Subject: Armericanism and the "Too Big To Fail" Syndrome "Too big to fail" is the cancer of moral hazard in the US finance system. Moral hazard is a term in banking circles that describes the tendency of bankers to make bad loan based on an expectation that the lender of last resort, either the Federal Reserve domestically or the IMF globally, to bail out troubled banks. The term also applies to bad loans made to borrowers that are considered "too big to fail" such as GE, Citigroup, JP Morgan Chase or General Motors, or borrowers such as Third World governments. In general, the principle of moral hazard states that bailouts encourage future recklessness. Brady bonds to bail out Latin debts are labeled instruments of moral harzard in some circles. Most bankers reject the moral harzard charge because they welcome government intervetion when it comes to protecting their profits. They only want to get government off their backs when it tries to help the poor. In global finance, the issue of moral harzard is more complex. Economic imperialism uses moral harzard as an argument to oppose debt forgiveness for the poorest economies. During the Asian finacial crisis of 1997, the IMP imposed harsh "conditionalities" (namely high interest rates, corporate restructuring that results in lay off and massive unemployment, austere fiscal policies) justified by moral hazard arguments, punishing the poor in debtor nations for the sins of their bankers. Many, including myself, have observed that the shrinking intermediary role of banks in funding the economy, brought about by the rapid growth the non-bank credit and capital markets, has increased system risk in recent years. This risk manifests itself only in a bear market. This is now building up to a crisis. Banks have also compensated for their shrinking funding role by moving into equity investing and securitization and trading through their investment banking subsidiaries, not to mention derivative finance and trades. There is no doubt that GE, the nation's biggest financial conglomerate, whose commercial papers are the bellwether for the dollar and euro CP markets, will fall from borrower defaults and its size will be the "too big to fail" reason for Fed intervention. GE's acquisition of Honeywell is an attempt to shift, in market image if not in reality, back toward an industrial conglomerate, with heavy defence potentials. It is very clear that troubled debt-ridden corporations will turn to the banks for help, not because bankers are friendlier than bondholders, but because banks have access to the Fed discount window. Greenspan's recent message to banks to continuing lending is a clear signal that he will provide all the liquidity that is needed to prevent a systemic collapse. The trouble is that the inter-linkage through structured finance makes even tiny companies "too big to fail". The Nasdaq alone has made $3 trillion of market cap disappear in the last nine months of 2000 which has put many corporate bonds under water. Unless the Fed is prepared to inject that much reserves into the banking system, the debt crisis cannot be solved. And if the Fed does that, what will happen to inflation and the exchange rate of the dollar? Cash denominated in dollars is looking less a safe haven everyday. Flight to euros? It is an irony that at the very time when the US financial system is showing signs of structural failure, the global trend to adopt American business and finance practices is reaching its peak. All over the world, governments are rushing to privatize assets, securitize debts and deregulate their transitional economies with the hope of reaping the enviable results that the US economy has enjoyed for a decade. The bill of this enviable boom is now fast coming due and much of the world will to have pay without ever having enjoyed the benefits. The "race to the bottom" syndrome in trade competition has been replaced by the "race toward risk" syndrome in finance competition. The marketplace of ideas, not unlike financial and commodity marketplaces, often operates on mis-information until cruelly pulled back into reality by unforgiving facts. Much governmental and institutional aping of American practices is based on a misunderstanding of what Americanism really is. There is some truth in the popular myth that American ways are more flexible, more willing to innovate and to adopt to change. In the last decade, American innovation and quick response in business have produced a record long boom, with spectacular rise in profits and asset value. US household net worth, until the recent (and first wave) market crash, peaked at over $24 trillion, rising 50% in a decade. The end of the Cold War and the global eclipse of socialist tenets have left American faith in market fundamentalism with the aura of a natural philosophy. Americans call their system capitalist democracy. In doing so, care is taken to distinguish democracy from equalitarianism. Conceptually, while the Declaration of Independence claims that "all men are created equal", it readily accepts the premise that men do not create wealth equally. The American system rejects social democracy which aims to remove economic differences between people. The American system claims it promotes equality of opportunities rather than equality of rewards. It believes that