Sometimes, it is easy for commentators and other finance professionals to write articles or base their calculations on a series of mental math that somehow eludes their intended audience, thereby causing no small amount of confusion. This was brought home to me by recent e-mail correspondence (see the Asia Times Online letters and forum pages).
By far the most controversial, the idea of figuring what Asian governments have lost since 2007 in the financial crisis is nevertheless relevant for citizens and other stakeholders to think of. Let’s imagine for this exercise an Asian central bank entrusted with $100 billion at the end of 2006.
For ease of calculation, assume that their choices were either US Treasuries or some of the duff mortgage-backed securities. As we are discussing Asian central banks, let us also assume that their currencies appreciated against the US dollar by a constant rate, say 5% every year. Further, let’s assume that 2008 is over already (a lot of people on Wall Street certainly wish that were true). Also, I present the absolute return at the end of 2008 rather than annualized numbers, to keep things more simple for readers.
|US “Triple A”||$10bn||0%||$10bn||-50%|
Based on that very simple scenario, Asia transferred wealth to the US for the past two years, with mortgage losses this year translating to a whopper of money sent back.
In contrast, let us look at the picture of Asia actually floating local currencies. With that, you would have seen a reduction in total surpluses and therefore gross investment in the US market would have reduced. The effect though doesn’t end there: because total volume of investment would have decreased, compensation would have increased and quite dramatically so. Consider the following alternate picture:
|US “Triple A”||0||0%||0||-50%|
This is the wonderful situation in which a one-off adjustment (for floating) in 2007 would have caused investment losses then, but subsequently helped both to increase yields on US government bonds and also rendered unnecessary any investment in fancy mortgage-backed financial products.
The basic math principle is to think of the feedback loop caused by actions or inaction. In this case, the process of Asian central banks not investing in the US bond market would have caused a massive increase in bond yields, thereby bringing forward a slowdown for the economy and for all intent and purposes causing a soft landing scenario for the global economy.
Let us change the above calculations for central banks to look at “normal” banks, say in the US. Here, the question is both assets and liabilities, so let us assume the following at the end of the last good year (that is, 2006), against the “make-believe” story at the end of 2007 and the current position with mark-to-market.
So what happened here is that, as the dodgy assets (mortgages, collateralized debt obligations and what have you) fell in value in 2007 and this year, the mix of liabilities changed. First, banks are unable to borrow in the interbank market, which is why the borrowings fall from 10 to five to nothing this year; secondly, as the bonds mature, banks cannot refinance, so we put the outstanding value at five. Incremental finance is taken on by the Fed, which sees its lending to that bank rise from 0 to 15, that is, it holds up the whole banking system through a web of collateralized lending.
By now though, as the bank has wiped out its entire capital, bondholders have no option but to push the bank into default to seize the good assets before anyone else does. That is where the bailout plan of US Treasury Secretary Henry Paulson comes in. Let’s see the impact below, using the comparison of 2008 against purchasing the securities at market prices (PP-I) versus buying them at an inflated, above market price (PP-II). The latter is what Federal Reserve chairman Ben Bernanke calls, quite gently, the “appropriate hold-to-maturity” price.
In effect, the Paulson plan will inflate the value of assets and create fictitious capital for the banks that is generated simply by a subsidy from taxpayers. If the assets are purchased at market price, there is NO change to the total capital, which is why the first two columns above are exactly the same. This is why the worst suspicions of everyone criticizing the plan are true: there is no reason to carry out the plan if no such subsidy is intended.
Meanwhile, this week various European governments have run to the rescue of their banks: Fortis (Belgium, Netherlands and Luxembourg); Dexia (Belgium, France and Luxembourg); Glitnir (Iceland); all Irish banks (Ireland) and so forth. French President Nicolas Sarkozy reportedly proposed a $500 billion rescue package for all the banks in Europe, which was shot down quickly by other governments, including Germany.
The math in this case pertains not so much to whether these banks are too big to fail, as to whether they are too big to save. The following set of numbers certainly points to that logic; this is based on information provided by the International Monetary Fund and highlighted in other financial media this week.
In contrast, the combined assets/gross domestic product (GDP) of the top three US banks is only about 35%. Isn’t that wonderful? Thanks to decades of mollycoddling their domestic industries, you now have a situation where European banks – many of whom Asians haven’t even heard of – are now bigger than the GDPs of their home countries. Why does the ratio of assets over GDP matter? Because to pay for failed banks to foreign creditors and all that, governments have to run a surplus to GDP for a while.
Let’s take an example. Iceland moved to guarantee its banking sector even as its top three banks are about 13 times the size of its GDP. In other words, if the government runs a budget surplus of 10% of GDP (massively contractionary fiscal policy), it would still take a trifling 130 years or so to pay for all its borrowings needed. For Switzerland, this figure is a mere 100 years, while for those like Belgium, that ratio stands at some 75 years. Remember, these are just figures for the bank losses, not counting all the other stuff that will be lost as a result of the failure of the banking system; for example the industrial base, trade and so on.
The fact that not a lot of people take a logical view of math can be absorbed by the rise in Irish banking deposits this week after the government moved to guarantee the banks. Aren’t the Europeans a wonderful people, so trusting and naive in the ways of the world?