Page 2 of
2 For the markets, global
chill By Julian Delasantellis
Settlements, the lenders must meet
what are called capital reserve requirements of
what are called the Basel II accords.
This
means that the amount they can lend is limited by
the value of whatever actual assets the bank has
in its portfolio. How much the bank can lend out
is dependent on what kind of asset the bank
actually has, but whatever the underlying asset
is, the bank
can
lend many times its actual value. Hence money is
created.
For the borrowers, it's the same
process, but in a mirror. Borrowers need
collateral to borrow. If they get the loan, that
loan becomes their capital reserves to lend to
someone else.
When asset prices rise, it's
as if El Mystico has waved his wand. Both the
values of the reserves for the lenders and the
collateral for the borrowers are rising; that
means that commensurately more can be lent and
borrowed based on these newly inflated prices. The
mechanism becomes virtually self-reinforcing:
higher asset prices leading to more borrowing and
lending, more liquidity creation, higher asset
prices, and so on.
Until, as the residents
of Mystico Point were warned not to do, somebody
begins to doubt whether this is all real.
Yes, this did all start with the
subprimes. It was obvious to everybody (especially
the realtors and mortgage brokers) but the
prospective buyers that a lot these people were
not going to be able to afford the monthly
payments on a no-down-payment $1 million ranch
house in Orange county, California. When these
people started to fall behind on their mortgages,
the great money engine ground to a halt and,
slowly, went into reverse.
The subprime
mortgages had been pooled and sold as
interest-paying bonds called collateralized debt
obligations (CDOs). As many of the mortgage
borrowers were not paying their mortgages back,
these CDOs, as measured by the ABX subprime
indexes, fell in value. With their decline in
value, banks and other financial institutions that
had been using the CDOs as either capital reserves
or collateral found that the fall in the value of
the CDOs meant they could not lend or borrow as
much as they could previously. Under the hot,
glaring sun of reality, the global wave of
liquidity starts to dry up.
Many of the
banks and brokerages with a presence in the
subprime/CDO market also had a presence in other
aspects of the capital markets. The contractionary
effects of the withdrawal of liquidity from
subprimes is starting to take its toll there, as
well.
Many have noted that it is the rise
in corporate buybacks and private-equity buyouts
(see my February 22 article The highs and lows of
buyouts) that has greatly supported US,
and more recently world, equity prices these past
few years. This is not surprising; if one company
in a particular sector gets bought out at, say, a
25% premium to current market prices, stock
investors come to believe that the rest of the
companies in the sector might be similarly bought
out by other, greater fools - sorry, canny
entrepreneurs.
The whole private
equity/buyout phenomenon would not have been
possible without the wave of liquidity. The supply
of shares is, at least in the short term, fixed;
if the supply of money keeps growing
exponentially, more of it will be employed to
drive stock values up. As the wave of liquidity
recedes, so does the argument that you must own
stocks so as to profit from the next buyout. No
financing means no buyouts, and without buyouts,
stocks are just not thought of as valuable as they
were previously.
The news that really got
the selloffs rolling last week were the reports
that banks were having trouble arranging financing
for the $7.4 billion buyout of Chrysler by the
private-equity firm Cerberus. Across the Atlantic,
similar problems were being faced in the leveraged
buyout of the UK drugstore chain Alliance Boots by
Kohlberg Kravis Roberts (of 1988's
Nabisco/Barbarians at the Gate fame). The
initial public offering of the Blackstone Group,
considered a bellwether for the worldwide
private-equity business in general, has sunk like
a rock; it's down 17% from its offer price.
Without the belief, the faith, that there will
be more forthcoming liquidity to support these
deals, stock prices are reverting to what they
would be based on - just the companies'
fundamental prospects for further growth in
earnings from these levels.
That was last
week. It wasn't pretty.
Greed drives stock
prices up, and fear takes them down. Here, the big
fear is that of the unknown - nobody knows just
how much bad and/or deteriorating debt these banks
and brokerages have on their portfolios.
"Transparency", financial-market jargon for
information, might help the situation; the banks
and brokerages could report just what they do have
on their loan books. This could help through
calming some nerves here.
The banks and
brokerages will never do this individually, for
the companies that open their trading books put
themselves at a significant competitive
disadvantage against those that do not. You would
need some greater power, like the US secretary of
the Treasury, perhaps acting in concert with
financial officials from other countries, to get
everyone to do this simultaneously.
That
is unlikely; the administration of US President
George W Bush does not want to tarnish the image
of its one success, the strong economy, and thus
have the public realize that the administration's
failure to oversee and regulate the US debt
markets properly is, just like Iraq, Afghanistan,
the inability to capture Osama bin Laden and the
response to Hurricane Katrina, just another among
its many failures. Besides, just as then-defense
secretary Donald Rumsfeld once said his Pentagon
doesn't do quagmires, Hank Paulson's Treasury
Department doesn't do market intervention.
Or the US Federal Reserve could intervene
and supply extra reserves to the banking system,
either directly through lending from its discount
window or by lowering interest rates. This is the
approach that has been employed in previous
financial crises and panics, among them the 1982
bailout of Mexico, the 1987 stock-market crash,
the 1989-90 implosion of the US savings-and-loan
industry, the 1998 bailout of hedge fund LTCM, and
the 2000-01 dot-com bubble burst. Here too pride
goeth before the fall. This probably will happen
eventually, but only once the crisis deepens and
intensifies so greatly that US populist
politicians, such as Ron Paul on the political
right and Dennis Kucinich on the left, start to
get a serious hearing in the popular media on
their charges that the US political structure is
way too dominated by the interests of finance
capital.
That'll get the Fed moving.
In the meantime, let's look at El
Mystico's assistant, the Amazing Janet (Carol
Cleveland). According to the Monty Python skit,
"as Napoleon has his Josephine ... so Mystico has
his Janet. An honors graduate from Harvard
University, American junior sprint record holder,
ex-world skating champion, Nobel Prize winner,
architect, novelist and surgeon. The girl who
helped crack the Oppenheimer spy ring in 1947. She
gave vital evidence to the Senate Narcotics
Commission in 1958 ... In 1967 she became
suspicious of the man at the garage, and it was
her dogged perseverance and relentless inquiries
that two years later finally secured his
conviction for not having a license for his car
radio. He was hanged at Leeds a year later despite
the abolition of capital punishment and the public
outcry."
Maybe a young lady this talented
is what we need to tell Ben Bernanke that his
phone is ringing.
Julian
Delasantellis is a management consultant,
private investor and educator in international
business in the US state of Washington. He can be
reached at juliandelasantellis@yahoo.com.
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