“Spare the rod, and spoil the child.” – Anon
In a controversial case a good 16 years ago this month, Singapore’s much-vaunted legal system ruled on administering a punishment of caning for a 18-year old American student by the name Michael Fay. After much protests from United States president Bill Clinton and 24 assorted Senators among a series of legal and government nominees, Singapore agreed to reduce the sentence from six lashes to four. Fay’s Asian compatriots in the crimes of vandalism were less lucky, each getting a few months in prison and more lashes of the cane.
Four years later, in 1998, Michael Fay shot back to prominence, accused of possessing drugs in Florida; he was set free on a technicality involving arrest procedures. No further crime reports were ever received for the Asian compatriots of Michael Fay who didn’t receive the leniency that he did.
The above isn’t to suggest that this author supports corporal punishment; rather that the idea of people receiving the full penalty of applicable laws is the functioning basis for any society. Whenever that aspect of implementing laws breaks down; or where special favors are granted for any number of reasons, it is likely that results prove counter-productive.
In the above example, the US government intervened in the laws of a democracy that had a history of applying its stern disciplinarian measures on all of its citizens; in an attempt to protect the narrow interests of one individual. It is possible that the individual felt “good” enough about his government’s intervention to feel special; which then translated into behavioral problems later on. In contrast, the boys who got the full punishment under Singapore law never did return to the world of crime, petty or otherwise.
We can see the same examples everywhere. In both of the world’s largest countries, China and India, there is clearly a class of people who do not face the full force of the law because of who they happen to be. In other words, political or economic superiority protects some people from laws designed to be applied across society. The net result is stunning levels of corruption (see my article “The wages of corruption, Asia Times Online, August 19, 2006) as well as, perhaps more importantly, rising criminality. China’s ruling classes are the very epitome of corruption and petty theft from government coffers; while in India the selective application of laws has resulted in politics becoming the archetypal dirty profession.
When looking at the political classes of both China and India today, I am reminded of Mark Twain’s eternal quote, “There is no native criminal class in America, except Congress”. Interestingly, almost 100 years after he made the statement, events of the last year have contrived to create a new criminal class across Western society, and that is the world’s bankers.
It wouldn’t be an idle speculation in my mind at least to compare the politicians of India and China today to the bankers of America and Europe tomorrow.
How did we get to this point? What can be done about it?
The Lehman boondoggle
Over the past few days, newspapers around the world have dredged up their one-year calendar observance special – ie on the aftermath of Lehman Brothers and what it meant for the global financial system. Comments have veered around the following poles:
- Groups of inevitably “liberal” commentators whose refrain has been a steady “Lehman should have never been allowed to fail” which then explains their follow-up assessment of how the right-wing views on financial system integrity were reversed and therefore benefited the world. This group has an altogether rosy view of the world economy, certifying that bailouts have worked and so on.
- The conservative, right-wing view is of course the opposite, namely that the failure of Lehman Brothers was a good thing for the world economy and the wider financial system; this group also holds that bailouts of the financial system that followed would create resource misallocation, inflationary panic and the like.
No prizes for guessing which group I belong to.
This article isn’t about the merits and otherwise of the Lehman rescue; but rather about the moral hazard construct that is integral to these situations. In particular, I will seek to examine the behavioral aspects of the past year’s government efforts on a new generation of bankers and financiers, broadly continuing the themes first suggested in past articles such as The New Brahmins [Asia Times Online, March 29, 2008] and Easy bets with other people’s money [Asia Times Online, May 23, 2009].
In previous articles, I have pointed out time and again that creative destruction is an integral part of capitalism much as bureaucratic sloth is integral to communism; disallowing failures of private companies while also preventing necessary reforms will essentially create the worst of both worlds.
This is broadly where we are today:
- Governments have spent hundreds of billions of dollars and euros on the rescue of banks around the world, guaranteeing all manner of senior and junior debt obligations in addition to deposits at the banks (actually, according to the International Monetary Fund the total bill thus far is a staggering US$12 trillion; as in $12,000 billion or $12 million million).
2. Governments’ slivers of equity, instead of giving them management control, have provided adverse incentives to pushing through real (structural) reforms. Politicians have spent inordinate amounts of time discussing what to do with their shares in the banking system, rather than what to do with the banking system itself.
