Sunday, 14 December 2008

The Gorilla in the Room


14th December 2008

The Malta Independent on Sunday

Questions are being asked about the acute financial crisis that hit the world, especially ever since Lehman Brothers declared bankruptcy last September. People obviously want to know how is it possible for such a crisis to erupt so suddenly, how no one predicted its outbreak and most of all what caused it.

The suddenness of its eruption is not unlike that of a long dormant volcano that suddenly springs into action. Living for so long in perceived safety at the foot of the volcano tends to give a false sense of security that what has not happened for decades or even centuries is unlikely to happen tomorrow. When it happens we call it an outlier event, a black swan, or in technical terms, an event several standard deviations away from the reversion to mean what is statistically feasible to expect.

Stating that no one predicted its outbreak is not quite accurate. There are always a few contrary-minded individuals around who are generally wrong but if they persist in their predictions of doom long enough, they will unavoidably be proved right at some point in time. After all, even a dysfunctional clock shows the correct time twice a day.

The truth is that market movements tend to be very asymmetrical. On the upside, when the economy is growing, asset price increases generated by improving investment risk appetite, or greed if you wish, is a process that builds on itself rather gradually, sometimes over several months, quarters or even years. On the downside, when the economy slips into a recession, asset price decreases generated by an aversion to risk, or fear if you wish, is an instant process. It is panic that builds on itself as people in the room all try to get out of the narrow door at the same time. So doctors of doom like Roubini and Taleb are generally wrong very slowly, almost unobtrusively over a long period of time, but then, when the black swan arrives, they are proven right instantly and in magnanimous dimensions, so that they can shout ‘I told you so’ from all rooftops.

What I wish to dwell on more here is the theme of what caused it. So many reasons have been given that one gets confused in distinguishing between cause and effect. Yet it is important to understand what caused it if we are to take steps in devising a new world financial order that avoids such predicaments in future.

In identifying the causes one has to distinguish between the triggering event(s), the intermediate causes and ultimately the fundamental causes which created the intermediate causes which ultimately led to the triggering event.

The triggering event is a point in time that is easily identifiable. There seems little doubt that this was the bankruptcy of Lehman Brothers on Sunday 14 September. This was a game changing event that crushed the basic assumption on which the modern credit and financial system was built, i.e. that large banks could safely provide inter-bank market liquidity to each other on the assumption that no government would allow one of its major players to go under. This notion was strengthened in March when the US Treasury and the Federal Reserve intervened to lend their tangible support for the takeover of troubled Bear Stearns by J P Morgan Chase.

Who could have guessed that if Bear Stearns was too big or too inter-connected to fail in March, larger Lehman Brothers was not similarly worth salvaging in September? The answer to this question in the coming years will be subject to epic writings, books and probably movies.

The intermediate causes that led to the triggering event are many and varied, some evident and some less so. Probably, if they need to be defined simplistically, the best way to do it is by invoking securitisation.

Securitisation is the process whereby banks take financial assets that produce revenue streams over a long number of years (like mortgage loans, credit card loans, or rental of immoveable), package them into bundles, slice them as to the risk they carry (i.e. which package takes the first loss, and which package takes the next loss and so on), often get such financially packaged complex products rated by a recognised rating agency and then sell them to ultimate investors who are attracted by a coupon which is higher than what is generally obtainable from similarly rated simple products like straight uncomplicated bonds. Names for such complex products (now referred to as toxic products) come by such acronyms as ABS (Asset Backed Securities) MBS (Mortgage Backed Securities) CDO (Collateralised Debt Obligations) CLO (Collateralised Loan Obligations) and so on.

There is nothing intrinsically wrong with such process of securitisation, which until recently was praised as a formidable financial innovation which helps to keep the market stable by spreading the risk, helping investors to take on exactly the type of risk they prefer, reducing concentration of financial intermediation through the banking system and generally providing liquidity to the financial markets to extend further credit supporting robust economic growth. That was when the going was good, when easy credit was fuelling asset prices and making homes available through easy credit to people who couldn’t really afford them and who depended for their solvency on an ever-booming real estate market.

Nothing lasts forever. When the property bubble burst in the US somewhere in the first half of 2007, the benefits of securitisation turned into problems. The fact that risk was too spread made it difficult to understand who was carrying it, leading banks not to trust each other causing seizure of inter-bank markets. Liquidity disappeared making securitised assets difficult to value. Mark to make accounting rules forced banks to report theoretical losses, which turned many banks insolvent needing recapitalisation. Banks consequently lost all appetite for new lending and started hoarding liquidity fearing worse to come from a developing credit crunch. Without adequate supply of credit and with the banking system extremely fragile, the problems in the financial system were quickly extended to the overall economy as consumers were shocked to see trusted big name banks go cap in hand for government support or for external capital beyond their loyal shareholding base. Globalisation made sure that such economic problems did not stop at America’s shore but were exported throughout the world having all major economies go into recession at the same time, something never experienced since the great depression of the thirties.

Still problems with securitisation were only the intermediate cause and not the ultimate cause of why the property bubble was inflated in the first place. Few seem to be focusing on the ultimate cause, which indeed is the 800-lb gorilla in the room. After China joined the WTO, it became the factory of the world, exporting not only physical goods but also reduced prices, which lead to low inflation and easy capital through re-investment of the huge balance of payments surpluses that it started amassing.

Low retail inflation sourced by cheap imports from China led to maintenance of low interest rates for an unduly long time. Even when Central Banks started raising interest rates in 2004/2005 from the record level they were allowed to fall in 2002 – 2003 to protect against recession from the aftermath of the tech bubble which burst in 2000/2001, interest rates at the long term end of the curve remained obstinately low as China continued to pump its massive reserves resulting from accumulating balance of payments surpluses into long term Treasuries and Bonds. Greenspan had referred to this as a conundrum.

Economic boom, low retail inflation and low long term interest rates were a perfect recipe for asset price inflation that inevitably led to the creation of the property bubble. So the ultimate cause of the current financial crisis is the simple truism that strategic and obstinate balance of payments surpluses are as unsustainable and as dangerous as symmetric obstinate and strategic deficits. China’s surpluses were US deficits.

The basic lesson we must take home from this is that it is dangerous for longevity of the system for a huge economy like China to partake in free trade and globalisation only by half. A free system would normally have ensured that China’s wealth from its economic development would have cascaded down to the consumers, rather than being filtered by the State who thus become the gorilla in the room. If we are to avoid similar recurrence and sustainable growth, China has to play all the way spending its wealth by providing more social security to the population accordingly reducing their need to save and allowing Chinese consumers to upgrade their lifestyle in a way that would recycle the balance of payments surpluses through two-way trade rather than mere financing. In the equation there must also be factored in the floatation of the Chinese currency to reflect the country’s efficiency gains and protect from explosive domestic inflation.

Unless the ultimate cause of the current crisis get addressed in whatever international financial order that will emerge in the aftermath of the crisis, unless we accept that structural balance of payments surpluses and deficits have to be addressed rather than carried indefinitely through artificial financing, we would only be storing troubles till they erupt again when another black swan arrives.

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