the logic of the market is the most equitable arbitrage. Free-marketeers decry intimate relationships between government, finance and business and oppose even corporatism as an adjunct to the welfare state. They believe that the market's unforgiving rules of selecting and rewarding winners and penalizing losers is inherently fair, efficient and necessary for maximizing overall economic growth. The trouble with this view is that it is a fallacy to assume that truly free markets can exist. Markets are always constrained by local customs and rules, unequal conditions and unequal information access by participants. In fact, markets come into existence through artificial construction by initial participants with rules that subsequent participants must observe as a price for entrance. These artificial rules generally favour the market founders and put later comers at a perpetual disadvantage. WTO rules are the latest visible example. Often the only option left to late comers is to start alternative markets hoping that they will enjoy the very privileges and advantages they oppose in existing markets. Thus all markets require a wide range of regulations to check and balance their inherent march toward inequality and unfairness. Trade, by definition, is based on mutually balanced weaknesses. Mutual strength leads only to war, and unequal strength leads to conquest of the weak. Adam Smith advocated "free trade" in the mercantilist context as an activist government policy to breakdown the protectionist policies of other nations while subsidizing national industries to competition in a tariff-free and open world market. 'Free enterprise' was first developed by royal charters and grants from the sovereign for business operations and for land development within his domain, and for trading rights and command of the high seas to "freely" exploit colonies and foreign locations. In other words, free enterprise was begun and fostered with government aid and grants that private investors found too risky or whose potential rewards too remote. Royal charters, letters of patent, patents and copyrights are all instruments of government for the privilege of exploiting the resources in the sovereign's domain Government and free enterprise have always co-operated in conceert. Modern free enterprise manages to prevent the monopolistic or oligarchist control of markets only by government action. Business always wants government help before the market is mature and after the market is saturated. It only wants "free" markets when there is easy profit. Business by nature abhors competition. The notion of "too big to fail" is sacred in US regulatory philosophy. This remains true even as the anti monopolistic restraint of trade regulatory regime of the New Deal has been steadily modified in recent decades to permit mergers and acquisition toward increased size and market share to achieve strategic advantage. The scenarios of the ideal free market is that there should be only five entities in every sector: two market leaders and three window dressing market followers to keep regulators at bay. The US economy has always been organized along oligarchistic lines in its core industries, allowing a high degree of centralization while preserving only a token degree of competition. The rules of competition are generally set by market leaders of every industry. Self-regulation is the mantra. While the US promotes globalization, American attitude on foreign ownership remains schizophrenic. Furthermore, there is an inherent contradiction in globalization in that while capital is allowed to move freely across political borders, labor is not. It is now conveniently forgotten, when the IMF was established by the Bretton Woods Conference, its Articles of Agreement specifically sanctioned restriction on movements of capial across national borders. Until labor can also move freely, the lopsided globalization is nothing but economic neo-imperialism. It is not a march toward one world, it is a march towards an hierarchical world of structural inequality. Another defining characteristic of modern US finance is the broad access to credit. American business has long enjoyed access to open credit markets. Today, the developing credit crunch notwithstanding, no US corporations of any size is effectively shut out of the highly developed credit market, regardless of credit rating. Low credit ratings only affect the interest rate rather than market accessibility. In fact, debt securitization has brought virtual security to credit unworthiness on a massive scale. The commercial paper market first burgeoned in the 1960s and today, collaterallized loan obligations dominate the global credit market. Securitization is a process of turning nonmarketable credit instruments into marketable ones through pooling. Securitization creates credit worthiness out of the theory of large numbers and the theory of averaging to manage the risk of default by spreading it to a large pool. When a lender lends to a risky company, he bears the full risk of default. But if he invest in a collateral loan obligation instrument, he is lending to a pool of companies whose default rate may be, say, 6%, a risk level coverable by the interest rate spread. The fatal enemy of securitization is a liquidity crisis when all exits from purportedly