Satyajit Das, author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives,” writes a distrubing article posted on the NPR web-site. Excerpts from the article:
- In the Arabian Nights, the beautiful princess Scheherazade buys one day of life at a time by recounting fantastic fables that entrance the King who has condemned her to die. Investors and traders are currently telling each other fairy tales to buy one day at a time to stave off the inevitable.
- The drama and tumult of recent events are not symptoms of the disease but the cure. The “disease” is the excessive debt and leverage in the financial system, especially in the US, Great Britain, Spain and Australia. …The “cure” is the reduction of the level of debt (the great “de-leveraging”).
- In 1931, Treasury Secretary Andrew Mellon explained the process to President Herbert Hoover: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down. … enterprising people will pick up the wrecks from less competent people.”
- The initial phase of the cure is the reduction in debt within the financial system. The overall losses to the financial institutions (net of re-capitalisation via new equity issues) are $400 to $600 billion and may well go higher. This requires reduction in financial sector balance sheets (assuming bank system leverage of around 10 times) of around $4 to $6 trillion through reduction in lending and asset sales.
- The second phase of the cure is the higher cost and lower availability of debt to the real economy. This forces corporations to reduce leverage by selling assets, reducing investment and raising equity (for example, as GE have done). This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.
- De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt. The process of destruction echoes W.B.Yeats’ words: “All changed, changed utterly: A terrible beauty is born.” Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages.
- The US government’s $700 billion package is the latest magic potion. It is puzzling why this initiative is seen as the “silver bullet” that will “fix” the problems.A cursory analysis of TARP (Troubled Asset Relief Program) reveals considerable confusion about even what problem it is addressing. TARP and many of the other initiatives merely transfer the problem onto the US government and taxpayer balance sheet. Government support for financial institutions in this financial crisis is already approaching 6% of GDP (compared to less than 4% for the Savings and Loans crisis). This will ultimately place increasing pressure on the US sovereign debt rating and vitally the ability of US to finance its requirements from foreign creditors.
- Money being supplied to the banks is not being lent through. Banks are parking the money in short dated government securities in anticipation of their own funding requirements. Around $2-3 trillion of assets are returning to bank balance sheets from the “shadow” banking system of off-balance sheet structures that can no longer finance themselves. In addition, banks have large amount of maturing debt (estimates suggest $1.5 trillion by the end of 2008) that they must fund.
- Ultimately, “all the king’s horses and king’s men” cannot prevent the de-leveraging of the financial system under way. At best, the actions can smooth the transition and reduce the disruption to economic activity. The risk is that well-intentioned steps prevent the required adjustments from taking place, delay recognition of problems and discourage action that must be taken by financial institutions, corporations and consumers.
- The key issues are availability of capital and liquidity. The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage. As the system de-leverages, it is becoming clear unsurprisingly that available capital is more limited than previously estimated.
- Government and central bank actions need to be focused on managing the transition to a lower debt world. Actions should be directed to three areas. Banks must be forced to write-off bad loans without delay even if this means breaching minimum solvency capital requirements. Bank capital needs must be addressed by forced mergers and restructuring, new equity issues and (in the absence of other options) nationalisation or liquidation. Central banks need to guarantee (for a fee) all major bank transactions to reduce counterparty risk enabling normal transactions between banks and other parties in the financial markets to resume.
- A global conference (along the lines of Bretton Woods) under a respected chairman (Paul Volcker is the obvious choice) must be convened. It would bring together all the major players including the vital creditor nations — China, Japan etc — to develop a framework for the major economic reforms (currency policies, fiscal disciplines, trade barriers) to work towards a resolution of the crisis. A principal objective of this conference would be ensuring supply of funding for the US in the transition period.
- Like a giant forest fire the de-leveraging process cannot be extinguished. Thoughtful actions can create firebreaks that limit preventable damage to the economy and the international financial system until the fire burns itself out.
- The Arabian Nights had a happy ending. The King after 1,001 night of enchantment and three sons pardons the beautiful Princess Scheherazade who becomes his queen. Despite the fairy tales that investors are putting their faith in currently, the de-leveraging that is at the heart of the current financial crisis may not have such a happy ending.
