Every year, the world's most boring people, namely its bankers, await their
version of the "Swimsuit edition", the annual report of the Bank of
International Settlements or BIS. The latest version [1], produced on June 30,
provides a fascinating glimpse into the thinking of the people who are often
described as the central bankers to the world's central banks. Of course, I use
the term "fascinating" quite loosely here.
The report was widely anticipated for two reasons; first as it represents the
BIS view on the global financial crisis that unfolded over the 2007-08 period
and second because the world's bankers really have nothing else to do these
days than to sit around reading biopsy (or, more cruelly, autopsy) reports on
their sector. Instead of reading a lengthy volume over the course of summer
though, bankers need to read just a part of one sentence: "... loans of
increasingly poor quality have been made and then sold
to the gullible and the greedy, the latter often relying on leverage and
short-term funding to further increase their profits".
This is really a wonderful sentence for the succinct way in which it describes
the goings-on for the wider masses, therefore appearing like a wonderful bikini
on the beach. But like a bikini, it conceals some vital aspects while revealing
a fair bit. In this case, the BIS has avoided mention of the real source of all
the dumb money that swirled around financial markets in the first place,
flooding banks and investment managers with more funds than could be invested
with reasonable returns.
That would be where central banks in the Middle East and Asia come into the
picture, as they retained their significant trade surpluses on account in a bid
to maintain currency parity, especially against the US dollar. As I have
written before on these pages, the idea for Asian economies makes some kind of
"I missed a few classes in economics" sense as officials attempted to keep
their exporters happy. For the economies in the Middle East that export nothing
but commodities, the idea of a US dollar peg represents nothing other than the
subservience of Arab rulers to US interests.
The connection to the banking crises sweeping the US and Europe now is that
much of private wealth generated in the Middle East found its way to banks in
those countries, and was in turn diverted to "safe" choices like money market
funds - the short-term funding sources the BIS discusses above - that invested
in the best quality triple A securities. I discuss ratings a bit later in this
article.
Back to the Middle East though. US officials led by Treasury Secretary Hank
Paulson recently completed a trip around the region, where they urged Gulf
countries to avoid changes to US dollar pegs, even as these countries struggle
to contain double-digit inflation that they are importing due to the pegs. It
is even thought in some circles that the whole idea of "containing" Iran may
have come as a quid-pro-quo from these meetings.
Anyway, oil prices surged to a new high of over US$145 a barrel on Thursday
morning (July 3), just in time to remind Americans driving around in their
wasteful sports utility vehicles (SUVs)for the July 4 Independence Day weekend
the sheer futility of their lifestyle choices going forward. Non-farm payroll
data out later in the day may prove to be another nail in the coffin of the
American dream, not that I feel this is something to celebrate rather than
introspect about.
Back to the BIS report though, this glaring error of omission on the main
source of market liquidity that prompted the excess of greed and gluttony not
to mention gullibility makes the rest of the report rather pointless. It may
seem understandable that an agency concerned with the actions of commercial
banks doesn't focus so much on policy institutions such as central banks, but
in ignoring the role played by the People's Bank of China, the US Federal
Reserve, the European Central Bank and others, the BIS has essentially dumbed
down the report.
Blaming the speculators
Even as the BIS makes an attempt to draw a line between incompetence, greed and
perverse incentives, the world's governments continue to avoid taking
responsibility for their own actions. In a recent speech [2], India's Finance
Minister P Chidambaram took the cake in calling for a price band on oil that
would act much like today's currency peg bands, setting both a floor and
ceiling price for oil.
This kind of market intervention is always to be expected from socialist clowns
during times of crisis, as we saw during the Asian financial crisis 10 years
ago. The reason that the Indian finance minister's remarks rankle are of course
the huge fuel subsidies that persist in India (see
Incredible India Indeed, Asia Times Online, July 1, 2008), at the cost
of strategic priorities such as education and infrastructure.
Such fuel subsidies, as China is also now discovering to its peril, help to
keep demand artificially high while disallowing attempts to improve efficiency.