3. All manners of public securities have been purchased directly under the programs initiated by the European Central Bank (ECB), the Federal Reserve (Fed) and US Treasury. Further in this article, I will specifically discuss the game theory aspects of the US mortgage market securities (RMBS); resulting from the fact that governments are the largest owners of privately issued securities.
4. Bank balance sheets have actually expanded because of the adverse incentives pushed through by the largest shareholder (governments) and easy refinancing available at the “discount” window.
I am no mastermind like Federal Reserve Chairman Ben Bernanke, but it does appear to me that the simple implications for each of the above can be or more importantly, should be the following:
- The wide use of monetary stimulus in dealing with the current crisis is roughly equivalent to 40% of the combined GDP of the United States and Europe, this means that today’s asset values are vastly inflated. In addition, the apparent illusion of wealth so created by seemingly higher stock and property values also engenders inflationary trends on key commodities (why oil prices have risen), over-optimism on the part of suppliers (emerging market countries have seen stunning rebounds) and a failure to reduce leverage (while savings rates are up in the US and Europe, these are more than dwarfed by rising government debt). None of this though is nearly as important as the increase in volatility implied for the future: at some point, all this money has to be removed from the system one way or another (ie, either through withdrawal of quantitative easing or through inflation of asset and retail prices). Oh and did I mention – in conjunction with all that, governments around the world but particularly in the US and Europe will need to raise taxes or cut public services?
2. Controlling the banks hasn’t made governments in the US and Europe any smarter. If anything, incentives to restrain the financial system and put institutions on a self-sustaining course have actually gone in the opposite direction, with a new generation of “value maximize initiatives” in each government being tasked with making sure that banks produce more profits. That has immediately led banks to increase their balance sheets, which given poor economic data, also means that the quality of balance sheets has become worse not better under government tutelage. You don’t hear much about banks being forced to become smaller, because they aren’t being told to become smaller. So let’s see now: we have financial institutions with significant exposure to high-risk assets. Gee, what a refreshing change from 2007.
3. The US government, through the Treasury and the Fed holds hundreds of billions of securities in basically, itself. Let me explain: the Treasury bought some $700 billion of “troubled assets” from US and European banks. In addition, the Fed is authorized to purchase $1.25 Trillion (that’s $1.25 million million) of conforming mortgages that are backed by Federal agencies (Fannie Mae, Ginnie Mae, and Freddie Mac), $300 billion of long-term US Treasury bonds and $200 billion of the debt issued by (the now nationalized) Federal agencies.
4. This self-ownership of debt raises important questions on the market reaction: Chinese government sources have released details of the country’s concerns at the Fed essentially printing money to purchase US debt, but it doesn’t appear that a wider acceptance of this position has been found with other Asian central banks or indeed, global bond investors. As with the stunning rise of the stock market, I am left dumbfounded by the complete avoidance of risk discussions in the middle of this mess by the investors most exposed to downside risks of the strategy: namely Asian investors.
5. Then again perhaps I have been blindsided in the past, too: the part of the program detailing the purchases from US Federal agencies was clearly an attempt to mollify the Chinese government which had the biggest exposure to such MBS and Federal agency debt. In other words, the US government may have bailed out the Chinese government directly, in return for the latter to continue buying other US government debt. Indeed, there have been a number of articles on the Internet suggesting that Fed purchases have been directly linked to asset disposals by Chinese government entities. This raises a very interesting game theory argument, which I explore later in the article.
6. Amid all this liquidity sloshing around, the world’s bankers have been quietly having a nice party in the back. Banks still making markets in securities – a fancy way of saying that they can both buy and sell these securities – have reaped the benefits of extremely wide spreads between the buying and selling prices (‘bid-ask spreads’ in the jargon). Additionally, they have managed to refinance the most illiquid stuff on their balance sheets with the respective central banks, and used the borrowed money to buy very toxic assets (As I wrote in previous articles including Easy bets with other people’s money, Asia Times Online, May 23).
7. Then there is the whole mark-to-myth malarkey that has been egged on by central bankers and regulators – thanks to their ownership of the banks as highlighted two points above – which means there is no longer any reason to take accounting losses on problem assets. Let me be clear – banks haven’t stopped having loan losses; they have simply stopped accounting for them. Lastly, with low deposit rates and high lending rates, their basic businesses have made substantial profits this year. Out of all this, readers should expect that banks will set aside bumper bonuses for their executives, and do these out of stock grants to mollify critics; but don’t for a moment forget where the money for those equity gains comes from.
