By Jon Markman | 23 February 2008
The financial system has become dependent on debt and the transfer of risk via convoluted debt instruments, creating a mess that will require hundreds of billions of dollars and unprecedented global cooperation to fix [[and years and years of pain! : normxxx]].
Since the wheels started coming off the stock market last summer, investors have looked to at least seven white knights to end the distress with a bold stroke. Yet each, including Federal Reserve Chairman Ben Bernanke and U.S. superinvestor Warren Buffett, has failed to lift investors' spirits for more than a couple of weeks, ultimately leaving stocks to tumble ever lower. Why? The fundamental problem in the world economy is that it grew over the past two decades to be incredibly reliant on optimistic risk takers' willingness to accept increasingly complex IOUs from companies, banks and government institutions— as investments instead of real assets [[casually produced instruments of credit (IOUs/derivatives) replaced actual money in all manner of trade: normxxx]]. Now we are seeing the same movie play back in reverse, as massive investor losses in debts once believed to be as safe as real money have led to falling confidence, rising pessimism and extreme risk avoidance.
In a gentler era, debt was important but not as vital to world finance [[it served largely as a lubricant, a way to enable unsynchronized financial events to 'mesh': normxxx]]. But, in recent years, debt became the oxygen of the world financial system [[high pressure oxygen, at that: normxxx]], along with a fanciful means of 'transferring its risks' from borrowers and issuers [[and conservative investors— VERY conservative investors: normxxx]]to [[self-selected, risk assuming (for a price): normxxx]] investors. To the extent that neither debt nor its conveyances are now trusted by anyone, even from organizations once considered rock-solid, the entire global banking system is asphyxiating before our eyes.
The first symptoms appeared in subprime-mortgage debts and seemed to be confined to the faltering U.S. home-construction industry. Then we learned that mortgages had been "securitized" and thus had become a problem for brokerages that issued and traded them. Next it turned out that banks held warehouses full of these securities [[which they had been caught holding when the lenders suddenly disappeared: normxxx]] and would suffer large losses.
Then it turned out that these damaged credits had been used as collateral for further bank loans, amplifying losses as margin calls demanded selling at deteriorating prices. Then we learned that not just banks but also corporations, states and cities had created and traded their own versions of the convoluted debt instruments and risk-transfer mechanisms that once seemed so promising. And in turn we learned about the troubled $45 trillion market for insurance on all of these credits.
The Threat Of The Obscure
Now, with our antennae up, virtually every week we discover a new large but obscure corner of the U.S. and world financial system that— unknown to all but a few practitioners— depends on the confidence of debt buyers in order to survive. And they are all today gasping for breath. Take, for instance, the obscure tender-option-bond programs or auction-rate securities that I wrote about in my past two columns. These lightly regulated, trillion-dollar financing programs underpin our civic infrastructure, and their possible failure seriously threatens the health of our cities, hospitals and transportation networks.
We are not quite talking about a terminal illness here, but close enough. This slow-motion asphyxiation is worse than a flu or pneumonia, and it's more resistant to treatment than cancer. And that's why the problems besetting the market are not solvable by conventional fiscal or monetary policy changes, political gestures or mere tens of billions of dollars in new investments [[or even the injection of almost three quarters of a trillion dollars, by the Fed and ECB, into the maelstrom: normxxx]].
To breathe a meaningful amount of new oxygen into the financial system, and thus effect a lasting reversal in the fortunes of major banks and stocks, experts now believe will require hundreds of billions of dollars just as a baseline. Plus we'll need to see a restoration of confidence in dishonored regulatory bodies, bank execs and ratings agencies, and quite possibly wholesale changes in the way financial companies are governed and managed worldwide. For all that, add the most precious commodity of all: time.
Until U.S., European and Asian central banks, investors and governments can coordinate a solution on an unprecedented scale, all interim white knights are doomed to fail. With them will go every minor stock market rally such as the one that kicked off at the start of this week.
Everyone Wants To Play The Hero
Let's catalog the knights that have been eagerly anticipated and then failed so far:
- Bernanke and his power to lower interest rates. Cheaper money hasn't worked; banks are hoarding it by raising loan requirements.
- Buffett and his power to buy distressed banks and insurers. He's interested in only the most valuable casualties, leaving the worst and most dangerous institutions to dangle from nooses.
- Sovereign wealth funds and their ability to inject $10 billion-plus at a shot into battered banks. They're no smarter than the average investor, just larger. Even their sizable efforts so far amount to little more than a drop in the proverbial bucket, and they face mounting criticism and resistance at home.
