Central banks' easy virtue, easy money
By Julian Delasantellis
There's an old story about the late British statesman Winston Churchill at a
party. Probably on one of those many nights where never in the field of human
excess had so much cognac, brandy and scotch been consumed by a person who
historians now say was not an alcoholic, he staggered up to a socialite matron
and posed a question:
Churchill: "Madam, would you sleep with me for 5 million pounds?"
(In the 1930s, when the British pound was worth more than twice as much to the
US dollar than it is now, this was a
particularly impressive sum over which to surrender one's virtue.)
Woman: "My goodness, Mr Churchill ... Well, I suppose ... we
would have to discuss terms, of course."
Churchill: "Would you sleep with me for 5 pounds?"
Woman: "Mr Churchill, what kind of woman do you think I am?!" Churchill: "Madam, we've already established that. Now we are
haggling about the price."
Thanks to last week's events in the financial markets, we now know the price at
which the world's three largest central banks, the Bank of Japan, the European
Central Bank and the Federal Reserve Bank of the United States, will drop their
posturings about the importance of setting good examples regarding promoting
sound banking, lending and credit usage policies and put their principles up
for sale.
If the world's stock markets lose, oh, say, US$2 trillion of valuation or so in
a month, well, it looks like it's at that point they start "discussing terms".
Since March, I've written a number of times in Asia Times Online about what has
come to be known as the "subprime crisis", but it was at the end of that first
March 6 article,
Rocking the subprime house of cards, where I first postulated that this
situation would eventually degenerate to a point where central banks and
bankers would be called on to intervene. This happened last week.
The Fed and other central banks put up a good fight for their virtue. After the
Fed's August 7 meeting, its board of governors produced a statement
aggressively optimistic about the state of the US economy and contemptuously
dismissive about the possibility that the subprime crisis might represent a
potential cloud or two on this relentlessly blue horizon. After reading it, one
might have wondered if chairman Ben Bernanke needed his manic-depressive
prescription refilled.
The next day, as markets reacted against the Fed statement and the attendant
realization that no immediate central bank help was on the horizon, the Fed and
the world's other major central banks reversed themselves and went
full-throttle floozy for the rest of the week. According to Reuters, by the end
of last week the world's major central banks had put more than $325 billion of
extra liquidity into the system; the Fed's contribution to that total is said
to be in the neighborhood of more than $100 billion.
The US media report stories like this in much the same way they report baseball
statistics or Hollywood blood-alcohol test results - lots of coverage but
little real understanding. It is only in knowing the mechanics and causation of
these events that one can understand just how serious this crisis is now
becoming.
The media verb of choice for these procedures is that the Fed has "injected"
reserves into the banking system, but this does not mean this exercise is such
that you have bankers reporting to Dr Bernanke's office, wherein they lower
their Hugo Boss suit trousers to receive a hypodermic syringe's bolus of bucks
into their buttocks.
The core method in which the US Federal Reserve exercises day-to-day control
over the economy in its purview is through operations that buy and sell debt
securities in what is called the Federal Funds market; these are called open
market operations. If a central bank wants to withdraw reserves from the
banking system, it will sell from their portfolios a quantity of government
debt securities into the market; when the buyer clicks a button on his trading
terminal and transfers the purchase price of the securities via the miracle of
electronic funds transfer (EFT) out of the institution's account into that of
the central bank's, the supply of money decreases in the banking system by an
amount concomitant with the worth of the securities.
Many of the transactions in this market are repurchase agreements, or repos,
wherein one party, usually a large money-center bank, agrees, for a fee, to
lend specific securities to another party with a need to fund its reserve
requirements for a short period, sometimes as short as one night. The process
is reversed when, as happened last week, the central bank wants to increase the
supply of money in the banking system. There it buys securities; when it pays
for them via EFT, then the money supply gets increased in a similar fashion. In
the United States, this process is effected through the Federal Reserve's
ongoing relationship with 21 large commercial banks called "primary dealers".
In the 1980s, when central bankers worshipped pint-sized monetarist economic
guru Milton Friedman as the living god of wealth, the purpose of these
operations was to set and meet a defined policy objective as to where the
absolute quantity of money in the economy should be. These days, central
bankers are more likely to target a previously specified interest rate; when
the media report the results of a Federal Reserve or other central bank's
interest-rate decision, this is this rate to which they are referring.
