Every year, the world’s most boring people, namely its bankers, await their version of the “Swimsuit edition”, the annual report of the Bank of International Settlements or BIS. The latest version , produced on June 30, provides a fascinating glimpse into the thinking of the people who are often described as the central bankers to the world’s central banks. Of course, I use the term “fascinating” quite loosely here.
The report was widely anticipated for two reasons; first as it represents the BIS view on the global financial crisis that unfolded over the 2007-08 period and second because the world’s bankers really have nothing else to do these days than to sit around reading biopsy (or, more cruelly, autopsy) reports on their sector. Instead of reading a lengthy volume over the course of summer though, bankers need to read just a part of one sentence: “… loans of increasingly poor quality have been made and then sold to the gullible and the greedy, the latter often relying on leverage and short-term funding to further increase their profits”.
This is really a wonderful sentence for the succinct way in which it describes the goings-on for the wider masses, therefore appearing like a wonderful bikini on the beach. But like a bikini, it conceals some vital aspects while revealing a fair bit. In this case, the BIS has avoided mention of the real source of all the dumb money that swirled around financial markets in the first place, flooding banks and investment managers with more funds than could be invested with reasonable returns.
That would be where central banks in the Middle East and Asia come into the picture, as they retained their significant trade surpluses on account in a bid to maintain currency parity, especially against the US dollar. As I have written before on these pages, the idea for Asian economies makes some kind of “I missed a few classes in economics” sense as officials attempted to keep their exporters happy. For the economies in the Middle East that export nothing but commodities, the idea of a US dollar peg represents nothing other than the subservience of Arab rulers to US interests.
The connection to the banking crises sweeping the US and Europe now is that much of private wealth generated in the Middle East found its way to banks in those countries, and was in turn diverted to “safe” choices like money market funds – the short-term funding sources the BIS discusses above – that invested in the best quality triple A securities. I discuss ratings a bit later in this article.
Back to the Middle East though. US officials led by Treasury Secretary Hank Paulson recently completed a trip around the region, where they urged Gulf countries to avoid changes to US dollar pegs, even as these countries struggle to contain double-digit inflation that they are importing due to the pegs. It is even thought in some circles that the whole idea of “containing” Iran may have come as a quid-pro-quo from these meetings.
Anyway, oil prices surged to a new high of over US$145 a barrel on Thursday morning (July 3), just in time to remind Americans driving around in their wasteful sports utility vehicles (SUVs)for the July 4 Independence Day weekend the sheer futility of their lifestyle choices going forward. Non-farm payroll data out later in the day may prove to be another nail in the coffin of the American dream, not that I feel this is something to celebrate rather than introspect about.
Back to the BIS report though, this glaring error of omission on the main source of market liquidity that prompted the excess of greed and gluttony not to mention gullibility makes the rest of the report rather pointless. It may seem understandable that an agency concerned with the actions of commercial banks doesn’t focus so much on policy institutions such as central banks, but in ignoring the role played by the People’s Bank of China, the US Federal Reserve, the European Central Bank and others, the BIS has essentially dumbed down the report.
Blaming the speculators
Even as the BIS makes an attempt to draw a line between incompetence, greed and perverse incentives, the world’s governments continue to avoid taking responsibility for their own actions. In a recent speech , India’s Finance Minister P Chidambaram took the cake in calling for a price band on oil that would act much like today’s currency peg bands, setting both a floor and ceiling price for oil.
This kind of market intervention is always to be expected from socialist clowns during times of crisis, as we saw during the Asian financial crisis 10 years ago. The reason that the Indian finance minister’s remarks rankle are of course the huge fuel subsidies that persist in India (see Incredible India Indeed, Asia Times Online, July 1, 2008), at the cost of strategic priorities such as education and infrastructure.
Such fuel subsidies, as China is also now discovering to its peril, help to keep demand artificially high while disallowing attempts to improve efficiency. This is what the US faced because of decades of governments not imposing a fuel tax as they feared a popular backlash, thereby mispricing a negative economic good (air pollution) at zero; in turn prompting citizens to increase their usage exponentially.
(I dare say that if you buried a few of America’s biggest SUVs today for future generations of humans (if any) to find, archaeologists in the year 3000 will have a tough time explaining quite what they were used for; most logically they will conclude that the average American was three meters tall and weighed about the same as a rhinoceros. Strictly speaking, that view wouldn’t be entirely wrong, but I will desist from making statements about fat people in this article.)
The idea of calling for a price band to eliminate fuel price speculation conveniently shifts the burden of responsibility from consumers of a scarce natural resource to the people making prices on the commodity. This is stupid for any low-level official to attempt and much more silly for the top finance official of any country to suggest. An Indian journalist of my acquaintance told me this week that he was “deeply embarrassed” by the finance minister’s performance, even likening the speech to the infamous “Zionist plot” speech of Malaysia’s Mahathir Mohamad during the Asian financial crisis 10 years ago.
In addition, our Indian eminence also ignored the role of currency pegs to the US dollar. In an environment of a falling US dollar that doesn’t necessarily translate into demand/supply changes (those that could affect future prices of processed items) the only alternative for anyone intending to hedge inflationary spirals would be to buy physical commodities such as gold and oil.
I have written previously about global banks attempting to kick down the price of gold (A conspiracy against gold, Asia Times Online, April 3, 2008) to keep their own relevance intact; that leaves oil as the most sensible diversification tool in a world with too many dollars floating around. That’s why the price of oil has gone up, not speculation or rapacious market traders or aliens from Mars.
In times of crisis, there are some curious market rituals to be observed, by far the most entertaining of which would be to observe what investment banks say about each other. Research reports from analysts employed by investment banks who write about other investment banks have become headline news items, with Bank A “downgrading the forecast earnings of Banks B, C and D” while the analyst from Bank B does the same for A, C and D and so on. At the end of this spectacle you have the wonderful feeling that all of them are in big trouble.
This is exactly where we are now, as the most entertaining of reports make their way suggesting that investment banks would have to cut about 25% or more of their staff into the global downturn. Most of the business models are irreparably broken, according to the analysts.
This presents a logical, if somewhat perverse question. If the analysts in question are so smart, why then do they work for an investment bank themselves? And if they aren’t smart enough to have decamped to a hedge fund or climbing Mount Everest, why then should normal equity investors listen to them?
Another curious market ritual is what happens with the rating agencies when they finally fess up to their mistakes as they do in every crisis. In the last round, they came out about how the rating processes for companies like Enron would be changed, while also showing the limitations of rating more than US$100 billion of debt issued by telecom companies that had to be serially downgraded in 2002.
This time around, Moody’s announced that a computer model used to rate Constant Proportion Debt Obligations (CPDOs) had been faulty, but the rating company then took the extraordinary step of firing key people in its European unit for violating procedures. What seems to have transpired is that once the errors were discovered, instead of going forward with downgrades, these officials may have “consulted” with the banks issuing (or worse, holding) the CPDOs to discuss financial implications. A downgrade from triple A to something more reasonable for the risk, around single-A, would have meant losses of more than 30% of the principal amount, according to some observers, so clearly the decision wasn’t an easy one to make.
The point though is that this particular ritual exposed the rating agencies for what they are – a bunch of businesses that make money providing so-called independent opinions that really only represent the best interests of the investment banks selling those products. This attitude at the heart of one of the more stable money-making businesses on Wall Street – fixed income – says more about the future of the investment banks than any of the research reports do.
Thus it is that starting with the BIS, then harkening to the Indian Finance Ministry, and going on to investment banks and to the rating agencies, we find it is not what people say that matters – it is almost always what they don’t.