[R-G] 'Cracks' in credit

[Anthony Fenton]

Aug 25, 2007
	
Asia Times
'Cracks' in credit
By Chan Akya

Not a day goes by without a major European or US bank announcing some  
kind of financial complication or the other. While much of the  
problem lies with exposures to the US subprime market, it is perhaps  
no exaggeration to point out that when banks cannot or will not lend  
to one another, the global financial system is for all intent and  
purposes broken.

There are multiple facets of this problem, as I described in recent  
articles: first, [1] the penchant of Asian countries to preserve  
fixed currency values against the US dollar, which has caused the  
massive and unnecessary reserves buildup that underpins the whole  
deck of cards that the financial system is today. The second issue is  
the repackaging of billions of dollars of US housing (mortgage) debt,  
the defaults on which threaten to wipe out many years of already  
meager investment returns for Asian central and commercial banks. [2]  
Third, we have the reactions from the Western central banks such as  
the US Federal Reserve and the European Central Bank that are aimed  
at stabilizing the financial system but draw much on the implicit  
support of Asian savers. [3]

Caveat venditor
Since the mid-1980s, the United States has waged an undeclared war  
against Colombian drug suppliers. Reeling from a mounting problem of  
substance abuse in urban America and the inevitable decay this caused  
across the productive landscape, US lawmakers in essence took  
international law into their own hands and authorized their military  
and Central Intelligence Agency to attack the various Colombian drug  
cartels (such as those based in Medellin, Cali et al).

I have no sympathy with drug pushers, but the attacks on Colombia,  
which included precision air strikes deep within sovereign territory,  
did raise two important questions: first on the right international  
protocols that must be observed and, perhaps more important, the  
second consideration of why the United States wasn't tackling its end  
of the problem with equal fervor or aggression.

I will leave the first issue for diplomats to consider and address,  
especially as the pattern has repeated since then, with the most  
recent examples being the invasion of Afghanistan and Iraq,  
ostensibly under the guise of killing terrorists based there.

The second issue raised above, though, goes much deeper, into the  
moral values that the United States upholds. The principle of caveat  
emptor or "buyer beware" has held for centuries. It in essence  
implies that anyone purchasing a product must bear the consequences  
of subsequent performance. In the case of illegal drugs, though, the  
US government changed this core principle to caveat venditor or  
"seller beware", in other words transferring the onus of the problem  
to the sellers and indeed their countries.

Attempts at destroying supply lines without changing the demand  
situation, as more and more American youngsters and their parents get  
stoned, obviously runs counter to good economic principles. Prices  
simply go up and, when they do, suppliers become increasingly  
desperate and therefore ruthless. Within the "community" of US drug  
pushers, the "war on drugs" thus caused the gentlemanly Italian  
mobsters rapidly to give way to the ruthless Latin American gangs who  
left a much greater trail of carnage behind.

The lack of a comprehensive program to reduce drug usage by  
youngsters and nip the demand problem in the bud remains an extremely  
relevant one even today, well after the "war on drugs" started some  
30 years ago. The biggest weakness in the US armory is thus its own  
inability to cut demand. Without such ability the country can pursue  
drug pushers to the moon (which is not a function of how "high" they  
can get) and still fail to curb the problem.

Credit is addictive too
Much like the supposed highs from using illegal drugs, borrowing  
outside of one's means provides the opportunity for people to make  
more than their fair share of income. This leveraging effect has been  
at the heart of much of the value that the United States supposedly  
created for itself in the past 20 years. Take it away and suddenly  
the famed finance-based economy simply falls apart like a house of  
cards.

A typical person would carefully examine what he can afford before  
taking out a loan, especially on an asset as important as a house. He  
would then find something that fits his budget, move in and hope for  
the best. This is not without risk, but at least the basic process of  
taking only risks acceptable to everyone is indeed followed. The  
process also has an advantage in that when someone makes a choice of,  
say, a mortgage that cannot be afforded, the banking counter-party  
typically turns him down, forcing him to reduce his expectations.

During the 1990s, though, the US basically discarded every basic  
principle of banking. First, a central banker intent on protecting  
Wall Street bonuses jumped the gun on cutting interest rates sharply,  
in essence creating negative interest rates that presaged rampant  
asset inflation. The moves were already quite controversial because  
of what had happened in Hong Kong during the early 1990s, when the  
currency peg to the US dollar kept interest rates below the local  
inflation rate, in essence fueling a massive asset bubble that popped  
painfully in the late '90s and caused house prices to fall some 50%.  
Despite the wealth of historical and recent examples, then-Federal  
Reserve chairman Alan Greenspan and his cohorts chose to keep  
interest rates too low.