Since an interest rate is, in essence, the price of money, as it goes up so
does the cost of borrowing money from a lender, and as it goes down the
reverse. This is how the world's interest rates act as the world's economic
throttle.
Right now, the target interest rate for funds lent and borrowed in this market
is 5.25% in the US; on many days the Federal Reserve Bank of New York,
operating on instructions from Federal Reserve headquarters in Washington, DC,
goes into the market either to add required liquidity or to sop up and remove
excess liquidity, to keep the target interest rate, called the Federal Funds
rate, in line.
It is not at all uncommon for the Federal Funds rate to vary from the target
rate. Around the Christmas holiday season, the system is frequently short of
reserves, as people empty their bank accounts to buy presents; this was
particularly true during the holiday season of 1999, when people emptied their
bank accounts both to buy presents and because of media reports warning that
middle America would soon resemble Fred Flintstone's Bedrock City after the
biblical-level devastation soon to be visited on the heartland by Year 2000.
Likewise, in the spring, as people deposit their income-tax refund checks, bank
reserves are plentiful.
This week, the Federal Reserve noticed that the Federal Funds rate had jumped
well beyond its target of 5.25% toward the low and middle 6% range. Other world
central banks noticed similar increases beyond their target ranges; in Europe,
after news that America's subprime problems had jumped the Atlantic and had
been found in European financial institutions such as BNP Paribas and Germany's
IKB group, rates had moved to 4.5%, a half-point beyond their target range.
The most common factor that traditionally explains rising interest rates is
economic growth; more companies and individuals are borrowing from banks to
finance their economic expansion plans. This was not the case last week;
borrowings from the system were stable.
The problem wasn't the demand for money; it was the supply. The
subprime-mortgage banking crisis, which a year or so ago began in far-distant
fields of verdant identical pastel highrise condominiums in such places as San
Diego and southern Florida, had finally spread into the absolute core of the
modern financial system, this interbank market for overnight reserves.
Calling this entire thing the "subprime crisis" evokes the incorrect notion
that the entirety of the "storm and stress" of what the world's markets are
going through these days is centered on those poor sods sitting in their
overpriced houses on which they've stopped making payments, awaiting the
morning when the local county sheriff knocks on their door to put all their
rented furniture on the sidewalk when evicting them.
This is where the crisis started but, in reality, like a toy balloon filled
with too much air that tears apart at a random point on the balloon's surface,
the bursting of the credit/liquidity balloon that so inflated this decade could
have begun at any number of the places where irrational exuberance-greed had
affected allegedly rational economic actors.
So, out there in the hinterlands of economic activity, subprime borrowers are
not paying their mortgages. The people who bought these mortgages, rolled and
bundled up into interest-bearing bonds called collateralized debt obligations
(CDOs) , now find that they have what is delicately called a "liquidity
crisis"; in real-people-speak, they have no income. They are no longer
receiving the CDO coupon interest that derived from the mortgage interest
payments.
That's a problem both for them and for the institutions they might have
borrowed the money from to get the funding to buy the CDOs. If they're not
receiving any income payments from the CDO owners (because the CDO owners
aren't receiving the mortgage interest payments from the subprime borrowers),
then soon they'll be suffering their own "liquidity crisis".
And so on and so on, on and on up the finance food chain until you get to late
last week, the arrival of the crying baby of this crisis at the doorstep of the
interbank market for short-term reserve finance. The problem has been
particularly exacerbated by the current trend in finance to manage
balance-sheet assets and liabilities aggressively; in essence, at every level
the financial system is now continually doubling down on every bet it makes. If
you've got an asset worth x, you might use it as collateral to borrow 5x or
10x, and a pretty similar process governs lending as well.
In many of my articles here I have noted that the key component of modern
international finance has been the massive "wave of liquidity" that has buoyed
prices on everything from private-equity buyouts to 1950s-era TV-show lunch
boxes on eBay.
The wave of liquidity is one of the central arguments for those who believe
that the entire subprime crisis is just a tempest in a teapot, that it will
have little or no effect on the "real" economy. At a news conference last
Wednesday, US President George W Bush opined, "Another factor one has got to
look at is the amount of liquidity in the system. In other words, is there
enough liquidity to enable markets to be able to correct? And I'm told there is
enough liquidity in the system to enable markets to correct."
