In a controversial case a good 16
years ago this month, Singapore's much-vaunted
legal system ruled on administering a punishment
of caning for a 18-year old American student by
the name Michael Fay. After much protests from
United States president Bill Clinton and 24
assorted Senators among a series of legal and
government nominees, Singapore agreed to reduce
the sentence from six lashes to four. Fay's Asian
compatriots in the crimes of vandalism were less
lucky, each getting a few months in prison and
more lashes of the cane.
Four years later,
in 1998, Michael Fay shot back to prominence,
accused of possessing drugs in Florida; he was set
free on a technicality involving arrest
procedures. No further crime reports
were ever received for the
Asian compatriots of Michael Fay who didn't
receive the leniency that he did.
The
above isn't to suggest that this author supports
corporal punishment; rather that the idea of
people receiving the full penalty of applicable
laws is the functioning basis for any society.
Whenever that aspect of implementing laws breaks
down; or where special favors are granted for any
number of reasons, it is likely that results prove
counter-productive.
In the above example,
the US government intervened in the laws of a
democracy that had a history of applying its stern
disciplinarian measures on all of its citizens; in
an attempt to protect the narrow interests of one
individual. It is possible that the individual
felt "good" enough about his government's
intervention to feel special; which then
translated into behavioral problems later on. In
contrast, the boys who got the full punishment
under Singapore law never did return to the world
of crime, petty or otherwise.
We can see
the same examples everywhere. In both of the
world's largest countries, China and India, there
is clearly a class of people who do not face the
full force of the law because of who they happen
to be. In other words, political or economic
superiority protects some people from laws
designed to be applied across society. The net
result is stunning levels of corruption (see my
article "The
wages of corruption, Asia Times Online, August
19, 2006) as well as, perhaps more importantly,
rising criminality. China's ruling classes are the
very epitome of corruption and petty theft from
government coffers; while in India the selective
application of laws has resulted in politics
becoming the archetypal dirty profession.
When looking at the political classes of
both China and India today, I am reminded of Mark
Twain's eternal quote, "There is no native
criminal class in America, except Congress".
Interestingly, almost 100 years after he made the
statement, events of the last year have contrived
to create a new criminal class across Western
society, and that is the world's bankers.
It wouldn't be an idle speculation in my
mind at least to compare the politicians of India
and China today to the bankers of America and
Europe tomorrow.
How did we get to this
point? What can be done about it?
The
Lehman boondoggle Over the past few days,
newspapers around the world have dredged up their
one-year calendar observance special - ie on the
aftermath of Lehman Brothers and what it meant for
the global financial system. Comments have veered
around the following poles:
Groups of inevitably "liberal" commentators
whose refrain has been a steady "Lehman should
have never been allowed to fail" which then
explains their follow-up assessment of how the
right-wing views on financial system integrity
were reversed and therefore benefited the world.
This group has an altogether rosy view of the
world economy, certifying that bailouts have
worked and so on.
The conservative, right-wing view is of course
the opposite, namely that the failure of Lehman
Brothers was a good thing for the world economy
and the wider financial system; this group also
holds that bailouts of the financial system that
followed would create resource misallocation,
inflationary panic and the like.
No prizes
for guessing which group I belong to.
This
article isn't about the merits and otherwise of
the Lehman rescue; but rather about the moral
hazard construct that is integral to these
situations. In particular, I will seek to examine
the behavioral aspects of the past year's
government efforts on a new generation of bankers
and financiers, broadly continuing the themes
first suggested in past articles such as The
New Brahmins [Asia Times Online, March 29,
2008] and Easy
bets with other people's money [Asia Times
Online, May 23, 2009].
In previous
articles, I have pointed out time and again that
creative destruction is an integral part of
capitalism much as bureaucratic sloth is integral
to communism; disallowing failures of private
companies while also preventing necessary reforms
will essentially create the worst of both worlds.
This is broadly where we are today:
Governments have spent
hundreds of billions of dollars and euros on the
rescue of banks around the world, guaranteeing
all manner of senior and junior debt obligations
in addition to deposits at the banks (actually,
according to the International Monetary Fund the
total bill thus far is a staggering US$12
trillion; as in $12,000 billion or $12 million
million).
Governments' slivers of
equity, instead of giving them management
control, have provided adverse incentives to
pushing through real (structural) reforms.
Politicians have spent inordinate amounts of
time discussing what to do with their shares in
the banking system, rather than what to do with
the banking system itself.
All manners of public
securities have been purchased directly under
the programs initiated by the European Central
Bank (ECB), the Federal Reserve (Fed) and US
Treasury. Further in this article, I will
specifically discuss the game theory aspects of
the US mortgage market securities (RMBS);
resulting from the fact that governments are the
largest owners of privately issued
securities.
