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Sunday, 28 September 2008

What's new news?

In the FT, John Authers makes an excellent point, hesay, "Writing anything about this financial crisi is nerve-wracking. People may be reading how financial journalists wrote about this crisis decades from now, and things we now accept as unquestioned orthodoxy may come to be ridiculed. I am acutely conscious of this..." He goes on to report how nearly a decade ago analysts were penalising banks (such as WAMU, now the US's biggest traditional bank failure) if they did not leverage their mortgage lending to the hilt.
Reading the weekend press, there is righteousness galore about the irresponsible activities of banks etc. over the past decade. No one is asking what were the warnings and who did not heed them? Not much mea culpa, though plenty of bankers bewailing that the future will be a very different place for them. Yet, we've been here before and not just 70 years ago, but 10 and 20 will do. In the late 80s early 90s 1,500 financial institutions failed in the USA alone. Many household names have disappeared, been merged, consolidated, broken up since then. Financial management is an eminently moveable feast. Every economic downturn has seen as many brands disappear as property developers, and new ones spring up like daisies after each time the lawn is mown. Were banks and bankers especially bad? It is easy to make general condemnations in public about matters that are not discusssable in detail in public, matters that were they discussed in detail most general readers would not have the patience or comprehension to absorb. But I'll try again, as this is the purpose of these 50+ blogs in a month, to explain to the uninitiated.
When banks packaged up their loanbooks and securitised them as bonds (providing risk protection, underwriting and insurance) mainly for sale to non-banks who clamoured for more (the so-called originate-to-distribute model), this was deemed prudent risk managementm and even a great way to disover a market price for the assets that banks carry. The foreign demand for banks' asset-backed bonds was very great; somewhere to invest dollar surpluses when in North America and Europe governments balanced budgets and borrowed less (issuing far less bonds). Banks were encouraged to grant mortgages to the poor, thus savings governments almost all of their previous spending on social housing. More poor got assets and could borrow. Credit boom economies boomed and the rest of the world grew exports and also boomed, not least China and India. Everyone seemed a winner.
What had not been reckoned with, except by relatively few Cassandras, was that the extreme imbalance in world trade could not continue rising, ditto house prices, consumer debt and governments evermore balancing their budgets. Additionally, the high AAA to AA- investment grades attached to asset backed securities issued by banks became very desirable to non-bank financial services firms such as hedge funds (and other active funds) because they were excellent collateral for further borrowing and could support 20 or more times their amount in short term loan facilities for trading with short term in the financial markets. The risk of losses day to day are (or were) accepted by everyone as relatively tiny so long as markets behaved relatively normally. At the same time as thousands of trading firms employed these assets to balloon the size of speculative positions they could take in wholesale financial markets, at the retail end thousands of brokers blossomed to market and sell mortgages (and other retail investment products). This is the era of the guinea-hunter, the commission agent, the financial intermediary. The idea of capitalism was founded on sub-dividing production tasks in the industrial age, on 3 month retail and trade credit, on bonds, and on property and unearned property income as collateral and that, in recent decades, was now reproduced into professional services, increasingly specialised, everyone, each process, could be disintermediated, contracted out, a firm for every identifiable task, from the bottom turning 50% of social security cheques into interest-only mortgages that could leverage credit card balances to the very top end of turning lowest paying triple-A bonds into 38% returns via short term capital borrowing. In fact the model of capitalism is not the factory; it is the city, urbanisation, the building of mega-cities in which every transaction requires money.
At both end of this spectrum the game was volume because volume meant higher fee and commission income for the long chains of intermediaries; never mind value now today, all real values are what in the short term can be traded on long term expectations of future values - and for Heaven's sake why not. In a world of fleas (where 90% of animal life by weight is insects) where even the smallest fleas have lessers fleas and everyone is a flea on something bigger, all fleas have to get their share?
The banks in the middle felt they were losing out if hey didn't join the circus and so they too pushed to grow their investment banking and especially their own proprietary speculative trading using similar leverages as the hedge funds (even though they were using the deposits of far more risk averse and vulnerable customers) while also, at the same time, in retail banking all aggressively pushed at mortgage business growth. No zero sum games; everyone a winner. Equity markets boomed too and corporations borrowed less from banks (as banks also became less interested in lending to them anyway), and the corporations issued more bonds (secured on their rising equity values). In this apparently virtuous, accelerating, global self-multiplying circle of money and values much general good appeared to be generated, but who could control it if matters went too far, and when and where is too far? Could governments risk cutting back on growth in an increasingly competitive world, or hold down house price rises somehow?
Ideologues said that growing the world's free trade is an immense benefit, and so what if the US deficit is almost everyone else's surplus, that's good too, surely? Bank regulators issued warnings about diversification and balanced risk-taking, but that is what the banks believed they were doing, mostly, and the non-banks like hedge funds were in any case biased risk-takers and their investors knew that. Economists too, the naturally gloomy party had given up largely on macro-economics and joined the party to earn fees building profit forecasting models and getting more handsomely paid than ever for micro-economics studies. Along the way, firms of all kinds rose like rockets and crashed, so this was not a risk-free one-way bet world, not entirely.
What went wrong began to do so when the first signs of a coming recession began to be predictable three years ago (in 2005) and the first US house price falls began (but only in a handful of states, yet despite half of all US mortgages already being Federally insured) and various holders of the original securitised bonds and related credit derivative sought tried to sell them on as interest rates rose and raw material commodity (especially oil) inflation pressure built. As with all new assets or tradable instruments that are tested for the first time by their first market correction, suddenly the leveraged holders found themselves vulnerable to knock-on discounts rippling through long chains of financial dependencies. Banks, as they always do, were in the middle of the money flows as they dtuttered and hiccupped. The banks had grown far faster that the general economies in which they operated. Goldman Sachs for example in only ten years had grown its assets forty-fold. Many others had similarly spectacular growth. But they were not the only ones, not the only institutions to be to blame. Everyone, including regulators and governments were caught up in the new paradigm economics. And arguably economics itself had failed to publicly address what was happening. In any case who wanted to listen to them? It was all like the catch-phrase, "it's above my pay-grade to answer that or take responsibility for that." Many firms have failed, retail depositors and many mortgage holders are quite secure and several hundred financial officers have been arrested and about 40 firms are under criminal investigation. More arrests, more investigations and hundreds of court cases are pending. If all it takes is a few $trillions to get us out of this mess and out of a potentially much worse one, and if the government debt required to do so is largely or totally recoverable (see WA WA WA MU blob below that shows the US Government potentially making a profitable gain for itself or taxpayers from the $700bn TARP of over $500bn), then so what, let's do it? It is hard on the ideologues, however. They too were sold a fanciful deram. The ill-disciplined House Republicans who tried to stymie TARP because suddenly they feared for their neo-liberal, small is better government, lower taxes, free market, let's privatise everything capitalist model - they had a panic attack. Their Euro-centric, multi-polar world, counterpart rivals are also panicking because Europe is not disconnectable and remains economically interdeoendent with the USA. All this is in the weekend papers. What a great time to be a student again returning to college for the Michaelmas Term - new thesis research topics in abundence and the prospect of redefining (not just re-callibrating) the financial (and macro-economics) landscape. We are now in a world without a dominant economic growth model or a dominant financial banking model and if we don't watch out at intervene now we may soon lose some cherished industrial business and urban development models as well! Which thought takes me back to my work for tomorrow - more principles and precepts for EU economic impact audit models!!

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