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5 CREDIT BUST BYPASSES
BANKS Part 1: The rise of the non-bank
financial system By Henry C K
Liu
In a period of just weeks, the
subprime time-bomb that had been ticking unnoticed
for half a decade suddenly exploded into a
systemwide liquidity crisis that then escalated
into a credit crisis in the entire money market
dominated by the non-bank financial system that
threatens to do permanent damage to the global
economy.
As an economist, Ben Bernanke no
doubt understands that the
credit
market through debt securitization has in recent
years escaped from the funding monopoly of the
banking system into the non-bank financial system.
As chairman of the US Federal Reserve, however, he
must also be aware that the monetary tools at his
disposal limit his ability to deal with the
fast-emerging marketwide credit crisis in the
non-bank financial system. The Fed can only
intervene in the money market through the
shrinking intermediary role of the banking system,
which has been left merely as a market participant
in the overblown credit market.
Thus the
Fed is forced to fight a raging forest fire with a
garden hose. One of the reasons the Fed shows
reluctance in cutting the Fed Funds rate target
may be the fear of exposing its incapacity in
dealing with the credit crisis in the non-bank
financial system at hand. What if the Fed fires
its heavy artillery but the credit crisis
persists, or even gets worse?
Liquidity
crunch only a symptom Banks worldwide now
reportedly face risk exposure of US$891 billion in
asset-backed commercial paper facilities (ABCP)
due to callable bank credit agreements with
borrowers designed to ensure ABCP investors are
paid back when the short-term debt matures, even
if banks cannot sell new ABCP on behalf of the
issuing companies to roll over the matured debt
because the market views the assets behind the
paper as of uncertain market value.
This
signifies that the crisis is no longer one of
liquidity, but of deteriorating creditworthiness
systemwide that restoring liquidity alone cannot
cure. The liquidity crunch is a symptom, not the
disease. The disease is a decade of permissive
tolerance for credit abuse in which the banks,
regulators and rating agencies were willing
accomplices.
Commercial paper
crisis Investment vehicles in the form of
commercial paper that mature in one to 270 days,
which normally carry top credit ratings, allow
issuing companies to sell debt in credit markets
to institutions such as money-market funds and
pension funds at rates lower than bank borrowing
or standby bank credit lines. Unlike non-financial
companies, which use the short-term debt proceeds
to finance inventories, financial-company debtors
invest the proceeds in longer-term securities with
higher yields for speculative profit from
interest-rate arbitrage.
Many of these
higher-yield securities are in the form of
collateralized debt obligations (CDOs) backed by
"synthetic" high-rated tranches of securitized
subprime mortgages, which have been losing market
value as the US market seizes from
subprime-mortgage default rates that have risen to
the highest levels in a decade and are expected to
get worse - perhaps much worse than currently
admitted publicly by parties who are in a position
to know the ugly facts.
At what level such
willful withholding of material information
crosses over from serving the public interest by
benign calming of market fear to criminal security
fraud in disseminating false information is for
the US Securities and Exchange Commission (SEC),
and eventually the courts, to decide.
SEC as advocate for
investors The professed mission of the SEC
is to protect investors and maintain fair, orderly
and efficient markets while facilitating capital
formation.
Claiming to be an advocate for
investors, the SEC proclaims on its website: "As
more and more first-time investors turn to the
markets to help secure their futures, pay for
homes, and send children to college, our
investor-protection mission is more compelling
than ever. As our nation's securities exchanges
mature into global for-profit competitors, there
is even greater need for sound market regulation."
The SEC declares:
The laws and rules that govern the
securities industry in the US derive from a
simple and straightforward concept: all
investors, whether large institutions or private
individuals, should have access to certain basic
facts about an investment prior to buying it,
and so long as they hold it. To achieve this,
the SEC requires public companies to disclose
meaningful financial and other information to
the public. This provides a common pool of
knowledge for all investors to use to judge for
themselves whether to buy, sell, or hold a
particular security.
Only through the
steady flow of timely, comprehensive, and
accurate information can people make sound
investment decisions. The result of this
information flow is a far more active,
efficient, and transparent capital market that
facilitates the capital formation so important
to our nation's economy. To ensure that this
objective is always being met, the SEC
continually works with all major market
participants, including especially the investors
in our securities markets, to listen to their
concerns and to learn from their experience.
The SEC oversees the key participants in
the securities world, including securities
exchanges, securities brokers and dealers,
investment advisors, and mutual funds. Here the
SEC is concerned primarily with promoting the
disclosure of important market-related
information, maintaining fair dealing, and
protecting against fraud.
The issue
of systemic fraud It is now clear that
material information about the true condition of
the financial system along with material
information of the financial health of major US
banks and their financial-company clients has been
systemically withheld, over long periods and even
after the crisis broke, from the investing public
who were encouraged to buy and hold even at a time
when they should have really been advised to sell
to preserve their hard-earned wealth. The aim of
this charade has not been to enhance the return on
the public's investment, but to exploit the public
trust to shore up a declining market and postpone
the inevitable demise of wayward institutions.
For example, Larry Kudlow, a
self-proclaimed "renowned free-market, supply-side
economist armed with knowledge, vision, and
integrity acquired over a storied career spanning
three decades", and host of the Kudlow &
Company TV show on CNBC, is an intrepid
cheerleader for the debt economy in an
evangelistic manner, while the logo for his
program is "Putting Capital Back into Capitalism".
As an evangelist for free-market
capitalism who celebrates debt and voices loud
calls for central-bank intervention to reinflate
the burst debt bubble, Kudlow sounds amazingly
similar to the campaign of Christian evangelist
Pat Robertson of the 700 Club to put God back into
people's lives while advocating assassination of
Venezuelan President Hugo Chavez and proclaiming
Israeli prime minister Ariel Sharon's stroke as
divine retribution for the Israeli pullout from
the Gaza Strip.
The problem of both
evangelistic programs is that the declarations of
faith are frequently countered by faithless calls
for sinful response to developing events. One is
grateful that evangelists are not yelling fire in
a theater crowded with believers, but to tell the
audience to sit and finish watching the movie when
fire has broken out is not exactly doing God's
work.
There is indeed need to put capital
back into debt-infested finance capitalism. Until
then, Kudlow's evangelistic message that
"capitalism works" is just empty words. While
market capitalization of US equity reached US$20.6
trillion at the end of 2006, the US debt market
grew to more than $25 trillion in trading volume.
There is $5 trillion of negative capital in US
capitalism, about 45% of gross domestic product.
Debt drives the market Hedge
funds, which number some 10,000, commanding assets
in excess of $2 trillion funded with debt, have
become dominant
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