Game theory: Why Americans should default on mortgages
There is also an interesting point about the circularity of US mortgages that bears close monitoring. At a very simplistic level, Americans borrow money from their banks, which sell (conforming) mortgages to Federal agencies, which then issue securities that are bought by Chinese banks that are then repurchased by the US Fed. What happens when some people start repaying their mortgages? The ultimate losers would be the US Fed in the above scheme. This is handled either through money made available by the US Congress (new taxes) or interest rates being raised (more expensive mortgages). Either way, the average US homeowner will find his costs of living going up. If you were an American taxpayer and homeowner, what would be the most optimal course of action? Think of it this way – if the government owns all the housing debt effectively, and there are a number of defaults every year, everyone who defaults will be better off (financially) than those that continue to pay. If you were one of a 1,000 people getting a mortgage and say 100 people defaulted, then you would in effect (one way or another) be paying for those 100 people who default. As the number rises, you would be pushed towards greater financial pressure as both taxes and mortgage servicing costs rise. Meanwhile, for the people who default, the scheme of arrangement for their debts will mean lower fixed mortgaging costs and other benefits such as tax holidays. For self-employed people who tend to receive cash for their work, defaulting on mortgages could easily become the route to prosperity with low taxes and little debt repayment. So the logical course of action for a hardworking taxpayer holding a mortgage would be to default right away. This becomes more compelling when you consider the general tightening of credit across the US and Europe, where other forms of credit that used to be easily available previously (credit cards, personal loans) are more difficult to come by now. In typical game theory perspective that means the “penalty” of defaulting on mortgages in the form of reduced credit availability isn’t really applicable because that is the case for everyone now. Add the bit about all that money basically enabling the Chinese to sell their risky assets to the US government in return for US government liabilities, then something far worse looms. At best, this means China executed a perfect portfolio switch, going to better quality assets with lower durations; at worst it means that their direct leverage over the US government has increased substantially. This means that a “buyers’ strike” from China will inevitably lead to higher interest rates; which could further increase the pain for US mortgage borrowers. The persistence of that risk on the horizon simply makes the need for Americans to default on their mortgages that much more likely.
Learning from hedge funds
The performance and risks of the banking system wouldn’t be so bad if we didn’t have anything to compare them with. Unfortunately for the banks, that isn’t the case really. Look at hedge funds, those much derided vehicles of capitalists that had been billed as the most destructive forces in the world barely a year ago:
A vast number of hedge funds have closed down since the middle of 2008, a trend that continues till today. This bout of creative destruction has meant that strategies that were wrong have been shut down; only hedge fund strategies (and managers) that worked well through the volatile period of 2008 and the more benign conditions of 2009 have survived. Contrast this to the banks, where good and the bad bankers not only co-exist, but bad bankers actually appear to be thriving.
While some smaller hedge funds have opened shop, by and large capital hasn’t been made available; and certainly nowhere to the degree of stating ‘business as usual’. Contrast this with the hundreds of billions in largely public funds that have been pumped into the banking system, as previously highlighted.
Consolidation has increased, with the largest hedge funds attracting a greater amount of new capital than smaller entities. This effectively means that the average risk of hedge funds as a financial asset group has declined in the past year; again to be contrasted with the rising risks of the banking system.
Overall leverage in the sector has declined, as hedge funds trimmed their overall asset size relative to their capital bases. For example, credit hedge funds have on average cut their leverage by over 25% with the median around 50%; these are interesting statistics because credit hedge funds approximate the basic qualities of banks (that have certainly not cut leverage and indeed may have increased the same).
So far, there has been one major scandal involving a hedge fund (Bernie Madoff’s $50 billion caper). Compare that to the multiple number of scandals plaguing banks across the world, that are virtually too numerous to highlight.
In effect, hedge funds prove that capitalism does work. By imposing significant penalties on failures combined with rewards for success, it has been relatively easy to align the interests of all parties concerned. Risks have declined for investors, and returns have increased.
Over the horizon
The inevitable conclusion from all this is that capitalism provides a readymade whipping tool, ie bankruptcy, that keeps errant capitalists in check. Confuse that picture, be it for a delinquent teenager or an overextended banker, and the results are fairly predictable: ie a repeat of previous behavior. This then is the true legacy of Lehman Brothers: the aftermath that virtually ensures that eventually there will have to be more such bankruptcies.