Bank balance sheets have actually expanded
because of the adverse incentives pushed through
by the largest shareholder (governments) and
easy refinancing available at the "discount"
window.
I am no mastermind like Federal
Reserve Chairman Ben Bernanke, but it does appear
to me that the simple implications for each of the
above can be or more importantly, should be the
following:
The wide use of
monetary stimulus in dealing with the current
crisis is roughly equivalent to 40% of the
combined GDP of the United States and Europe,
this means that today's asset values are vastly
inflated. In addition, the apparent illusion of
wealth so created by seemingly higher stock and
property values also engenders inflationary
trends on key commodities (why oil prices have
risen), over-optimism on the part of suppliers
(emerging market countries have seen stunning
rebounds) and a failure to reduce leverage
(while savings rates are up in the US and
Europe, these are more than dwarfed by rising
government debt). None of this though is nearly
as important as the increase in volatility
implied for the future: at some point, all this
money has to be removed from the system one way
or another (ie, either through withdrawal of
quantitative easing or through inflation of
asset and retail prices). Oh and did I mention -
in conjunction with all that, governments around
the world but particularly in the US and Europe
will need to raise taxes or cut public
services?
Controlling the banks
hasn't made governments in the US and Europe any
smarter. If anything, incentives to restrain the
financial system and put institutions on a
self-sustaining course have actually gone in the
opposite direction, with a new generation of
"value maximize initiatives" in each government
being tasked with making sure that banks produce
more profits. That has immediately led banks to
increase their balance sheets, which given poor
economic data, also means that the quality of
balance sheets has become worse not better under
government tutelage. You don't hear much about
banks being forced to become smaller, because
they aren't being told to become smaller. So
let's see now: we have financial institutions
with significant exposure to high-risk assets.
Gee, what a refreshing change from 2007.
The US government,
through the Treasury and the Fed holds hundreds
of billions of securities in basically, itself.
Let me explain: the Treasury bought some $700
billion of "troubled assets" from US and
European banks. In addition, the Fed is
authorized to purchase $1.25 Trillion (that's
$1.25 million million) of conforming mortgages
that are backed by Federal agencies (Fannie Mae,
Ginnie Mae, and Freddie Mac), $300 billion of
long-term US Treasury bonds and $200 billion of
the debt issued by (the now nationalized)
Federal agencies.
This self-ownership of
debt raises important questions on the market
reaction: Chinese government sources have
released details of the country's concerns at
the Fed essentially printing money to purchase
US debt, but it doesn't appear that a wider
acceptance of this position has been found with
other Asian central banks or indeed, global bond
investors. As with the stunning rise of the
stock market, I am left dumbfounded by the
complete avoidance of risk discussions in the
middle of this mess by the investors most
exposed to downside risks of the strategy:
namely Asian investors.
Then again perhaps I
have been blindsided in the past, too: the part
of the program detailing the purchases from US
Federal agencies was clearly an attempt to
mollify the Chinese government which had the
biggest exposure to such MBS and Federal agency
debt. In other words, the US government may have
bailed out the Chinese government directly, in
return for the latter to continue buying other
US government debt. Indeed, there have been a
number of articles on the Internet suggesting
that Fed purchases have been directly linked to
asset disposals by Chinese government entities.
This raises a very interesting game theory
argument, which I explore later in the
article.
Amid all this liquidity sloshing around, the
world's bankers have been quietly having a nice
party in the back. Banks still making markets in
securities - a fancy way of saying that they can
both buy and sell these securities - have reaped
the benefits of extremely wide spreads between
the buying and selling prices ('bid-ask spreads'
in the jargon). Additionally, they have managed
to refinance the most illiquid stuff on their
balance sheets with the respective central
banks, and used the borrowed money to buy very
toxic assets (As I wrote in previous articles
including Easy
bets with other people's money, Asia Times Online, May 23).
Then there is the whole mark-to-myth
malarkey that has been egged on by central
bankers and regulators - thanks to their
ownership of the banks as highlighted two points
above - which means there is no longer any
reason to take accounting losses on problem
assets. Let me be clear - banks haven't stopped
having loan losses; they have simply stopped
accounting for them. Lastly, with low deposit
rates and high lending rates, their basic
businesses have made substantial profits this
year. Out of all this, readers should expect
that banks will set aside bumper bonuses for
their executives, and do these out of stock
grants to mollify critics; but don't for a
moment forget where the money for those equity
gains comes from.
