

This marks the culmination of problems that have been quietly intensifying for a year. This decade, investors have relied heavily on rating agencies to act as a compass in the world of complex financial products. However, when the agencies started to downgrade mortgage-linked securities last summer – sometimes moving AAA securities to junk – confidence in the ratings was shattered.

At that point, some investors looked to markets to make sense of complex finance. After all, American capitalism has an in-built reverence for market price signals; so much so, that regulators have increasingly forced financial institutions to mark their books to market prices this decade.

However, over the past year, trading has dried up in many corners of the complex financial world, making it almost impossible to get real market prices. So, in desperation, investors and auditors have started using other, potentially flawed sources of valuations – such as the so-called “ABX” index, which tracks the cost of insuring mortgage-backed bonds against default.

That has had devastating implications for the banks. Over the last year, the ABX has tumbled: the implied price of some AAA instruments was just 45 per cent of face value on Thursday.

As a result, financial institutions, such as AIG or Merrill Lynch, have reported massive mark-to-market losses – often seemingly out of the blue.

That has ravaged their capital base. However, it has also caused investors to increasingly lose confidence in banks and their published accounts. And as investors have shunned banks, these institutions have tumbled into funding problems too.

Central banks have tried to allay those immediate liquidity concerns: on Thursday they pledged $160bn. But this is unable to allay the root cause of the concern: namely a fear that the banking system lacks the capital needed to cover the ever-swelling credit losses. Worse, with estimates of that gap ranging from $200bn to $500bn, investors cannot see how it can be raised from private sources.

Some investors hope that governments could end up stepping in. But the US Treasury’s contradictory stance on Lehman Brothers and AIG this week has sown confusion about what Washington is willing to do – or not – creating more uncertainty.

In the long term, the saga will undoubtedly strengthen calls for regulatory reform. The credit default swap (CDS) market, for example, is likely to face more scrutiny; mark-to-market accounting may also come under fire too.

However, the more pressing challenge now is how to end the disorientation. That will not be easy. After all, market confidence is unlikely to return until it is clear how banks will plug the capital gap. And investors are unlikely to start purchasing assets until they have a real sense of what clearing prices should.

Wall Street theory would suggest that market forces should eventually produce those all-important clearing prices, at least when institutions recover enough nerve to start trading assets again. Merrill Lynch, for example, recently sold a portfolio of distressed securities, at 23 per cent of face value.

However, private sector led initiatives could take months to materialise, partly because many banks are reluctant to sell in case this creates more capital losses. Consequently, some bankers are now lobbying for the government to step into the breach, by creating a modern-day version of the Resolution Trust Corporation, an institution that purchased assets from troubled banks in the early 1990s and then sold these at state-sponsored auctions.

On paper, that idea has something to commend it, given that the RTC did establish clearing prices a decade ago.

But sadly, it could be fiendishly hard to implement any such initiative in an election year, let alone at the speed that investors so desperately need to see, to regain their sense of a financial compass. It is indeed a terrible political and financial trap. Stand by for plenty more disorientation in the weeks ahead.


Copyright The Financial Times Limited 2008

This greed was beyond irresponsible

By John Gapper
Published: September 17 2008 19:09 | Last updated: September 17 2008 19:09

I have a fine seat in the FT’s New York office looking down the canyon of Sixth Avenue towards the banks of Midtown. From my perch, I have watched the flabbergasting events of the past week.

My initial reaction was excitement – what a time to be observing Wall Street for a living! This steadily gave way to bafflement, fear and finally, after the US government’s $85bn (£48bn, €60bn) bail-out of AIG , anger.

I was pleased that Hank Paulson, the Treasury secretary, heeded my advice (OK, that of others too) and refused to rescue Lehman Brothers. Guess what? The world did not end on Monday, even if the stock market dropped, and on Tuesday, the Federal Reserve was also defiant.

