Glancing over some long misplaced boxes in my garage the other day, I chanced on this wonderful decision globe – a sphere that is mounted on a pedestal. Rotate it at random and as the sphere comes to rest, an arrow points to one of many choices, such as yes, no, fire him, hire him, etc. But the most popular choice is the one to which the globe defaults to more often than not, thanks to a gentle skew in its structure – Cry for mom.
A decidedly poor performance of over 5% stock market losses in a single month will probably get investors into the crying mode; all too often, though, the respondent isn’t so much their biological mothers (mom) as some long-lost refugee from an Egyptian sarcophagi (mummy). This has all the makings of a good old-fashioned B-grade horror movie.
If this week is anything to go by, the Fed has graciously accepted its role of being the market’s mom, although questions involving paternity will most likely end in unnecessary lawsuits. Still, even with all the good intentions – more on that later – the Fed will find that it was answering the market’s pleas with entirely the wrong answer. As I wrote last week (The rogue and the pogue, Asia Times Online, January 26, 2008) what global markets need now is not so much liquidity but capital.
Put differently, the Fed has been busy trying to answer the question of “what” is missing – ie money chasing risky assets such as equities – but failed to ask the more important question of “why”. The answer to the latter question is capital, or in this case, the absence of capital.
Banks in the US and Europe do not have enough capital to run the level of risk on their balance sheets – and this includes the basic bread-and-butter of banking, namely loans to individuals as well as companies. The pain and shock caused by market losses over the past few months now has a real world impact, namely that banks cannot set aside enough capital to do more risky business.
Thus, as the Fed and other central banks attempt to inject more and more money into the banking system, they fail to recognize that banks have no ability to use the proceeds. This process called de-leveraging, or reducing the actual amount of leverage on the balance sheet of banks, in turn reduces the velocity of money. And that, senator, is a problem that cannot be fixed easily.
In all horror movies, the staple is to create a suspenseful situation that turns out anticlimactically, but as the key players express some relief throw a nasty surprise for them. The story about the absence of liquidity is the fake scare, and as the Fed and others cut interest rates to leave the markets somewhat reassured, something worse lurks around the corner.
As if banks didn’t have enough problems of their own, the rating agencies, whose greed and foolishness caused much of the current mess, have quite suddenly discovered religion. Consequently, they have become more activist in a futile attempt to reverse past mistakes.
Asians will of course remember the over-arching nature of such downgrades: South Korea had the ignominy of being reduced to a single-B ratings status (six notches worse than the lowest investment grade) from a high of double A (six notches above the minimum investment grade). That swing of 12 rating notches – and back in the case of South Korea – took many years.
In much the same way, major American banks are being threatened with ratings downgrades, as are large European banks. These actions come exactly at the point when banks need their higher credit ratings in order to attract capital.
Rating agencies have also realized that the monoline insurers (who guarantee payments on highly rated securities) are themselves inadequately capitalized, and thus have begun a lengthy review of their ratings. This will produce further downgrades of banks as their investments currently marked near par on the basis of such insurance will suddenly have to collapse sharply in price (and therefore increase equity capital needed to cover the losses).
As someone with little or no sympathy for bankers, I still marvel at how deep they have dug themselves into a hole. The first rule of getting out of such holes is of course to stop digging; in banking parlance, this means they have to stop adding any risk to their balance sheets. That’s the little detail that the central banks have missed completely.
A gentle aside at this point – about the only people willing to do the stupid thing, ie put capital into American banks, are central bankers and government wealth funds in Asia including the Middle East. Yet American politicians have taken to pouncing on these poor souls, demanding transparency and goodwill rather than simply saying “Thank you” like their moms taught them to. (This in the movies would be the annoying side character that insists on helping our victims secretly, only to be ignored by them and instead gets bumped off by one of the bad guys).
Back to the B-grade movie
The monster of capital losses at banks cannot be cured in any way except to recognize them, set aside the capital required and go hat in hand to other shareholders. Subterfuge will not help, and indeed may only make the monster more angry, as the management of Societe Generale (see last week’s article) is now discovering to its chagrin.
What about Asia – does the region get to play the long lost cousin who happens to be driving by and seeing signs of trouble, pulls over and finally effects a gallant rescue? Until a few weeks ago, this is what I thought (See “Storm warning for Asia, Asia Times Online, January 4, 2008), but unfortunately the region’s governments all appear to have retained their blinders. Japan slides mercilessly into a recession, even as the rest of the region slowly reacts to the sound of a hissing noise as air is being let out of the asset bubble.
China has not abandoned its currency peg regime and is instead pursuing a self-contradictory policy of providing fiscal stimulus even as the central bank continues to tighten monetary policy in order to combat inflation. Other regional governments are either unaware or unsure of what to do, and in any event do not have enough heft to do anything meaningful.
The hero of the day will probably turn out to be the little guy in the back who suddenly discovers that he has with him the ingredients required to push back the monster. With a bit of pluck and a kiss or two from the leading lady, he quickly concocts the potion and throws it at the market devil.
This antidote is of course the return of risk-seeking by small investors, who had earlier been trampled by the large beasts of the structured finance world. As they walk into the rumble of assets and start picking up the pieces they like – local bank bonds offering double digit returns, equities that have fallen more than half and so on, the flow of capital starts once more around the world.
Only trouble is, last I checked this group of people is still sound asleep.