The essential assumption in that sentiment is that the amount of liquidity, of
money and credit, in the system is fixed, as if it's all safely stored away in
neat little shrink-wrapped bundles or something.
The very concept of a credit crunch, illustrated in last week's markets, proves
this false. We are now seeing that much of the world's liquidity wave can
disappear with the same effortless ease with which it was created.
Specifically, as the market values of CDOs decline, less can be lent out using
them as collateral. With globalized finance meaning that subprimes are now
being found in so many more portfolios than previously expected, such as those
of BNP and IKB, the process of credit contraction immediately spreads across
the planet, much as the global equity-market selloffs are illustrating.
A special factor that spooked the Federal Funds market late in the week, and
probably the one that most directly led to the intervention of the Fed and
other central banks, was that this market's players can push back from the
table any time they want.
The transactions in the Federal Funds markets carry no type of federal
deposit-insurance coverage or protection. Thus if you make a deal with another
player to be repaid in 24 hours, and if your counterparty goes belly-up in that
period, you get right into line at the courthouse door with all the other
institutions to which the dearly departed bank owed money; an intended 24-hour
transaction might turn into one that lasts a decade, with you paying hefty
lawyers' fees the entire time.
Amazingly enough, late last week such gross fear spread through the markets
that there were concerns that one or more primary dealers, institutions such as
Goldman Sachs, JPMorgan and Credit Suisse, the most cerulean names in US
blue-chip finance, might fail to roll up their window-shades and open their
doors for business the next morning. Rather than make uncovered loans to these
potential cordon bleu deadbeats, other players got up from the table and
pulled in their lending to this market. That produced the shortage of lendable
reserves in this market that caused the rise in short-term interest rates, and
was what drove the central bankers to ride in and attempt their first of what
could be many rescue attempts.
Elvis Presley was more likely singing about women than international
financial-market liquidity when he sang the title track for a movie in 1967,
but the principle is the same. Easy come, easy go.
Illustrative of the fact that, yes, the subprime crisis is having an effect in
the "real" economy is the rather anomalous behavior currently going on in the
commodity markets, particularly for petroleum products. (See my April 4 article
Crude: Barrels of fun to crack you up and the April 24 article
Why oil chiefs are feelin' groovy, on last spring's activity in the oil
markets.)
In late spring and early summer, it seemed that oil and product futures prices
were on a one-way trajectory straight to the moon and stars, as shortages in US
refinery capacity were putting tremendous upward pressure on these markets.
However, since August 1, oil futures prices have plunged 11% on US markets.
Much like equities, there's just not enough money and liquidity around to
support the previously high prices anymore; beyond that, there's an extended
message that the markets are trying to deliver, that soon a lot of people are
going to be focusing their driving efforts more on short trips to the local
unemployment office than to some far-flung mall.
The response of Bush and other economic conservatives (such as the ones he
appointed to the US Federal Reserve Board) to the rescue of the subprime market
now underwater has been in essence similar to his response to the rescue of New
Orleans when it was underwater from Hurricane Katrina in 2005. No.
Late last week, a possible solution to the subprime crisis was raised; the US
semi-official mortgage guarantor agencies, the Federal Home Loan and Mortgage
Corp (called Freddie Mac in the markets) and the Federal National Mortgage
Association (similarly called Fannie Mae), suggested they might be willing to
buy up at risk subprime paper in the market, thus allowing the homeowners to
stay in their homes. More important for Wall Street, it would take the
now-radioactive subprime CDOs off its hands and inject more liquidity into the
system. Bush sniffed at the suggestion; he said the two agencies had to be
first "reformed" of the rampant corruption that economic conservatives always
seem to find in public agencies.
In general, economic conservatives say the role of government in ameliorating
this crisis should be, at most, virtually non-existent.
Much like pregnant ghetto teenagers, they say that those suffering in the
subprime crisis are there wholly through their own misguided actions,
specifically, their greed. No government actions, including anything by the
Federal Reserve, should be taken on their behalf. They must suffer the pain
that is the rightful and just consequence of their imprudent actions. An
editorial in Saturday's Wall Street Journal summarized this philosophy very
succinctly.
No one wants to see someone lose his home to foreclosure.
