EYE ON
AMERICA Your
move, Mr Bernanke By Walter T
Molano
There is a consensus in the
northern latitudes of the Western Hemisphere that
the US Federal Reserve under chairman Ben Bernanke
will magically solve the markets' woes. Asset
prices rallied last week, as television
commentators debated whether the US central bank
would cut interest rates by 25 or 50 basis points.
Politicians from both sides of the aisle called
for a reduction in rates and an increase in
liquidity.
Although the United States
insists on central-bank independence
as a
precondition for multilateral assistance, it does
not feel it should be held to the same standard.
The televised assurances by senior politicians
that the Fed would ease interest rates made a
mockery of the nation's monetary authorities.
Moreover, the notion that a reduction in interest
rates would solve the ongoing credit crunch was a
naive understanding of the damage that has been
done.
On the surface, the global financial
system is in the midst of a liquidity crisis - but
it is really in the throes of a confidence crisis.
The lack of confidence in the rating and
derivative systems led to the seizing up of the
financial system. No one knows how to price the
trillions of dollars in collateralized derivative
structures.
As a result, no one can
move the paper off their books. Last week, a
European financial institution sold a AAA tranche at
a price of 78, forcing it to assume a huge
writeoff. This means that lower-rated tranches will
result in even larger discounts. With billions of US
dollars in open derivative contracts, much of it
in the form of collateralized obligations, the
global financial system is bracing for massive
writeoffs. It is for this reason that credit
evaporated.
Banks are slashing lines of
credit, paring back trading positions and refusing
to roll over commercial-paper obligations because
they must husband their cash. That is why a
50-basis-point cut or a 400-basis-point reduction
in Fed Funds will not do anything to restore
confidence. It is also the reason the markets will
panic the day after the Fed's hand is forced on
September 18, when they realize that financial
institutions will still be unable to move the
collateralized derivative structures off their
books.
The epicenter of the crisis is in
the US, but the reverberations are global - thanks
to the universal implementation of the Basel
Accords. In retrospect, the accords were a
stealthy virus that contaminated the global
financial system.
Under the guise of
improving financial regulation, supervision and
stability, banks around the world were given a
rating-based framework to manage their portfolios
and risks better. Unfortunately, the pathway to
hell is lined with good intentions.
Given
the dearth of rated instruments in non-Group of
Seven countries, financial institutions around the
world reduced their credit staff and local assets
- replacing them with rated instruments peddled by
the investment-banking community. Sensing a unique
opportunity, Wall Street distributed repackaged US
consumer loans throughout the globe, creating a
systemic time bomb that would eventually explode.
That is why, regardless of what the
Federal Open Market Committee does on September
18, bank regulators, risk officers and boards of
directors will think twice before buying another
collateralized derivative obligation. Without
limitless access to credit, US consumers will have
to reduce spending, thus marking the onset of a
global contraction.
The recent actions by
the Bank of Japan, which stemmed the appreciation
of the yen, signaled that Asia was not willing to
offset the US contraction. Therefore, a global
slowdown is in the works, regardless of what
happens to Fed Funds - unless something is done to
restore confidence in the rating and derivatives
systems.
(Copyright 2007 Walter T Molano,
The Emerging Market
Adviser.)
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