Reality is often stranger than fiction. It is only much more so in financial
matters. Who would have thought at the beginning of this year that a few
deadbeats driving trucks in Arizona would spark the greatest financial crisis
in recent history, aided and abetted by the very regulators who are (over) paid
to stop such things from every happening? And that their actions would have
consequences enough to dethrone many a Wall Street head and their lackeys, as
well as threaten a multitude of regulators and in future, governments too? That
the attempts at keeping these truckers in good financial health would unleash
inflation across Asia and in turn threaten further economic calamities in the
near future?
Given the unprecedented nature of recent events, it is necessary to invent a
new word, which captures the emotive, urgent and
contagious nature of the new disease at the heart of the global financial
system, and for those reasons, I hereby coin the term "financialitis" to mean
the unexpected and wide-ranging blow up of a country's financial system. The
US, Germany and the UK have seen mild forms of Financialitis this year and yet
are nowhere near a recovery point.
In an article earlier this year (Hobson's
choice Asia Times Online, March 10, 2007), well before the onset of
financialitis, I wrote about the inter-dependency between the US financial
system and Asian savers that leads the latter to bail out the former and in
turn heap on themselves the adverse results of financial losses as well as
inflation. Over a period of time, the value of the assets being purchased by
Asian central and commercial banks turned rather suspect indeed, leading to
billions in investment losses (
The robbery of the century Asia Times Online, July 14, 2007).
Interestingly, this led to a Hong Kong-based bank being downgraded earlier this
month as rating agencies discovered material exposure to US assets in a lender
that really shouldn't have had any based on its geography and expertise. That
is just the one bank that got caught. I have no doubt that many others will
slowly reveal the extent of their investment losses in months to come.
That opinion on the prevailing equilibrium, ie that Asians would quietly absorb
losses and play for longer-term benefits accorded by keeping the American
consumer above water, was soon shaken by the onset of jitters between major
global banks, which refused to lend to each other (In
gold we trust Asia Times Online, September 8, 2007). This proved the
undoing of asset valuations, in turn pushing bank-borrowing costs through the
roof, and in one extreme case sparking a bank run in the UK (Rocking
the land of Poppins Asia Times Online, September 22, 2007). Despite a
number of attempts to quell the costs of borrowing, such as ill-timed interest
rate cuts by the US and UK central banks as well as freeing up of
"discount-rate" borrowings over the counter, the crisis persists till today,
with year-end financing still proving quite dear for many banks across the
world.
SUVs, SIVs and SWFs
The effects of an over-consuming America on the world are best typified by the
country's reliance on an outmoded transport system that places excessive
emphasis on individuality at the expense of optimality. The emblematic vehicle
is of course the SUV, which is neither sports nor utility and is perhaps
responsible in large part for America's addiction to oil. Then again, the
nature of US polity is such that its not the addict but rather the supplier who
faces the stick ('Cracks'
in credit Asia Times Online, August 25, 2007) and much the same has
unfolded in the world of finance over the course of this year.
US officials, led by the Treasury secretary, have been busy trying to push
through cosmetic improvements to financial assets, as shown by the Super-SIV
program that has come to represent everything that is wrong with the US. SIVs,
or special investment vehicles, are usually owned by banks or other
"respectable" financial institutions and designed to gather funds at costs
similar to that of banks from the wholesale market, mainly from vehicles called
money-market funds. These funds in turn get deposits from the general public,
who invest on the assumption that returns are slightly higher than what is
available on bank deposits.
The SIVs in turn invest in illiquid assets that represent the toxic waste
thrown out by US banks but are packaged to look more respectable than they
actually are by the sleight of credit ratings provided by the very people who
help design the investments (this is the point where readers should be saying
"nice job if you can get it"). The reasons for this circuitous way of investing
in dangerous assets is to create enough margins for all parties involved while
providing legal protection to malignant financial engineers. US political
observers term this "plausible deniability" and what it really means is that
once a few sacrificial lambs have been offered up (Off
with their heads Asia Times Online, November 6, 2007), ways will be
found to resume business as usual.
Anyway, all these plans depended on the SIVs continuing to fund themselves in
the market, which unfortunately was not to happen once summer doldrums hit the
US and European financial systems. Soon enough, banks had to absorb the SIVs,
which is the same as buying back exactly all the dangerous bombs you thought
had been removed from your bunker last week, with the added problem that
someone had probably removed a few fuses on the devices along the way out and
back - as in because of the problems of the SIVs, it was no longer a secret
that some of the assets held by these vehicles were toxic and probably worth a
lot less than what they were bought for, and now that the sponsoring banks were
consolidating the SIVs into their own balance sheets, they had to absorb such
losses directly.