Of course, one shouldn't judge Greenspan too harshly either. He found  
himself presiding over an economy that had lost all of its productive  
capabilities (this was partly to blame for the drug problem cited  
above). The US could no longer make stuff, ranging from refrigerators  
to cars, that could compete with the offerings from Japan and Europe  
on either price or quality. In that context, creating a nation of  
software developers (the Internet boom and bust) and then property  
developers (real-estate boom and bust) seems a logical choice.

As borrowers expanded their appetite for loans and depended  
increasingly on house-price appreciation to repay mortgage debt, US  
banks of course felt the need to sell down their risks increasingly,  
in turn spawning the financial innovations that I wrote about in  
previous articles. Selling down the risk to hapless Asian savers  
seeking higher returns than Treasury bonds also freed up the banks to  
make more loans.

Therein lay the crux of the current crisis - as banks originated ways  
to distribute risk, they did not care about underlying credit quality  
to the same extent that they would have if the loans had sat in their  
own books. Investors buying into securitized transactions relied on  
data that had been gathered during periods when the banks did care  
about underlying credit quality. Removal of this crucial factor was  
to cause a massive increase in underlying problems soon enough.

Implications
Dealing with all these issues holistically requires us to examine the  
primary causal factor, which inevitably is the excessive consumption  
of the US consumer. In another article, [4] I described the United  
States as a corpulent feline that threatens the world with its  
firepower even as its own economy dies from within. This will come  
back to haunt both East Asia and the Middle East in coming weeks and  
months.

The collapse of market confidence has hit the North American and  
European financial systems hard. Banks fear the simple activity of  
lending to one another in the overnight market, necessitating that  
central banks cut rates for emergency funding (known as the discount  
window) and the Fed being pushed to cut rates next month, which now  
appears a dead certainty. However, neither rate cuts nor central-bank  
intervention will work without the crucial ingredient of the US  
getting more support from the rest of the world.

This is where the principle of caveat venditor that I described above  
will come into operation. In essence, US legislators have already  
started blaming lenders for the problems being faced by borrowers.  
The country's most famous bond manager, Bill Gross at PIMCO, has gone  
to the extraordinary length of suggesting direct government  
assistance for affected mortgage borrowers. I don't know if he plans  
to run for election as the next governor of California, but this is  
among the silliest things said by pretty much anyone in the markets  
recently.

Thus lenders will be asked to pony up for further restructuring  
payments in one way or the other - either by accepting lower interest  
rates or by facing the dreaded haircuts that I wrote about  
previously. They wouldn't be given the option to sell down risk,  
though, as the financial system has frozen up. Government officials  
including US Treasury Secretary Hank Paulson have reportedly made  
dozens of calls to Asian central banks this week demanding support  
for their markets, to be provided through emergency issues of loans  
for banks in Europe and North America.

A lack of cooperation would inevitably increase the chances for more  
nasty outcomes - including trade sanctions of the sort that the US is  
now mulling on China ostensibly for quality-control reasons but more  
likely for the ones stated above. This is eerily similar to the  
treatment meted out to Colombia in the 1990s, albeit for entirely  
different matters. Once again, the United States rides to the rescue  
of its citizens at the expense of all else.

It remains an unmitigated principle of banking that if one owes a  
million dollars to a bank and cannot pay, one is in trouble, but if  
one owes a billion dollars to a bank and cannot pay, the bank is in  
trouble. By lending to inept bankers in North America and Europe,  
Asian savers will now realize how true that principle is.

There is always another choice open for Asian policymakers. That  
would be to examine the system as it stands now and decide that  
ultimately the United States can simply never repay its debts. This  
would mean calling the greatest bluff in history, that of US  
financial strength, and letting the system collapse under its own  
weight. Doing this would cause significant short-term pain to the  
global economy, but eventually the removal of excessive US  
consumption cannot but be a good thing for the rest of the world.

Pushing that process through, though, requires both vision and  
popular legitimacy, and Asia's tragedy is that I cannot think of a  
single policymaker around the region who has both. Despise it if you  
will, but Asian savers will remain under the thumb of their biggest  
borrower for a long time yet.

Notes
1. Deja-Wu: Why China must revalue, Asia Times Online, June 30, 2007.
2. Robbery of the century, ATol, July 14, 2007.
3. Asia and the vicious cycle of bank bailouts, ATol August 11, 2007.
4. Garfield with guns, ATol September 2, 2006.