open markets will be suddenly closed, when all participants move to the sell side, leaving the buy side empty at any price. Today, Fed Funds Rate target is 6.5% (this was written before the Fed action on January 3 2001 lowering ffr to 6%) and prime rate posted by 75% of the nation's 30 largest banks is 9.5%, while commercial paper rate placed directly by GECC is 5.67% for for 230-270 days, and dealers CP (high grade unsecured notes sold through dealers by major corporations) is 6.25% for 90 days. Derivatives are financial instruments whose values are derived from thevalue of another instrument. Among other effects, derivative tend to lower the systemic credit standard of the markets by manipulating the assignment of risk. Highly rated corporations can now arbitrage their high credit standing to further lower their cost of funds by issuing long-term fixed rate debt and then swapping the proceeds against the obligation to pay a floating rate. In other words, they monetized their high rating by taking on more risk. Simultaneously, lower-rated corporations that otherwise would be frozen out of the credit markets as the credit cycles mature can use derivatives to lock in long-term yields by borrowing short and swapping into long-term maturity obligations. In other words, they pay more interest to buy higher credit ratings, not withstanding that fact that high interest cost would actually further lower their credit ratings. The intermediaries, banks and other financial institutions who make credit markets and trade these obligations enjoy the illusion of being relatively risk free by linking their risks system wide. The credit rating of these banks appear relatively normal, but in fact they appear normal only because the overall credit rating of the system has declined. When individual risks are passed on to systemic risk, individual creditors are comforted by the safety of the "too big to fail" syndrome. The growth of pension and retirement funds can be viewed as a process in the socialization of capital formation. This process has brought about a corresponding growth in professional asset management based on competitive performance measured by short term market value, placing distorted emphasis on technical trends rather than fundamentals. The quest to socialize risk has led to indexation which works better in rising market to capture optimal systemic returns, but can also cause the categorical downgrade of entire families of debt instruments and their issuers without regard for individual strength. This can cause unnecessary and violent systemic damage, as it did in Asia in 1997. This socialization of risk associated with the socialization of capital formation means that a financial collapse will affect not merely the rich investors who may be able to afford the loss, but the entire population who can ill afford to lose their pension. The "too big to fail" notion then comes directly into play and government is forced to step in, putting an end to the myth of the free market. Moral hazard will be in full bloom as the nature of the beast. The Fed has been repeatedly held hostage to the "too big to fail" syndrome since 1930 and will again and again until its becomes the main agent to herald socialism to America, as Schumpeter predicted. Creative Destruction, of which Greenspan is so fond, will eventually destroy capitalism. Leverage is another development that not only magnifies volatility, but the abnormally high rates of leveraged return distort market judgement, making normally respectable returns look unattractive. Derivatives and hedging techniques have created the illusion of safety by risk management, while they merely reshuffle risks system wide and heighten exponentially the penalty of misjudgement. Litigiousness is a byword of the American notion of the rule of law. Innovative contracts and financial and business relationship are often inadequately defined to meet rapidly changing conditions, and disputes are settled in courts whose judgements can have drastic consequences to the litigating parties as well as the system. Major bankruptcies have been routinely caused by court decisions. The tobacco time bomb is a good example. Texaco was forced into bankruptcy when faced with a judgement that exceeded its entire market cap value, based on the legal definition of what contituted a valid offer in a merger. The list is long. The stabilizing value of legal precedents is greatly discounted in a world of constant unprecedented developments. Courts are frequently confronted with controversies that the judges and their law clerks are grossly unqualified to comprehend. Court decisions often hark back to symbolic posturing based on dated concepts. The anti-trust case against Microsoft is a classic example: the issue raised in the case are operationally obsolete, yet the courts are asked to make determinations based on them that will affect the future of software monopoly. The most fundamental flaw in American financial market system is its inherent drive towards excess. The market boom will only end with a market crash unless government intervenes in mid course. The quest for the short term maximization of returns leads inevitably a speculative bubble. The traditional demand/supply business cycle has been genetically modified into a debt-propelled cycle that