Tuesday, February 21, 2012

Standing Armies in Modern Finance - A Global Credit Crisis

"I sincerely believe... that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale." - Thomas Jefferson, 1816

Jefferson's warnings almost two centuries ago about the pernicious banking establishments were indeed prescient. The seismic events of 2008 set off by the chicanery of the high priests in modern finance have borne out his suspicions as citizens of the world grapple with the sheer scale of the global credit crisis.

In March 2003, as America's military was amassing on the borders of Iraq to uncover Saddam Hussein's phantom cache of weapons of mass destruction, America's army of investment bankers on Wall Street were quietly manufacturing its own arsenal, diabolically concocting an alphabet soup of financial sludge that masqueraded shaky mortgages and risky loans as AAA-rated investment grade bonds. At the click of a mouse, these toxic securities would transmit electronically over the trading terminals of the world and land on the doomed balance sheets of the unsuspecting buyers, where they would lie in wait to wreak maximum devastation.

With copious amounts of liquidity from the Federal Reserve, collaboration from the rating agencies, an insatiable investor appetite for yield, and good old fashioned American ingenuity, enablers at every level in the financial food chain were about to be richly rewarded for their parts in the great American revolution called "Securitization". In a low interest rate environment, debt or income producing assets such as mortgages, consumer loans, car loans, credit card loans and student loans would be securitized and sold as high grade investments, boasting yields superior to those on treasury bonds.

In the aftermath of 9/11, the world held its collective breath over the apocalyptic warnings of dirty nukes smuggled by terrorists in suitcase bombs. Concurrently, in the far-flung money capitals of New York, London, Sydney, etc, Saville Row suited bankers unfettered by regulators and trained in the dark arts of alchemy diligently sliced, diced and bundled credit derivatives for global distribution, setting the stage for carnage in markets and economies, while receiving eye-popping compensation for devising yet another amazing feat of financial wizardry.

Emerging from the tech bubble and bust of 2001/2002, individual and corporate balance sheets became leveraged at a dizzying pace as America gorged on Chairman Greenspan's largesse of low interest rates and easy credit from lending institutions. Living within one's means, once a lauded personal virtue, lost its quaint charm in the age of hyper-consumption. Without good paying jobs, consumers struggling to maintain high standards of living tapped into home equity to supplement discretionary spending, and sank deeper into personal debt.

Lenders took advantage of the credit binge and promoted variants of risky mortgages and facilitated their refinancing. Mortgage backed securities coveted by yield- starved investors enjoyed robust growth, and complicated derivatives engineered by former physicists fuelled rampant speculation on the trading floors of banks, broker dealers and hedge funds. Barely out of the ruins of the dotcom bust, America was ready to roll the dice again.

Customized to the risk appetite of the investor, derivatives of asset backed securities called CDOs (Collateralized Debt Obligations) would consist of portfolios of fixed income assets divided into separate tranches. The higher quality tranche would offer risk averse investors a lower yield, while investors in the lower quality tranche would be the first to suffer any portfolio impairment in exchange for the highest yield. Mathematical models of financial engineers had shown that, in a perfect world, securities of varying credit qualities could be bundled together with the desired amount of risk and return allocated to each investor. Such models would soon be discredited in the ensuing turmoil of the current global credit crisis.

Seeking the quickest and most attractive returns, vast amounts of liquidity poured into the housing market beginning in 2003, bringing dramatic changes to the status of housing in American society. The bricks and mortar of a residential home no longer provided just a shelter and a sound, long-term investment for the homeowner. Housing began to appeal to the speculative frenzy of the trader class, and runaway prices in California, Nevada, Florida, Arizona and other hot markets were enticing misinformed and unqualified buyers to take on mortgages they could not afford.

While Congress preached the ownership society, unscrupulous lenders used predatory lending practices to sell the quintessential American dream of home ownership. Affordability was sidestepped as a critical issue for the individual homeowner because housing prices were projected to rise in perpetuity, a fatally flawed assumption which remained unchallenged until it was too late. Real estate was deemed a safe investment, and a setback in prices was unimaginable. Standard & Poor's model for home prices had no ability to accept a negative number, according to the cover story titled "After the Fall" by Michael Lewis in the December 2008 issue of Condé Nast Portfolio magazine.

