Sometimes, you have to wonder if the mysterious forces of random events aren’t all lined up for specific outcomes. During a week when everyone’s attention and anger should have been turned on the world’s central banks after their foolhardy actions, news of a staggering US$7 billion loss by a “rogue” trader at Societe Generale, a French bank that pretends to be cleverer than it evidently is, comes as welcome distraction.
Much hand-wringing about phrases like “risk management”, “derivatives” and “who polices the police” will follow in coming weeks, but much of that baggage will be mislaid as usual, for the actions of central banks will unleash a new asset bubble on global markets in good enough time.
On a side note before delving into the mysteries of the world’s most prolific economist versions of Jack the Ripper, I find it difficult to believe that a rogue trader can tally $7 billion of losses in a relatively exotic business of a French bank, given the number of margin calls and cash funding requests that would have arisen in the past few months.
Still, assuming that the bank is telling the truth belatedly at least, unwinding those positions would have explained much of the bloodbath in Asian and European stock markets on Monday – the precise reason for the Federal Reserve to cut rates aggressively on Tuesday morning in New York.
Another such “technical” that hit Asian stock markets was the wildly successful initial public offering (IPO) of India’s Reliance Power, which drew in a record $189 billion for the $3 billion offer. The locking up of so much liquidity in one transaction left little for the rest of the market, causing a significant decline in the value of Asian stocks, led by India.
In an action reminiscent of the worst of the Alan Greenspan era in modern finance, Fed chairman Ben Bernanke this week parachuted a 75 basis points rate cut, after stock markets crashed for the previous few days and threatened to go further. Like a drug addict who’s just been given a fresh fix (‘Cracks’ in credit , Asia Times Online, August 25, 2007), the markets demand a further 50 basis points in the next Fed meeting on Tuesday. This would push the Fed rate to 3%, some half of inflation rate – as long the latter is calculated by a suitably independent source, such as my personal “money fitness” Guru, the Mighty Mogambo.
Meanwhile, the British government has thrown a five-year line of credit to its troubled mortgage lender Northern Rock (Rocking the land of Poppins, Asia Times Online, September 22, 2007), in what appears to be a government subsidy by another name. The sham privatization of an institution that has most likely wiped out its entire capital contradicts every principle of good governance. Maybe the British are finally learning from Continental Europe, where such state-sponsored malarkey is all too common.
The problem with governments intervening in markets is of course that they are ill equipped to do so. In the military, a “pogue” is slang for someone who is not a frontline soldier, like a cook or a planning clerk at headquarters: it is obviously used derisively. Central bankers get the same opprobrium from market professionals precisely for those reasons – they are essential for markets to operate but are most useful when staying in the background. No one expects the cook to take a leadership role in the fight by preparing hot curries to inspire better performance from frontline troops. (More likely he will just give them severe runs causing early withdrawal from combat).
Going back to the story at hand though, the Fed may find soon enough that it overreacted to what was essentially a short-run market phenomenon driven by one bank unwinding its positions and the Reliance Power IPO in India. By choosing to align itself with the health of volatile stock markets, the Fed has no one but itself to blame.
If you don’t know which wire to cut …
The phrase “Do Something!” when uttered by anyone in government or a central bank should send shivers down the spine of all rational investors, much like the exhortations of a potential victim to the chap in charge of bomb disposal. Not knowing which particular wire to cut, he must simply guess based on experience, or blind luck in other words. So if it happens that cutting the black wire has worked for him in the past, he will do the same, irrespective of whether it is the most logical choice for the current situation – for example, the black wire is not actually connected to anything inside the bomb.
To put in a bit of historical perspective, Greenspan was widely blamed by Republicans for not cutting interest rates quicker in the aftermath of the early 1990s recession that led to the party’s poor showing in the 1992 elections, when George Bush senior got a drubbing from Bill Clinton, thanks to the famous slogan “It’s the economy, stupid”. Confronting another election, it is still the economy, some 16 years on for the Republicans, and Greenspan’s Republican-appointed successor Bernanke is obviously a good student of history.