Game theory: Why
Americans should default on
mortgages There is also an interesting
point about the circularity of US mortgages that
bears close monitoring. At a very simplistic
level, Americans borrow money from their banks,
which sell (conforming) mortgages to Federal
agencies, which then issue securities that are
bought by Chinese banks that are then repurchased
by the US Fed. What happens when some people start
repaying their mortgages? The ultimate losers
would be the US Fed in the above scheme. This is
handled either through money made available by the
US Congress (new taxes) or interest rates being
raised (more expensive mortgages). Either way, the
average US homeowner will find his costs of living
going up.
If you were an American taxpayer
and homeowner, what would be the most optimal
course of action? Think of it this way - if the
government owns all the housing debt effectively,
and there are a number of defaults every year,
everyone who defaults will be better off
(financially) than those that continue to pay. If
you were one of a 1,000 people getting a mortgage
and say 100 people defaulted, then you would in
effect (one way or another) be paying for those
100 people who default. As the number rises, you
would be pushed towards greater financial pressure
as both taxes and mortgage servicing costs rise.
Meanwhile, for the people who default, the scheme
of arrangement for their debts will mean lower
fixed mortgaging costs and other benefits such as
tax holidays. For self-employed people who tend to
receive cash for their work, defaulting on
mortgages could easily become the route to
prosperity with low taxes and little debt
repayment.
So the logical course of action
for a hardworking taxpayer holding a mortgage
would be to default right away. This becomes more
compelling when you consider the general
tightening of credit across the US and Europe,
where other forms of credit that used to be easily
available previously (credit cards, personal
loans) are more difficult to come by now. In
typical game theory perspective that means the
"penalty" of defaulting on mortgages in the form
of reduced credit availability isn't really
applicable because that is the case for everyone
now.
Add the bit about all that money
basically enabling the Chinese to sell their risky
assets to the US government in return for US
government liabilities, then something far worse
looms. At best, this means China executed a
perfect portfolio switch, going to better quality
assets with lower durations; at worst it means
that their direct leverage over the US government
has increased substantially. This means that a
"buyers' strike" from China will inevitably lead
to higher interest rates; which could further
increase the pain for US mortgage borrowers. The
persistence of that risk on the horizon simply
makes the need for Americans to default on their
mortgages that much more likely.
Learning from hedge funds The
performance and risks of the banking system
wouldn't be so bad if we didn't have anything to
compare them with. Unfortunately for the banks,
that isn't the case really. Look at hedge funds,
those much derided vehicles of capitalists that
had been billed as the most destructive forces in
the world barely a year ago:
A vast number of hedge
funds have closed down since the middle of 2008,
a trend that continues till today. This bout of
creative destruction has meant that strategies
that were wrong have been shut down; only hedge
fund strategies (and managers) that worked well
through the volatile period of 2008 and the more
benign conditions of 2009 have survived.
Contrast this to the banks, where good and the
bad bankers not only co-exist, but bad bankers
actually appear to be thriving.
While some smaller
hedge funds have opened shop, by and large
capital hasn't been made available; and
certainly nowhere to the degree of stating
'business as usual'. Contrast this with the
hundreds of billions in largely public funds
that have been pumped into the banking system,
as previously highlighted.
Consolidation has
increased, with the largest hedge funds
attracting a greater amount of new capital than
smaller entities. This effectively means that
the average risk of hedge funds as a financial
asset group has declined in the past year; again
to be contrasted with the rising risks of the
banking system.
Overall leverage in the
sector has declined, as hedge funds trimmed
their overall asset size relative to their
capital bases. For example, credit hedge funds
have on average cut their leverage by over 25%
with the median around 50%; these are
interesting statistics because credit hedge
funds approximate the basic qualities of banks
(that have certainly not cut leverage and indeed
may have increased the same).
So far, there has been one major scandal
involving a hedge fund (Bernie Madoff's $50
billion caper). Compare that to the multiple
number of scandals plaguing banks across the
world, that are virtually too numerous to
highlight.
In effect, hedge funds prove
that capitalism does work. By imposing significant
penalties on failures combined with rewards for
success, it has been relatively easy to align the
interests of all parties concerned. Risks have
declined for investors, and returns have
increased.
Over the horizon The
inevitable conclusion from all this is that
capitalism provides a readymade whipping tool, ie
bankruptcy, that keeps errant capitalists in
check. Confuse that picture, be it for a
delinquent teenager or an overextended banker, and
the results are fairly predictable: ie a repeat of
previous behavior. This then is the true legacy of
Lehman Brothers: the aftermath that virtually
ensures that eventually there will have to be more
such bankruptcies.
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