Eventually, the alchemists' gold would revert to lead, and clueless investors in all manners of ill-conceived derivatives and asset backed securities, from Norway to China to the Middle East, would begin the painful process of writing down billions in losses. Seven years after the World Trade Center attacks aimed at destroying American capitalism failed, the world has since dodged another major bullet from Osama bin Laden. However, the irony cannot be lost on anyone that, having risen from the ashes of 9/11, the titans of Wall Street would ultimately succumb to their own greed, hubris and incompetence. The global Credit Crisis now threatens the very survival of the global financial system and the real economies of the world.

Since March 2008, storied names in banking, insurance and mortgage lending have collapsed from the rapidly imploding values of their sub-prime mortgage and derivative portfolios, while other lesser known, but similarly over-extended institutions on the brink have received taxpayer bailouts and written down close to US$1 trillion in losses. What has started as a U.S. housing crisis has evolved into a global credit crisis and has now morphed into a full-fledged economic meltdown that threatens to deflate asset prices worldwide. Haunted by the specter of 1930s depression reprised, governments in OECD countries rush to bolster their national banks and stimulate their economies; desperate to arrest the deflationary pressures from a de-leveraging process that is unwinding the financial system's historic indebtedness at warp speed.

The once mighty, now humbled and chastised, eagerly accept taxpayer balm at the federal trough which, in better days, would have been roundly condemned as utter folly of liberal socialism and, distinctly anti-capitalist. However, with the survival of industry behemoths like AIG and Citigroup in question, and the very future of the modern global financial economy in jeopardy, even the principled free marketeers who subscribe to Adam Smith and Ayn Rand recognize the dire need for temporary suspension of their much cherished laissez faire ideology, and grudgingly accept the economic pragmatism of government intervention. The day will hopefully soon return when the economy will right itself, and charges of socialism can again be thrown about in the same careless and carefree manner as they once were. But that day is not today.

The cumulative fallout from the housing and credit crises reverberating around the world has caused an unprecedented erosion of confidence in the global financial system. Balance sheets bloated with derivatives and mortgage backed securities suffer drastic impairment as the dubious values of non-performing assets are rapidly written down. Credit dries up and lending grinds to a halt at many banks because their capital reserves have depleted dangerously close to regulatory minimums. Without the flow of credit, global economies slam on their brakes simultaneously and enter recession. Stock market investors worldwide have suffered losses exceeding US$30 trillion in 2008, while commodity markets have also cratered with staggering losses in energy, metals and grains from their stratospheric peaks registered barely months ago.

The U.S. government has so far committed US$7.5 trillion in cash injections, loans, guarantees and consumer stimulus to bail out Wall Street, Main Street and Corporate America. The Federal Reserve has also cut short-term rates to almost zero with three and six month treasuries now yielding effectively nothing, Panic-stricken investors in their rush to de-leverage and exit risky investments have pushed up the prices of U.S. government bonds and put a floor under the US Dollar. In spite of massive bailouts, plunging markets, soaring deficits and mounting job losses that shatter investor confidence in the American financial system, the US Dollar has defied gravity and continued to frustrate traders hoping for a quick resumption of a greenback sell-off.

With the tidal waves of the financial tsunami rippling to the far corners of emerging markets like Iceland, South Korea and the Ukraine, it is apparent that the U.S.-originated systemic havoc is no longer contained domestically. Rather, the spreading contagion has exposed the vulnerabilities of an inter-connected global economy, confounding central bankers and policy makers alike as they ponder a global recession cascading over the economic horizon.

Without swift, bold, aggressive and coordinated policy action, a deflationary environment could take hold and the global recession could become a global depression. Although the extraordinary amounts of liquidity provided to counter the deflationary forces of wealth destruction could ultimately be inflationary in an economic recovery; that is probably an outcome which policy makers would not mind confronting, as they face the vastly more ominous threat of falling prices and shrinking output. At that time, when the economies of the world do finally recover, the US Dollar may come under renewed pressure as the currency market will have to digest the implications of an historic expansion of the U.S. money supply.

In the strangest of ironies, the US Dollar which has come to symbolize the collective ills of the American financial system has benefited the most from the de-leveraging process, and emerged amidst the chaos as the undisputed safe haven currency of choice. This phenomenon may be an aberration, but will likely continue until the last bit of excess and euphoria has been wrung from the system. It will take a gargantuan effort to extricate the world from the worst financial crisis since the Great Depression.

It is time to encourage real engineers to build roads, bridges and repair the crumbling infrastructure rather than allow financial engineers to wreak havoc with the next generation of destructive derivatives.

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