requires more debt to prolong. And the speed of the expansion dictates that more debt can only be added by a lowering the credit quality. This is what Greenspan means when he refers to unbalances in the system, that physical expansion of productivity cannot possible keep pace with credit expansion associated with the sudden wealth effect. At their peak in March 2000, stocks were valued at 181% of GDP (Dada from Bianco Research) while at the beginning of the decade they were 60% of GDP. One of the characteristics of a bubble economy is the delinking of the equity markets from the actual performance fo the economy. That is clear eveidence that the wealth effect does not reflect the performance of the economy. One of the few valid points made by Greenspan was that the wealth effect created imbalances that was more than the conventional time lag. The government budget surplus resulting from the credit induced extended long boom is merely a false signal of the illusionary soundness of the current US economy. It measures the size of the debt bubble rather than the size of the real economy. Some economists have been vocal that the budget surplus is the fact an indicator of economic trouble ahead. Those who proudly point to the budget surplus as the Clinton adminstration greatest achievement will live to look extremely foolish. Private debt, both consumer and corporate, has been growing at record pace in the US for the past decade, drawing funds from lenders all over the globe. Much of this debt is taken on by telecom companies whose revenues have fallen as much as 90% through deregulation. Telecom debt now matches real estate debt both standing at about $150 billion, but unlike reale state where rents are stabilized by by long term leases, telecom revenues can change in a matter of weeks, drastically affect share prices of the debtor companies. As the equity markets collapse from an earnings shortfall caused by an expanding market capitalization outpacing slower earning growth, the political pressure for the Fed to inject more debt into the system by lower interest rates will become irresistible. The emergence of an unregulated open credit market diminishes significantly, though not negates, the ability of central banks to manage the economy through conventional monetary policy measures, because of the banks' shrinking intermediary role in the credit market. A credit binge in which loose lending to borrowers of dubious credit worthiness is always followed by a credit crunch, as surely as gluttony leads to obesity that will outgrow the wardrobe. Bad loans are made in good times, as Greenspan is fond of quoting. A credit crunch is an interruption in the supply of credit which can be caused by destruction of the lenders' incentive through regulatory rigidity, or serious defaults by borrowers on loans taken out during a credit binge. When that happens, the central bank's only option is to alter the financial structure to reconnect credit supply in a timely manner. And in the current markets of electronic trading, timeliness is a matter of hours, not weeks. Yet Greenspan told Congress in his July 1999 Humphrey-Hawkins testimony: "But identifying a bubble in the process of inflating may be among the most formidable challenges confronting a central bank, putting its own assessment of fundamentals against the combined judgement of millions of investors." Investor judgements are now mostly based on technical analysis while the Fed is still looking down on it nose at fundamentals. This explains why the record of Greenspan's recognition of market trends has been consistently six months late. Yet the Fed cannot afford to wait for market discipline to correct a credit crunch. And because of the recognition time lag, coupled with the diminished ability of the Fed to affect market decisions, and the compressed chain reaction time of collapse, each subsequent intervention would need to be escalated or overshot to achieve comparable effect, which in turn increases moral hazard to fuel the next abuse. It is intervention inflation, similar to the narcotic syndrome of pushing towards the edge to reach new highs which always leads to fatal overdosing. The global financial upheavals since 1997 have damaged not only financial markets, but national economies along their paths. The Mexican crisis of 1994, the South Korean crisis of 1997-98 (the only one in Asian the US intervened because Brazilian investors were holding Korean bonds), and the Brazilian crisis of 1998, Argentina and Turkey in 2000, are all victims who have become permanent patients in the critical care unit of the IMF. Yet the US economy has been immune mostly because the Fed, taking advantage of the unique position of the dollar as the anchor currency in the existing international finance architecture, and its ability to print dollars unimpeded, applied a bailout standard on the US economy much less demanding than what the US required of the IMF for other economies. In recent decades, the Treasury and the White House have effectively usurped much of the Fed's alleged independence through the back door of foreign exchange rate policy which narrows domestic interest rates options. A strong dollar policy is part of US financial hegemony. It is a national security postion of the White House that the Fed must support. The