Starting with a self-appointed mandate of inflation and risk management, Bernanke promised to be “data-driven” in a dig at the more proletarian concerns espoused by his predecessor from time to time. Instead, he has quickly morphed into his superhero avatar of Helicopter Ben, ever ready to drop liquidity on the market when asked.
Back to the black wire, and the comparison to bomb defusing isn’t so far-fetched when we think about liquidity. There are times when the market is completely jammed up without any liquidity, for example when emerging countries see sudden demands for repayment or fund withdrawals. In such situations, injecting liquidity works to calm the markets and provide orderly pricing.
That however is not the problem confronting global markets now, especially not the world of credit at which the Fed chairman apparently aimed his rate cuts. Many of the reasons for stock markets to collapse of late appear temporary, thus are unlikely to be cured by Fed rate cuts. Rate cuts though may well cause the next bubble to inflate, and therein lies a bigger worry.
At the heart of the current logjam in credit markets is the simple issue of billions of dollars in fictitious assets that were flogged at exaggerated prices (forensic linguists can rest assured that the previous sentence isn’t tautological). Many of these assets, in the form of complex collateralized debt obligations and the like have but one solution – namely a mark down to zero value and moving on. Some others certainly are worth more than zero, but we won’t know that until the market opens up properly. Instead of acknowledging this reality though, government officials have created one hare-brained scheme after another. Close on the heels of the Treasury secretary’s Super-structured investment vehicles scheme that spectacularly collapsed in December, the rate cuts appear as the second salvo intended to free up lending once again.
Here is why this move (as well as the next two rate cuts) will fail – the problem with world markets today is not liquidity, but capital. The difference goes beyond nomenclature – while liquidity is long form for money flows, capital is the ability of banks to sustain the losses from such lending. For example, if you make a billion dollars of loans to individuals and expect to lose about 1%, you would set aside double that, say $20 million, as “capital”, and then calculate your return on those $1 billion in loans as a proportion to the capital deployed.
The problem that arose last year is that most banks seriously underestimated the risk of losses on a very larger part of their portfolio, and hence found themselves seriously short of capital required (additionally, absorbing the losses reduced their capital further). When banks don’t know how risky their assets really are, it stands to reason they view their own capital adequacy suspect, and by the same measure do not trust the capital adequacy of other banks either.
For capital to flow, markets need to have appropriate risk-adjusted returns. In turn, this means everyone needs to understand benchmark pricing once again, as in the cost of transacting interbank. This problem, which increased in the middle of last year and seemed to subside this year, has returned with the Societe Generale announcement, as banks once again do not trust each other. Until all banks are convinced that their counterparts do not have nasty surprises in store, lending will remain lumpy. And as long as banks don’t trust each other, they won’t trust anyone else either: which is why they are unlikely to lend money to companies and individuals unless they meet previously agreed deal terms.
It is impossible however to ignore the likely albeit unintended consequences of the Fed action. While a US recession cannot be averted, falling US dollar values will likely cause a recession in other economies, such as Europe, as some American manufacturers become more competitive within an environment of global demand declining. Similarly, the falling dollar will cause increased pricing pressures on parts of Asian manufacturing that operate with significant excess capacity, such as computer parts and automobiles.
Exceptional rate cuts will put further upward pressure on Asian currencies, and should regional central banks fail to float currencies soon, argue for significant monetary tightening at home. The leading concern in Asia is of course the People’s Bank of China – the central bank – which has made it a point to stay on the double-jeopardy path of a pegged currency and inadequate monetary tightening.
It is indeed possible that Asian currencies will maintain their peg for a while longer. However, it is unlikely that credit will flow back into the US economy and help lift it from a recession, which in turn means that the smaller trade surpluses being accumulated by the region have rapidly declining future values when expressed in foreign currency terms. Such depreciation in asset values can be expressed either through an eventual destruction of the US dollar or through further declines in asset prices, such as falling equity markets.
Alongside, US policy officials should also stand back and ask the question of how they would react if after allowing its currency to float against the US dollar, China started cutting rates every time the Shanghai index fell sharply. It is most likely that they would start haranguing Asians about market manipulation and all that. Yet, when it comes to troubles at home, suggested courses of action are somehow very different.