The Telegraph
Since 1st March, 1999
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There is a disconnect between the real and financial sectors in the American economy today. In the real economy, it was business as usual — almost, until recently. The fundamentals remain reasonably strong, with the subprime crisis yet to cast a shadow really and, to many people as of now, is but a speed bump.

The picture is changing, albeit slowly. The International Monetary Fund has cut its 2008 growth forecast for the United States of America to 0.8 per cent, consumer confidence has fallen drastically and factory output has failed to increase, indicating that damage from the housing-market contraction is pushing the economy toward a recession. From all signs, the economy has already moved into recession in December 2007. Now the only point to debate is, if it will land soft or hard, and if it will be short and shallow, lasting a couple of quarters, or be deep and protracted.

In the financial sector, a sea of red ink has already been splashed with large write-offs taking place regularly in the balance sheet of banks, security houses, insurance companies and other players in Wall Street. It will be months before anyone knows the full impact of the catastrophe that has had the entire world of finance — across geographies — caught in a vicious gridlock of huge losses with a tangled web of various sectors of the market pulling each other down, as crabs do.

The crisis, no longer restricted to the subprime sector, having spread into other sectors of the economy, is the first genuine global crisis in an era of globalization. The process of globalization saw an unprecedented concentration of capital in the US.

Cross border instant, free and fast IT-enabled capital flows, rapidly increasing since 1996, now stand at $7 trillion. Overseas currency reserves of countries like China and Japan have largely invested in the US, now amounting to around $6 trillion. Of the $1 trillion petrodollar revenue that is being generated annually, some $300 billion are looking for a parking space. Meanwhile, US firms’ accumulations in their home currency are growing, in the absence of fresh investment opportunities. Since 2001, banks’ credits have gone up 83 per cent to $14.9 trillion and the total mortgage debt is up 106 per cent over the last six-and-a-half years.

It was riding on this excess liquidity, following the collapse of the dotcom bubble, that Greenspan’s Fed moved into the $20 trillion housing market. From the beginning of 2001 to November 2002, bringing the Federal interest rate in 11 installments from 5 to 0.75 per cent per annum, they put the mortgage market into high gear, with the mortgage market now standing at around $11 trillion to become by far the biggest market in Wall Street, exceeding even the Treasury debt market of $9 trillion. In the process, they transformed the housing sector from its vital but demarcated role of providing decent, affordable housing, into a distorted giant that was made to become the prime prop for both the physical and financial sides of the US economy.

Securitization of the mortgage market had already begun by the time the Fed-directed money had started to enter them. There grew a shadow banking system, the securitization machine, based on the principle of diversification and corresponding slicing of risk. The system was led by a desire to move risks off-balance-sheet on the part of banks, and an overwhelming reliance on ratings by both ‘new’, non-traditional investors, Middle and Far Eastern banks, as well as traditional investors, banks and monolines, whose capital requirements were dictated by ratings.

Insurers, known as monolines insurers, also got sucked in while insuring the bonds to cover their risk. They were tempted to enter because a new instrument named credit default swap (CDS), that offered credit default protection to poorly rated debts, had been meanwhile developed specific to the market. As in all derivatives, the CDSs depend on counter-parties to honour the contracts. If one goes down, the instrument is useless. This has happened in the CDS market.

Anyway, the insurance companies had found a loophole in the law that allowed them to deal with these derivatives. They set up shell companies called ‘transformers’ that they used as off-balance-sheet operations where they sold CDSs in which one party assumes the risk of a bond or loan going bad for a fee. The transformers are now in trouble. The CDS outstanding today is notionally valued at $47 trillion and monolines, although with an asset base of around $2 trillion, have a thin capital base. The largest one in this sector faces a reported a risk of default and has had to cut dividends to retain its triple A rating. The second largest has almost had a similar experience. Several hundreds of billions will be needed to help these ailing insurance companies regain triple A ratings. Other investors will also lose on the write-downs on the value of securities guaranteed by the insurance companies if they are unable to regain their previous status.

The auction rate securities market, a $300 billion slice of the municipal bond market, has more or less collapsed recently. The venerable Port Authority of New York had to pay an unbelievable 20 per cent raising funds in this market. The commercial paper (CP) market of $1.87 trillion is contaminated to a large extent, as a large part of their housing-based assets has become unmarketable. The stock values of many important home lenders are now quoting huge discounts.

Banks own around $800 billion mortgage-related securities guaranteed by bond insurers. Bailing out these insurers will cost the banks around $150 billion. There are about 3,000 hedge funds with an asset value of about $2 trillion. They take a hit as actual investors in the mortgage markets and stand to lose both in the mortgage and the CDS markets because of the disappearance of counter-parties. The CP, money market funds (MMFs) and the consumer debt (credit card) sectors have also become tainted because of their holdings, often unauthorized, of the mortgage market securities.

The disturbance in the subprimes caused a major disturbance in the banking system. Anything that was ‘structured’ is now being shunned by the markets leading to the back-stop providers, typically banks, ballooning their balance sheets. As a result, banks have become wary of extending new credit at the margin. With major inventory of leveraged loans being marooned on bank balance sheets, residual exposures of collateralized debt obligations (CDOs) — an instrument first developed by an obscure firm called Norma Inc. — have caused the banks to take huge writedowns. Exposures that were guaranteed by the monoline insurers were determined to be largely worthless.