This is what the US faced because of decades of governments not imposing a fuel
tax as they feared a popular backlash, thereby mispricing a negative economic
good (air pollution) at zero; in turn prompting citizens to increase their
usage exponentially.
(I dare say that if you buried a few of America's biggest SUVs today for future
generations of humans (if any) to find, archaeologists in the year 3000 will
have a tough time explaining quite what they were used for; most logically they
will conclude that the average American was three meters tall and weighed about
the same as a rhinoceros. Strictly speaking, that view wouldn't be entirely
wrong, but I will desist from making statements about fat people in this
article.)
The idea of calling for a price band to eliminate fuel price speculation
conveniently shifts the burden of responsibility from consumers of a scarce
natural resource to the people making prices on the commodity. This is stupid
for any low-level official to attempt and much more silly for the top finance
official of any country to suggest. An Indian journalist of my acquaintance
told me this week that he was "deeply embarrassed" by the finance minister's
performance, even likening the speech to the infamous "Zionist plot" speech of
Malaysia's Mahathir Mohamad during the Asian financial crisis 10 years ago.
In addition, our Indian eminence also ignored the role of currency pegs to the
US dollar. In an environment of a falling US dollar that doesn't necessarily
translate into demand/supply changes (those that could affect future prices of
processed items) the only alternative for anyone intending to hedge
inflationary spirals would be to buy physical commodities such as gold and oil.
I have written previously about global banks attempting to kick down the price
of gold (A
conspiracy against gold, Asia Times Online, April 3, 2008) to keep
their own relevance intact; that leaves oil as the most sensible
diversification tool in a world with too many dollars floating around. That's
why the price of oil has gone up, not speculation or rapacious market traders
or aliens from Mars.
Market rituals
In times of crisis, there are some curious market rituals to be observed, by
far the most entertaining of which would be to observe what investment banks
say about each other. Research reports from analysts employed by investment
banks who write about other investment banks have become headline news items,
with Bank A "downgrading the forecast earnings of Banks B, C and D" while the
analyst from Bank B does the same for A, C and D and so on. At the end of this
spectacle you have the wonderful feeling that all of them are in big trouble.
This is exactly where we are now, as the most entertaining of reports make
their way suggesting that investment banks would have to cut about 25% or more
of their staff into the global downturn. Most of the business models are
irreparably broken, according to the analysts.
This presents a logical, if somewhat perverse question. If the analysts in
question are so smart, why then do they work for an investment bank themselves?
And if they aren't smart enough to have decamped to a hedge fund or climbing
Mount Everest, why then should normal equity investors listen to them?
Another curious market ritual is what happens with the rating agencies when
they finally fess up to their mistakes as they do in every crisis. In the last
round, they came out about how the rating processes for companies like Enron
would be changed, while also showing the limitations of rating more than US$100
billion of debt issued by telecom companies that had to be serially downgraded
in 2002.
This time around, Moody's announced that a computer model used to rate Constant
Proportion Debt Obligations (CPDOs) had been faulty, but the rating company
then took the extraordinary step of firing key people in its European unit for
violating procedures. What seems to have transpired is that once the errors
were discovered, instead of going forward with downgrades, these officials may
have "consulted" with the banks issuing (or worse, holding) the CPDOs to
discuss financial implications. A downgrade from triple A to something more
reasonable for the risk, around single-A, would have meant losses of more than
30% of the principal amount, according to some observers, so clearly the
decision wasn't an easy one to make.
The point though is that this particular ritual exposed the rating agencies for
what they are - a bunch of businesses that make money providing so-called
independent opinions that really only represent the best interests of the
investment banks selling those products. This attitude at the heart of one of
the more stable money-making businesses on Wall Street - fixed income - says
more about the future of the investment banks than any of the research reports
do.
Thus it is that starting with the BIS, then harkening to the Indian Finance
Ministry, and going on to investment banks and to the rating agencies, we find
it is not what people say that matters - it is almost always what they don't.
Notes
1. www.bis.org, the 78th Annual Report 2007/2008.
2. Remarks of Indian Finance Minister P Chidambaram at the Energy Ministers'
Meeting, Jeddah (Saudi Arabia) on June 22, 2008.
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