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The slow train wreck

NBR Special August 08

Why is capitalism trembling?

What has gone wrong?

Neville Bennett


This is the most trying time for capitalism since September 1931.
That month saw a contagious collapse of banks in Europe and the
USA; Great Britain was forced off the Gold Standard; its government
collapsed and was replaced by the first coalition in peacetime.
The Royal Navy mutinied.

Wall Street is in rout as its system is being devoured in a slow
train wreck. In a few days of naked brutality the venerable Lehman
Brothers, which had never before made a loss in its 158 year
history, plunged into bankruptcy—a move which may put pressure on
its counterparties. Merrill Lynch was sold to Bank of America and
AIG, the biggest insurer, was taken over by the state to be
dismembered in an orderly way.

This follows hard on the bail-out of Freddie Mac and Fanny Mae.
But the momentum of the wreck continues. Treasury admits that it
is concerned for the integrity of more institutions. The market
doubts that Morgan Stanley and Goldman can survive in their
present form. As bank-to-bank lending atrophies, other institutions
that borrowed too much may be going to the wall, including HBOS ,
and Babcock and Brown in Australia.

What is happening?

Make no mistake, Wall Street is in crisis. Even Greenspan calls
it a "once-in-a-century" financial crisis. The stock market is in
panic as indicated by the VIX index, and swap rates are
astronomical. Banks are very wary of lending to each other. They
do not know what others banks have in their cupboards. No one
dared buy Lehman without a government guarantee because they know
at one time Lehman were leveraged 40-to-one and might still have
many toxic instruments.

It may be significant that Lehman's did not try to swap its
collateral for credit. Even though the Fed is liberal in
discounting shonky assets for cash, Lehman's lacked the sheer
impudence to trade its assets for cash. It was active in the CDO
market, and perhaps involved in CDO squared and even CDO cubed.
Many players bought short and lent long term.

Wall Street always closes on Sundays. It is a sacred rule but it
was broken this week. The derivative exchanges had to open because
players wanted the chance to adjust their positions this indicates
that the Fed is doing every possible to reduce surprises in the
market.

Why did this mess arise?

Historical analysis is likely to become a massive growth industry.
Already, there is a consensus that a wall of money was created,
and with cheap interest rates, entrepreneurs chased yield
regardless of reasonable risk.

There are two views on why a flood of money was created. My column
today suggests a structural problem: emerging markets are
desperate to find sound, liquid assets and have piled their money
into the USA. Others blame the Greenspan administration for
reducing the bank-rate essentially to 1%. This was accompanied by
massive deregulation which encouraged new asset classifications.
Sub-prime mortgages were sliced, diced and repackaged to get them
off US bank balance sheets. They contaminated global credit.

Huge volumes of financial instruments, about $370 trillion
exclusive of derivatives, were created chasing yield with little
regard for risk. Investment banks and hedge funds turned debt into
derivatives, and sought new products and new customers. Banks used
credit derivatives to diversify their credit portfolios, and sold
more assets into markets repackaged as debt securities such as CDO
and Leveraged Buy Out instruments.

One major problem was that investment banks used their own money
to speculate. In the past, they were brokers. Now they get
involved, perhaps putting their own interests before their
customers. More importantly, they became over-exposed to massive
losses when the credit cycle turned against them. They were left
holding leveraged buy-out assets and CDOs. Their quantitative
experts insisted that they were spreading risk, but they
concentrated it in the banks and their hedge funds.

Packages of US housing debt, sold under a variety of names, were
syndicated and accepted because they had good credit ratings and
yields. However, there were escalating defaults. The crisis arose
because no one could mark –to- market a vast array of assets. My
belief is that the crisis got out of control for a very simple
reason: there was no exchange where assets could be sold. Shares
can be sold on exchanges, but CDO's etc were "over-the-counter
instruments", and impossible to price in chaotic situations.

Without an exchange, banks, insurers and hedge funds played a kind
of pass the parcel. They tried desperately to find a buyer who
might pay, say, 20 c in the dollar for a collection of sub-primes.
But as some mortgagees were walking away, it was difficult to
justify the price of an asset that could have eleven layers of
assets. The top layers were prime, and attested to by rating
agencies, but before long the market found that agencies were
compromised in their judgment. Banks have since been engaged in
hectic deleveraging. As prices feel, banks were forced to bring
larger and larger quantities of depreciating assets to market to
restore their balance sheets.

Banks throughout the world bought toxic assets and in varying
degrees destroyed their credit worthiness. Many are undercapitalized
shells. Some have merged. Others have raised capital. Almost all
have deposited assets with central banks in return for real
liquidity.

What next?

The banking sector is extremely debilitated, especially in the USA.
There must be doubts about its ability to function as a positive
agent in the economy. Banks have curtailed their lending, their
support of IPO's and their important buy-out and merging activity.
As far as banks are engines of economic growth, they are now
largely lame ducks.

The world economy remains positive. But the financial crisis
cannot be ring-fenced and it will inevitably impact negatively on
economic growth. Several economies have low growth, even recession.
Recovery will be harder because the financial sector is negative.
Moreover, central banks have concentrated on the stability of the
financial sector, to the detriment perhaps of growth.

The effort of central banks to rescue financials is a factor in
inflation, especially in food and commodities. This has created
severe problems for households. The decline of discretionary
spending is slowing global growth. The problems are aggravated in
the US, UK, Spain and Australasia especially by a housing market
in steep decline.

Governments know enough to prevent the world from spiraling down
into a 1930's-style depression. But there is no end in sight of
the wrecking of the financial system. A bear market will persist
for some time. Classical economists believe that real growth will
not resume until the credit crunch has eradicated debt and surplus
capacity. If they are right, the next few years will be painful.
1180






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