With that eventuality, major US and European banks had to announce revised loss
expectations, and to make matters worse, also come clean on a whole host of
other assets that were not even in trouble during the summer, such as corporate
loans issued for purchasing other companies (so-called LBO facilities). All
told, there are some estimated US$100 billion in new losses for just the major
banks from various lines of activity, which at the conservative price earnings
multiple of 10 times, would mean that a trillion or so dollars has been wiped
out of the stock market valuations. Just the top three US commercial banks have
lost over $150 billion in market value this year, while the top three
investment banks have done better due mainly to the performance of one firm
(Goldman Sachs), without which they are also down about $100 billion. In
Europe, we are probably looking at over a quarter of a trillion US dollars in
market capitalization wiped out, and that is before any financial crisis has
hit the Europeans.
The UK has seen two consecutive months of property price declines already, and
other European economies such as Spain and France are witnessing similar drops
in their domestic property since the third quarter of this year. It seems only
a matter of time before the Europeans catch the American disease of falling
property prices, which will likely push their financial system into a deep
crisis next year.
This is where the sovereign wealth funds (SWFs) have come into the picture.
With share prices falling across the global financial system, the US and other
governments have been "requesting" some degree of assistance from these funds,
aimed at shoring up confidence in their financial system. This is what I
predicted in Cracks in credit (see above), but it has happened even sooner than
I expected - which of course means that the crisis in the US and European
banking system is worse than what we have seen so far. This is of course
delicious irony, as these very SWFs were targeted for stern lectures just in
October this year (Dear
dinosaurs Asia Times Online, October 20, 2007).
The SWFs will fail in their efforts to shore up investor confidence in US and
European banks. Their share prices will decline further as more problems are
discovered and global investors realize that the basic business model of many
of these banks has been irreparably broken this year. Many will not survive in
their current forms, necessitating costly (ie shareholder-dilutive) mergers.
Then again, SWFs are usually in countries with poor or zero accountability to
the general population - such as Singapore, China and the Middle East.
Therefore, they will get away unscathed from such losses.
Asian impact
By and large, none of the above should matter to the average Asian borrower or
saver. I mean, why exactly does a manufacturer in Fujian province need to care
about the problems confronting bankrupt homeowners in California? In the old
days, that logic would indeed hold but unfortunately it does not any more.
It is indeed true that any manufacturer or service provider in Asia can get
enough funding from his local banks, but only so far as some conditions such as
final maturity and currency are met. This is a problem for many manufacturers
who attempt to create a natural hedge between their revenues and liabilities.
Thus, an exporter who receives payment in US dollars would hate to see his
liabilities denominated in Chinese yuan, as they keep increasing in value even
as his income from selling widgets in the US declines.
To get a US dollar-denominated loan though, he must pay up similar to what a
similar manufacturer in another country like Germany or Mexico or even the US
would need to pay. This comparative cost is now enhanced by the credit crisis
in the US and European financial systems.
The second path of impact for Asian borrowers is that as their local banks lose
billions on the US financial system, their natural tendency to tighten up
standards would likely cause hardships to the average borrower, either through
lower credit limits or higher cost of borrowings. Asian banks, unlike their US
and European counterparts, tend not to distribute their risk, which means the
impact of localized losses can be quite high, in turn triggering a tightening
in credit conditions.
Thirdly, it is now inevitable that Asian countries will loosen or abandon their
pegs to the US dollar over the course of 2008. Their battle with inflation lost
comprehensively, (Inflation
- China's lost battle Asia Times Online, December 15, 2007) governments
around the region have no choice but to get more aggressive on their monetary
conditions, which cannot be accomplished when their currencies remain pegged to
the US dollar.
When this happens, it is highly possible that even profitable exporters of
goods and services in Asia will have to confront a crisis of confidence from
lenders, who will fret about their ability to survive when the local currency
gains sharply against the US dollar. This process of creative destruction is
central to re-jigging Asian economies away from production towards consumption,
but it will be painful nevertheless.
Welcome then, to the New Year, when the broken parts of the world will remain
broken, while those that haven't yet succumbed will slowly get sucked into the
maelstrom. Asians will come out of the New Year, ie approach 2009, stronger and
more important than ever before, but there will be many a week and month in the
interim when it certainly won't feel anything like it.
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