credit bubble has been largely responsible for the spectacular growth of the financial infrastructure. The narrow focus on rising market capitalization value has obscured the high leverage in the US economy and to a lesser degree in the global economy. Global equity markets rebound within months out of the debris of sequential financial crises while the local economies stay depressed for years. Recovery is proclaimed all over Asia while people remain jobless and desperately poor. Stock options became currency not only for management compensation and corporate mergers, but for the general working population in the so-called New Economy and for seeding new enterprises. Loans collateralized by inflated market capitalization are preferred to liquidation as a devise to skirt capital gain taxes. These loans magnify growth in a rising market and they magnify contraction in a falling market. The Fed eased in 1998 after the Russian default. History would decided whether the Fed did the right thing by allowing Russia to default. But there is now cleared evidence that the Fed panicked and eased excessively after the Russian default and after the LTCM bailout, thus exacerbating the post 1998 bubble, foreclosing the prospect of a soft landing. A bubble is formed when there is aggregate overstating of financial value. Its existence saps real growth because profit can then be earned more easily from speculation than from increased productivity. That was the virus that seriously wounded the Japanese economy and kept it depressed for over a decade. It is now killing the US economy. The phenomenon that turned the dollar into the base currency for world trade is oil related. The US abandoned the Bretton Woods regime of gold-backed fixed exchange rates in 1971 but the dollar remained the anchor currency for world trade. The 1973 oil embargo gave APEC control of the oil market and its pricing. But oil is transacted with dollars. The black gold trade reinforced the dollar as the international trade currency, despite the fact that it has not been backed by US monetary and fiscal discipline for decades. Gold everybody wants but nobody needs. But oil, everybody needs in the modern world. The pricing of oil then becomes the true anchor for the value of the dollar, not the Fed's monetary measures. When the price of oil rises, the dollar depreciates in real terms. When it falls, the dollar appreciates. For most of last decade, the US has managed to keep oil prices low, around $10/barrel, reaping the benefit of a strong dollar with low inflation. But cheap oil price discourages conservation and exploration which eventually will cause oil prices to rise. $30 oil is expensive only in relative terms to recent prices, but its impact on the economic bubble is significant. The rise in oil prices in 1973 was handled by the recycling of oil dollars into US assets. It was the same strategy used to finance the US trade deficit in a decade of globalization, until 1997. By the 1980s, as oil dollars accumulated, the US economy, beset by the burst of a credit bubble which produced stagflation, was unable to absorb further investment at expected returns. The transnational financial institutions then discovered Third World lending which produced high returns commensurate with high risk. But as Walter Wriston proclaimed: "Banks go bankrupt, but countries don't." Thus oil money can earn high returns without commensurate risk in Third World loans, as governments will always bailout such loans. As history records, Third World borrowers defaulted en mass. By 1982, nine US banks had lent Mexico alone $13.4 billion, representing 50% of their combined capital. To handle the impact of sovereign default, Mexico temporarily closed its foreign exchange window and converted all foreign currency accounts into pesos and demanded a debt restructuring which the banks reluctantly complied. The US banking system was seriously weaken as a result of Third World debt. U.S. Treasury Secretary Nicholas Brady, in the 1980s in association with the IMF and World Bank sponsored the effort to permanently restructure outstanding sovereign loans and interest arrears into liquid debt instruments. Brady Bonds represent the restructured bank debt of Latin American and other emerging nations that overborrowed from U.S. institutions. Designed to prevent financial meltdown for lenders and borrowers alike, Bradys are normally collateralized by U.S. zero-coupon bonds of various maturities. That means principal is guaranteed, but most bonds' coupons are not. If a country can't make its interest payments, investors can collect 100% of their principal when the bonds come due. But they lose out on interest, and they have tied up their money for years instead of putting it into a paying investment. And because the bonds no longer pay interest, their value in the secondary market plummets to only a fraction of their face value. This market is extremely volatile, reacting to moves in U.S. bond prices and especially to bad news from emerging nations, such as the Mexican peso devaluation of 1994. Hedge funds, insurance companies, and other institutional investors have been willing to take that chance lately. Meanwhile, the managers of U.S. open-end mutual funds dedicated to emerging-market debt are insisting that Brady bonds have gone