Sometimes, it is easy for commentators and other finance professionals to write
articles or base their calculations on a series of mental math that somehow
eludes their intended audience, thereby causing no small amount of confusion.
This was brought home to me by recent e-mail correspondence (see the Asia Times
Online letters and forum pages).
Reserve math
By far the most controversial, the idea of figuring what Asian governments have
lost since 2007 in the financial crisis is
nevertheless relevant for citizens and other stakeholders to think of. Let's
imagine for this exercise an Asian central bank entrusted with $100 billion at
the end of 2006.
For ease of calculation, assume that their choices were either US Treasuries or
some of the duff mortgage-backed securities. As we are discussing Asian central
banks, let us also assume that their currencies appreciated against the US
dollar by a constant rate, say 5% every year. Further, let's assume that 2008
is over already (a lot of people on Wall Street certainly wish that were true).
Also, I present the absolute return at the end of 2008 rather than annualized
numbers, to keep things more simple for readers.
2007
2008
Invested
Return
Invested
Return
US Government
$90bn
4%
$90bn
3%
US "Triple A"
$10bn
0%
$10bn
-50%
Return
$3.6bn
3.6%
-$1.4bn
-1.4%
Currency adjusted
-1.6%
-8%
Based on that very simple scenario, Asia transferred wealth to the US for the
past two years, with mortgage losses this year translating to a whopper of
money sent back.
In contrast, let us look at the picture of Asia actually floating local
currencies. With that, you would have seen a reduction in total surpluses and
therefore gross investment in the US market would have reduced. The effect
though doesn't end there: because total volume of investment would have
decreased, compensation would have increased and quite dramatically so.
Consider the following alternate picture:
2007
2008
Invested
Return
Invested
Return
US Government
$50bn
7%
$50bn
7%
US "Triple A"
0
0%
0
-50%
Return
$3.5bn
3.5%
$3.5bn
-7%
Currency adjusted
-3.7%
+2.6%
This is the wonderful situation in which a one-off adjustment (for floating) in
2007 would have caused investment losses then, but subsequently helped both to
increase yields on US government bonds and also rendered unnecessary any
investment in fancy mortgage-backed financial products.
The basic math principle is to think of the feedback loop caused by actions or
inaction. In this case, the process of Asian central banks not investing
in the US bond market would have caused a massive increase in bond yields,
thereby bringing forward a slowdown for the economy and for all intent and
purposes causing a soft landing scenario for the global economy.
Intervention math
Let us change the above calculations for central banks to look at "normal"
banks, say in the US. Here, the question is both assets and liabilities, so let
us assume the following at the end of the last good year (that is, 2006),
against the "make-believe" story at the end of 2007 and the current position
with mark-to-market.
2006
2007
2008
Good assets
90
90
90
Dodgy assets
10
8
5
TOTAL
100
98
95
Deposits
75
75
75
Interbank borrowings
10
5
0
Bond borrowings
10
10
5
Fed borrowings
0
5
15
Equity Capital
5
3
0
TOTAL
100
98
95
So what happened here is that, as the dodgy assets (mortgages, collateralized
debt obligations and what have you) fell in value in 2007 and this year, the
mix of liabilities changed. First, banks are unable to borrow in the interbank
market, which is why the borrowings fall from 10 to five to nothing this year;
secondly, as the bonds mature, banks cannot refinance, so we put the
outstanding value at five. Incremental finance is taken on by the Fed, which
sees its lending to that bank rise from 0 to 15, that is, it holds up the whole
banking system through a web of collateralized lending.
By now though, as the bank has wiped out its entire capital, bondholders have
no option but to push the bank into default to seize the good assets before
anyone else does. That is where the bailout plan of US Treasury Secretary Henry
Paulson comes in. Let's see the impact below, using the comparison of 2008
against purchasing the securities at market prices (PP-I) versus buying them at
an inflated, above market price (PP-II). The latter is what Federal Reserve
chairman Ben Bernanke calls, quite gently, the "appropriate hold-to-maturity"
price.
2008
PP-I
At market
PP-II
Made up
Good assets
90
90
90
Dodgy/Cash
5
5
8
TOTAL
95
98
98
Deposits
75
75
75
Interbank borrowings
0
0
0
Bond borrowings
5
5
5
Fed borrowings
15
15
15
Equity Capital
0
0
3
TOTAL
95
95
98
In effect, the Paulson plan will inflate the value of assets and create
fictitious capital for the banks that is generated simply by a subsidy from
taxpayers. If the assets are purchased at market price, there is NO change to
the total capital, which is why the first two columns above are exactly the
same. This is why the worst suspicions of everyone criticizing the plan are
true: there is no reason to carry out the plan if no such subsidy is intended.
Europe math
Meanwhile, this week various European governments have run to the rescue of
their banks: Fortis (Belgium, Netherlands and Luxembourg); Dexia (Belgium,
France and Luxembourg); Glitnir (Iceland); all Irish banks (Ireland) and so
forth. French President Nicolas Sarkozy reportedly proposed a $500 billion
rescue package for all the banks in Europe, which was shot down quickly by
other governments, including Germany.
The math in this case pertains not so much to whether these banks are too big
to fail, as to whether they are too big to save. The following set of
numbers certainly points to that logic; this is based on information provided
by the International Monetary Fund and highlighted in other financial media
this week.
Country
Bank
Total Assets
Euro bn
Assets/GDP
%
Iceland
Kaupthing
53
623
Switzerland
UBS
1426
484
Iceland
Landsbanki
32
374
Switzerland
Credit Suisse
854
290
Holland
ING
1370
290
Belgium
Fortis
886
254
Belgium
Dexia
605
173
UK
RBS
2079
126
Holland
Rabobank
571
121
France
BNP
1694
104
Ireland
B.of Ireland
183
102
Belgium
KBC
356
102
Ireland
Allied Irish
178
99
In contrast, the combined assets/gross domestic product (GDP) of the top three
US banks is only about 35%. Isn't that wonderful? Thanks to decades of
mollycoddling their domestic industries, you now have a situation where
European banks - many of whom Asians haven't even heard of - are now bigger
than the GDPs of their home countries. Why does the ratio of assets over GDP
matter? Because to pay for failed banks to foreign creditors and all that,
governments have to run a surplus to GDP for a while.
Let's take an example. Iceland moved to guarantee its banking sector even as
its top three banks are about 13 times the size of its GDP. In other words, if
the government runs a budget surplus of 10% of GDP (massively contractionary
fiscal policy), it would still take a trifling 130 years or so to pay for all
its borrowings needed. For Switzerland, this figure is a mere 100 years, while
for those like Belgium, that ratio stands at some 75 years. Remember, these are
just figures for the bank losses, not counting all the other stuff that will be
lost as a result of the failure of the banking system; for example the
industrial base, trade and so on.
The fact that not a lot of people take a logical view of math can be absorbed
by the rise in Irish banking deposits this week after the government
moved to guarantee the banks. Aren't the Europeans a wonderful people, so
trusting and naive in the ways of the world?
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