Glancing over some long
misplaced boxes in my garage the other day, I
chanced on this wonderful decision globe - a
sphere that is mounted on a pedestal. Rotate it at
random and as the sphere comes to rest, an arrow
points to one of many choices, such as yes, no,
fire him, hire him, etc. But the most popular
choice is the one to which the globe defaults to
more often than not, thanks to a gentle skew in
its structure - Cry for mom.
A decidedly
poor performance of over 5% stock market losses in
a single month will probably get investors into
the crying mode; all too often, though, the
respondent isn't so much their biological mothers
(mom) as some long-lost refugee from an Egyptian
sarcophagi (mummy). This has
all the makings of a good old-fashioned B-grade
horror movie.
If this week is anything to
go by, the Fed has graciously accepted its role of
being the market's mom, although questions
involving paternity will most likely end in
unnecessary lawsuits. Still, even with all the
good intentions - more on that later - the Fed
will find that it was answering the market's pleas
with entirely the wrong answer. As I wrote last
week (The rogue and the pogue,
Asia Times Online, January 26, 2008) what global
markets need now is not so much liquidity but
capital.
Put differently, the Fed has been
busy trying to answer the question of "what" is
missing - ie money chasing risky assets such as
equities - but failed to ask the more important
question of "why". The answer to the latter
question is capital, or in this case, the absence
of capital.
Banks in the US and Europe do
not have enough capital to run the level of risk
on their balance sheets - and this includes the
basic bread-and-butter of banking, namely loans to
individuals as well as companies. The pain and
shock caused by market losses over the past few
months now has a real world impact, namely that
banks cannot set aside enough capital to do more
risky business.
Thus, as the Fed and other
central banks attempt to inject more and more
money into the banking system, they fail to
recognize that banks have no ability to use the
proceeds. This process called de-leveraging, or
reducing the actual amount of leverage on the
balance sheet of banks, in turn reduces the
velocity of money. And that, senator, is a problem
that cannot be fixed easily.
Boo! In all horror movies, the
staple is to create a suspenseful situation that
turns out anticlimactically, but as the key
players express some relief throw a nasty surprise
for them. The story about the absence of liquidity
is the fake scare, and as the Fed and others cut
interest rates to leave the markets somewhat
reassured, something worse lurks around the
corner.
As if banks didn't have enough
problems of their own, the rating agencies, whose
greed and foolishness caused much of the current
mess, have quite suddenly discovered religion.
Consequently, they have become more activist in a
futile attempt to reverse past mistakes.
Asians will of course remember the
over-arching nature of such downgrades: South
Korea had the ignominy of being reduced to a
single-B ratings status (six notches worse than
the lowest investment grade) from a high of double
A (six notches above the minimum investment
grade). That swing of 12 rating notches - and back
in the case of South Korea - took many years.
In much the same way, major American banks
are being threatened with ratings downgrades, as
are large European banks. These actions come
exactly at the point when banks need their higher
credit ratings in order to attract capital.
Rating agencies have also realized that
the monoline insurers (who guarantee payments on
highly rated securities) are themselves
inadequately capitalized, and thus have begun a
lengthy review of their ratings. This will produce
further downgrades of banks as their investments
currently marked near par on the basis of such
insurance will suddenly have to collapse sharply
in price (and therefore increase equity capital
needed to cover the losses).
As someone
with little or no sympathy for bankers, I still
marvel at how deep they have dug themselves into a
hole. The first rule of getting out of such holes
is of course to stop digging; in banking parlance,
this means they have to stop adding any risk to
their balance sheets. That's the little detail
that the central banks have missed completely.
A gentle aside at this point - about the
only people willing to do the stupid thing, ie put
capital into American banks, are central bankers
and government wealth funds in Asia including the
Middle East. Yet American politicians have taken
to pouncing on these poor souls, demanding
transparency and goodwill rather than simply
saying "Thank you" like their moms taught them to.
(This in the movies would be the annoying side
character that insists on helping our victims
secretly, only to be ignored by them and instead
gets bumped off by one of the bad guys).
Back to the B-grade movie The
monster of capital losses at banks cannot be cured
in any way except to recognize them, set aside the
capital required and go hat in hand to other
shareholders. Subterfuge will not help, and indeed
may only make the monster more angry, as the
management of Societe Generale (see last week’s
article) is now discovering to its chagrin.
What about Asia - does the region get to
play the long lost cousin who happens to be
driving by and seeing signs of trouble, pulls over
and finally effects a gallant rescue? Until a few
weeks ago, this is what I thought (See "Storm warning for Asia,
Asia Times Online, January 4, 2008), but
unfortunately the region's governments all appear
to have retained their blinders. Japan slides
mercilessly into a recession, even as the rest of
the region slowly reacts to the sound of a hissing
noise as air is being let out of the asset bubble.
China has not abandoned its currency peg
regime and is instead pursuing a
self-contradictory policy of providing fiscal
stimulus even as the central bank continues to
tighten monetary policy in order to combat
inflation. Other regional governments are either
unaware or unsure of what to do, and in any event
do not have enough heft to do anything meaningful.
The hero of the day will probably turn out
to be the little guy in the back who suddenly
discovers that he has with him the ingredients
required to push back the monster. With a bit of
pluck and a kiss or two from the leading lady, he
quickly concocts the potion and throws it at the
market devil.
This antidote is of course
the return of risk-seeking by small investors, who
had earlier been trampled by the large beasts of
the structured finance world. As they walk into
the rumble of assets and start picking up the
pieces they like - local bank bonds offering
double digit returns, equities that have fallen
more than half and so on, the flow of capital
starts once more around the world.
Only
trouble is, last I checked this group of people is
still sound asleep.
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