Banks have multiple ties with the mortgage markets. They are a direct investor in the mortgage market. These appear in their balance sheets as level 3 assets, valued according to their own models. They have ties with them through their special investment vehicles (SIV) entities they control indirectly as a part of the shadow financial system of money market funds, hedge funds and investment banks. The SIVs obviate the need for banks to have a regulatory capital charge for the liabilities in terms of the Basel convention requirements for their capital adequacy ratios. Structured securities often provided ‘independent’, and often fictitious, funds and kept out of the bank regulators’ range of vision. With losses that the SIVs have incurred on mortgage-related assets, banks have had to absorb them into their balance sheets, to pre-empt SIV investors from withdrawing their investments. The red ink will go deeper and farther since there are no complete disclosures on this score.

The global write-downs of mortgage-related assets of banks have already been significant. The United Kingdom’s Northern Rock has had to be nationalized. Globally, a swathe of banks — British, Swiss, German, French, Japanese, Middle Eastern and even Chinese — have been seriously affected. Their disclosure on the mortgage market exposure will come slowly, over a long time.

The capital of one of the largest US banks is $128 billion, its level 3 assets $135 billion. All Wall Street US investment banks, specially the larger ones, have a significantly high level of level 3 assets in relation to their capital. Any erosion of these assets would have a serious effect on their capital; in some cases, their very existence. For the commercial banks, write-offs have to be matched by replenished capital for the banks to remain within the Basel agreement. For investment banks, the erosion of level 3 assets will lead to a lowering of their credit quality and will have the effect of widening spreads on their borrowing. If level 1 and 2 assets become level 3 in a falling securities market, it will make matters worse.

The US’s current account requirements are around $3 billion a day, which it meets by paying in its own currency. With the weakening of the dollar following a steady exit of funds to other currencies, the US dollar is on the way to losing its seigniorage as the sole reserve currency and the economic hegemony it implies.

The following is an estimate of loss, tentative and ballpark since the scenerio is evolving. Among the important sectors are housing — $1.6 trillion at 8 per cent decline of the housing prices according to the Case-Shiller/S&P index. This market is in the worst recession since the Great Depression. According to Roubini of RGE Monitor, prices will eventually fall, relative to 2006, by 20 to 30 per cent; the mortgage market, reported $3.2 trillion, conservatively, $0.3 trillion; insurance, $0.2 trillion; banks, 0.3 to 0.5 trillion; a total, conservatively, around $2.6 trillion, representing an alarming loss of about 20 per cent of the $14 trillion 2007 US gross domestic product.

When tangible losses in the sectors chained together emerge, a significant part of the GDP will have been swallowed up, impacting on the already saving-less and debt-burdened consumers, who will suffer the effects of the seized-up credit estimated currently at $2 trillion. With the credit crunch, banks are crippled: largely unwilling and unable to extend credit as before. The credit crunch will eventually cause a large number of defaults and failures among corporations and the broker-dealers. Meanwhile, the shadow banking system has pretty much shut down. Contraction of consumption, 70 per cent of the GDP, will occur, leading to deeper recession. The resulting recession will lead to US and global stock market declines.

A global spread of the crisis is inevitable, both through trade and importantly through the complex web of financial links among nations. Much will depend on China, if it can remain de-coupled when the crisis has spread.

The policy response of the Bush administration to the crisis has been two-pronged. First, fiscal relief of one per cent of the GDP translating into $140 billion. Second, extension of mortgage payments by a month. On the face of it, they remain hugely insufficient for a crisis of this order.

The Federal Reserve money support to banks , jointly with a few other central banks, has so far totalled around $300 billion. This apart, the Fed has brought down interest rates from 5.25 to 3 per cent per annum (225 basis points) from September 2007 to date. Further cuts have been promised.

The benefit of a cheaper rate will be restricted only to banks who have the use of the discount window. Even then, though the short-term rate has declined, long-term rates have gone up expecting inflation. It will help debt-service, and may not create fresh debts, as banks remain strapped for liquidity. It is also more than likely, a cheap Fed rate will not help loosen the current knots in the bond and derivative markets. On the other hand, there is a real risk that, at the inflation rate ahead of the bank rate, hyper-inflation will follow. Finally, there is the threat of a liquidity trap which Japan has experienced over the last 17 years or so after the bursting of its own real estate bubble, where, at almost zero rates, growth has not materialized.

If excess liquidity has fathered this crisis, a fair share of blame must be apportioned to the sharpening of globalization since 1990, with attendant free movement of capital across the globe. Unless globalization is halted and the world returns to a Bretton Woods type of order putting up partitions around various nations’ trade and capital movements and putting the US in an isolation ward preventing contagion, the situation can only worsen. This will no doubt go against the grain of TINA, there is no alternative to globalization. But now that we are about to face perhaps the greatest and longest financial crisis of all time — its roots in excess liquidity, thanks largely to globalization — the suggestion to reverse globalization, needs urgently to be considered.

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