But many of those most at risk bought their homes with little or no money down,
and so have very little at stake economically. Bringing in the feds to bail
them out would send precisely the wrong message - that risky or overly
aggressive borrowing will be rewarded by the government rather than punished in
the marketplace. To the extent that bad loans were made, the market needs to
clear, not be propped up by federal aid programs ...
With the current market turmoil, Mr Bernanke faces his first big test as
chairman of the Federal Reserve. The biggest favor he could do for himself and
the markets is not to give in to the temptation to do favors for Wall Street or
anyone else, and to remain focused on his price-stability mandate.
What this editorial is trying to say is that the markets must be disabused of
the notion that some institutions are, like those that lent billions to hedge
fund Long-Term Capital Management in 1998, or the banks that lent to Mexico in
1982, "too big to fail". Much as the ghetto teenager who loses her welfare
benefits and so, like a modern-day Flying Dutchman of the service sector, is
sentenced to push a broom at McDonald's for all eternity, those who make
mistakes must forever pay for their actions.
Warnings against the dangers of excessive credit utilization are also a regular
part of Federal Reserve communications with the general public. In a
publication titled Building Wealth, the Federal Reserve Bank of Dallas
provides these dictums.
Liabilities are your debts. Debt reduces net
worth. Plus, the interest you pay on debt, including credit-card debt, is money
that cannot be saved or invested - it's just gone. Debt is a tool to be used
wisely for such things as buying a house. If not used wisely, debt can easily
get out of hand ...
Develop a budget and stick to it. Save money so you're prepared for unforeseen
circumstances. You should have at least three to six months of living expenses
stashed in your rainy-day savings account, because as the poet [Henry
Wadsworth] Longfellow put it, "Into each life some rain must fall." When faced
with a choice of financing a purchase, it may be a better financial decision to
choose a less expensive model of the same product and save or invest the
difference. Pay off credit-card balances monthly.
This is all
sound, prudent and conservative financial advice; the underlying cause of the
subprime crisis is that, for much of this decade, America's financial elite has
basically not practiced any of it. Do as I say, be cautious and careful, not as
I do; I'm borrowing and lending like a drunken sailor with free tickets to a
beer fest.
With this as intellectual background, you might have expected the
conservative-libertarian economic community to have decried the Federal Reserve
money-market interventions. After all, if a few or more primary dealers had
imprudent connections, even if they were once, twice or more removed, with the
subprime market, their insolvency and bankruptcy could only have a proper
disciplining effect on the market. The example of their misery and penury will
act to ensure that future market participants eschew the next upcoming
financial-market inanity.
Not on your life. While it's true that these economic conservatives are
cradle-to-the-grave misanthropes who decry everything from government funding
of infant inoculations to Meals on Wheels for elderly shut-ins, still they are
proving themselves to be a lot more sanguine about the prospect of government
assistance if the assistance is directed at members of their own elite class.
As former Ronald Reagan-era (1980s) economic official and current CNBC economic
commentator, Larry Kudlow, put it in his National Review Online blog, "The Fed
and other central banks are prudently injecting $131 billion of new cash to
'facilitate the orderly functioning' of markets. Fed chairman Ben Bernanke has
the story right."
Of course he has. Principles and ideologies are fine on a sunny day, but the
subprime crisis is now threatening core institutions of the financial system
that has rewarded the elite so generously - beliefs be damned, Bernanke, get in
there and save our portfolios. For all the "financial education" the US Federal
Reserve provides the masses, and all the verbiage about what cautious,
exacting, circumspect bankers they are, this crisis, like all the rest that
came before them and all those that are to follow, prove that they are, at
crunch time, just Wall Streetwalkers, always available to compromise their
principles to pleasure their masters.
In 1925, George Orwell lyrically described an encounter he had with a member of
the sisterhood of the oldest profession in the world.
When I was young
and had no sense
In far-off Mandalay
I lost my heart to a Burmese girl
As lovely as the day.
Her skin was gold, her hair was jet,
Her teeth were ivory;
I said, "For twenty silver pieces,
Maiden, sleep with me."
She looked at me, so pure, so sad,
The loveliest thing alive,
And in her lisping, virgin voice,
Stood out for twenty-five.
That's also sage counsel for
Bernanke. As the credit crisis continues to deepen, and as calls rise for a
50-basis-point cut in Federal Reserve interest rates, he can always provide an
effective palliative for his conscience by saying he "stood out for
twenty-five".
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.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
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