Its unanimous decision not to bow to market fears and cut interest rates was greeted with boos on the New York Stock Exchange floor. But the stock market took the medicine and went on to rally again.

Then came Mr Paulson’s retreat, executed with gritted teeth, as the government and the Fed reluctantly decided that the risks of letting AIG founder in the same way as Lehman were too great.

That frightened me.

There would be no justification for rescuing AIG under other circumstances. The chances of the average homeowner not getting an insurance claim paid if AIG’s holding company had been allowed to go under were slim, since its local property and casualty operations are sturdy and well-run.

Propping it up also creates moral hazard. Although its shareholders will lose most of their money, it encourages the idea that institutions can run amok in markets and will be bailed out. Indeed, the bigger they are and the worse they have behaved, the more likely it is to happen.

But forget all of that. It can be considered at leisure later on. The thing that frightened me was that Mr Paulson put up US government money when he so obviously did not want to. Having examined the heart of darkness – AIG’s $60bn book of derivatives written on other derivatives based on bad residential mortgages – his resolve crumbled.

Lord knows where this leaves us, since only He knows what a credit default swap (CDS) on a collateralised debt obligation (CDO) is worth.

Warren Buffett warned in 2003 that derivatives were “financial weapons of mass destruction” and that, while the Federal Reserve system was created in part to prevent financial contagion, “there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives”.

Incidentally, I recommend re-reading the entire passage, in the report for 2002 to Berkshire Hathaway shareholders, because it is amazingly prescient about the “time bomb” that has now detonated.

For want of an alternative, the Fed has now become that central bank. This alone is a mess. At least when the Fed rescued Bear Stearns in March, it could turn itself into the de facto regulator of investment banks. But insurance groups are supervised – absurdly – by a network of state regulators. What happens now?

Mr Paulson is not only picking up the bill for the states. He is also doing a favour for European governments, whose banks would have been hit. Many of AIG’s toxic insurance contracts linked to subprime CDOs were sold to European banks to allow them to treat the securities they held as double A rated.

Given that AIG was helping them to dodge Basel I capital requirements by taking out flawed insurance contracts, it is not surprising that confidence and interbank liquidity have collapsed. A spike in Libor and the need for Lloyds TSB to take over HBOS are two consequences.

My final reaction is anger.

We are now, unquestionably, in the worst financial crisis since 1929. We do not know how many more banks and institutions will fail – Washington Mutual, the US counterpart of HBOS, is under severe pressure – but Bear Stearns, Fannie Mae and Freddie Mac, Lehman and AIG are plenty.

There are lots of people and institutions to blame for that, from regulators to mortgage brokers to, let us admit it, all of us who decided to speculate on house prices.

But AIG takes the biscuit. Here was a huge multinational insurance group with a reputation for solid underwriting and risk management that decided to diversify from insuring risks it knew well – car crashes and fires – to covering derivatives it did not understand.

Of course, it thought it understood them. In presentations to investors this year, it emphasised how thoroughly its AIG Financial Products arm assessed the risks of insuring CDOs. It ran all the data and decided that, in the worst case, it risked losing $2.4bn on the portfolio.

Well, $24bn of write-downs later – a mere 10 times its maximum estimate – the company has burned through its equity, spread financial chaos to all corners of the earth and humiliated the US Treasury. The job of insurance companies is to guard others against catastrophes, not cause them.

The word “irresponsible” does not begin to describe AIG’s behaviour. Like Bear, Lehman and others, it saw a way to get in on the growing action in mortgage-backed derivatives. Its bankers were soon earning huge fees for themselves and AIG by piling up unimaginable risks.

Call me a spoilsport, but I do not believe that AIG or any other capital markets institution should be allowed to play like that with my money (I am a US taxpayer) in future.

If this means going back to basics, and redesigning the global regulatory system so that a renegade insurance company is denied the chance to blow up the world’s banks again, so be it. Regulation cannot solve everything but enough is enough.


Copyright The Financial Times Limited 2008