- Treasury Secretary Henry Paulson and his ability to force bankers to the table. Every smart private businessperson who has entered the Bush administration has failed once inside; Paulson's winter program to rescue banks' structured investment vehicles went nowhere.
- Congress and its ability to write tax-rebate checks. The prospect of a $160 billion injection into the U.S. economy, amounting to 1% of gross domestic product, boosted stocks for little more than two weeks. That sugar high is over.
- President Bush and his ability to coerce lenders to freeze mortgage rates. Prospects of a work-out plan for overstretched private mortgage holders rallied home builders for two weeks before petering out; it's too limited.
- New York Gov. Eliot Spitzer and his ability to split up bond insurance companies, saving the muni bond business. The plan will be tied up in the courts for years; it attempts to rescue states and cities at the expense of public shareholders and bondholders.
Each white knight offered hope that a few cough drops and slaps on the back would unclog the financial system's airways and send stocks on their merry way. Most have pushed stocks up for a week or two. Yet ultimately the folks with the most at stake— and who really understand what's going on— have re-entered the market as ardent sellers, pushing stocks to new lows. To grasp the magnitude of the problem that has freaked out investors, please sit through a quick, glib explanation of world financial regulations and then consider some basic math, courtesy of Australian derivatives expert Satyajit Das.
First of all, capital requirements at major banks are governed by the Bank for International Settlements, or BIS. In a set of accords hammered out in Basel, Switzerland, in 2004, regulators determined that banks must hold equity capital equal to 8% to 10% of their total loans outstanding. In other words, they need about $1 million in capital to make $10 million in loans.
That doesn't sound so hard. But all of those loan-loss write-downs that you have heard about lately have eroded banks' capital base. And there are many more multibillion-dollar write-downs to come. Plus, you may recall from previous columns (see "Your 'safe' money isn't so safe") that most large banks created off-balance-sheet entities called structured investment vehicles, or SIVs, for the purpose of generating fees by speculating on a variety of highly leveraged loans. Now that many of those loans have gone kaput, accounting regulations have required that banks bring the SIVs back onto their balance sheets. Since they are considered liabilities, they further weigh on those BIS capital requirements.
No Magic Bullet
Das figures there is $1 trillion to $2 trillion in SIVs, leveraged loans, warehoused loans and other assorted junk coming onto banks' books, all of which will tie up liquidity. Add to that the $150 billion to $250 billion in losses already recorded. Then add the roughly $100 billion that authorities believe will be required as reserves to shore up the troubled monoline insurers Ambac Financial Group (ABK) and MBIA (MBI). Call it $1.5 TRillion in total (the midrange). So to reserve against that, Das figures banks need at least $250 billion to $400 billion in new capital, because the deficit is constantly growing.
At present the global banking system has about $2 trillion in capital in total. So banks need to raise something like 10% to 25% of that amount in short order at a time when the market is scared and earnings are plunging.
Where will that money come from? The answer is nowhere, at least not very quickly. And that is why the markets are in danger of asphyxiation. It's also why the economy is threatened: For despite the lower cost of money, it's hard for businesses to get loans for expansion because banks need to keep as many dollars as possible on their balance sheets to meet reserve requirements.
One semi-reasonable way out at this point is a cheat: Bankers may need to throw BIS regulations out the window and rewrite the world's financial rule book [[the Japanese banks did just that, at the end of the last century— but they also basically went out of the 'new' lending business for several years— and only rolled over 'critical' loans: normxxx]]. Another alternative is for central banks to take all of the bad loans onto government books and print enough money to make them whole. That would lead to mind-blowing inflation and a loss of confidence, but at least it could hit the restart button on the global liquidity machine. Beaten-up commercial bank and brokerage stocks would then roar higher as they have after every other financial crisis, though from a much lower level.
I'll have more on potential fixes next week. In the meantime, I leave you with Das' bottom line: "The most fundamental thing is that people are pretending there is a magic bullet when there isn't one," he said.
Fine Print
To learn more about the BIS capital-rules framework known as Basel II, click here. . . . To learn more about Das' views and the origins of the credit crisis, read my Sept. 20 column, "Are we headed for an epic bear market?" . . . To learn more about the problems with cities' and states' obligations, see my Feb. 7 column, "The big threat of muni debt." . . .
To learn more about Singaporean politicians' growing skepticism of investments by the country's sovereign wealth fund, check out this MSN Money blog item. To learn more about the problems with insurance on credit derivatives, check out my Jan. 24 column, "A bad market? You ain't seen nothin'."
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Normxxx
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