mainstream. Countries involved in the Brady Plan restructuring: Argentina, Brazil, Bulgaria, Costa Rica, Dominican Republic, Ecuador, Mexico, Morocco, Nigeria, Philippines, Poland, Uruguay. Some countries like Mexico, Venezuela, and Nigeria have attached to their Par and Discount bonds rights or warrants which grant bondholders the right to recover a portion of debt or debt service reduction as stated in the Exchange Agreements, should their debt servicing capacity improve. In effect, some are known as Oil Warrants because they are linked to oil export prices and thus to the oil export receipts. The collateral consists of funds maintained in a cash account usually at the Federal Reserve Bank in New York and typically invested in AA- or better securities, for the purpose of paying the interest should a debtor country not honor an interest payment. A rolling interest guarantee (usually 12 to 18 months or 2 to 3 coupon payments) remains in effect as each successive coupon payment is made and the collateral continues to guarantee the next successive unsecured coupon payment. In the event the collateral is used, there is no obligation to replace it. In the 1987 crash, Greenspan, merely nine weeks as Chairman, flooded the system with reserves by having the FOMC buy massive quantities of government securities from the market, and announced the next day that the Fed would "serve as liquidity to support the economic and financial system." Some accuse Greenspan for bringing on the crash by raising the discount rate 50 basis points to 6%. Portfolio insurance has been identified as having exacerbating the crash. The technique involves selling stock futures when stock prices fall to limit or insure a portfolio against large losses. This gives index arbitrageurs the opportunity to benefit from lower future prices by buying futures in Chicago and selling the stock market in New York, adding selling pressure in the market. But the fundamental cause of the 1987 crash was the trend of corporation moving to debt from equity financing. Corporate new debt tripled in a decade, with debt service taking up 22% of internal cash flow. Total nonfinancial debt was 200% GDP in 1987, compared to about 120% in 1977. Corporate credit ratings deteriorated but the lending did not cease because funds were being raised in the non-bank credit markets. Historians have identified the causes of the 1930 Depression as: 1) Too much savings in relation to consumer power due to income disparity; 2) Over capacity due to excessive investment from surplus capital; 3) Over stimulation through the growth of debt through new intricate system of inter linked debt obligations; 4) Legalized price fixing through mergers and acquisitions; big corporations maintain price and cut production instead of lowering prices, resulting in massive unemployment; 5) Economic growth too heavily dependent of big ticket durable goods that cannot sell in a depression thus slowing recovery; 6) Exhaustion of public confidence and optimism; and 7) The collapse of international trade (Smoot-Hawley Tariff Act). 8) Irresponsible foreign lending (the US was a creditor nation with a credit balance about twice the size of the total foreign investment in the US.) Now every one of these causes is still present today at a larger scale and faster reaction time, with the exception that the US is now the world's biggest debtor nation. Greenspan testified in 1998: "We should note that were banks required by the market, or their regulator, to hold 40 percent capital against assets as they did after the Civil War, there would, of course, be far less moral hazard and far fewer instances of fire-sale market disruptions. At the same time, far fewer banks would be profitable, the degree of financial intermediation less, capital would be more costly, and the level of output and standards of living decidedly lower. Our current economy, with its wide financial safety net, fiat money, and highly leveraged financial institutions, has been a conscious choice of the American people since the 1930s. We do not have the choice of accepting the benefits of the current system without its costs." Well the costs are coming headlong like a runaway freight train. Whole testimony: http://www.bog.frb.fed.us/boarddocs/testimony/1998/19981001.htm Experts note that each financial crisis is unique, which probably is true in detail. These experts also seek comfort in the observation that the identified excesses of past crashes have been deal with through new regulatory measures, which is also undeniable. Yet financial crisis have persistent common threads in that they seem to defy precise anticipation and that their occurrence leave serious structural damage. Thus the requirement of a conservative debt to equity ratio is needed to protect the system from policy misjudgement. Yet the American system prospers on living on the edge through maximization and socialization of risk, thus building in failure or collapse that hurts no just the willing risk takers, but the general public who has been put into risky situations they cannot afford by the sales talks of sophisticated risk management. Will history compare Clinton to Coolidge and Bush II to Hoover? Henry C.K. Liu _______________________________________________ Crashlist website: http://website.lineone.net/~resource_base
