[R-G] Kolko / The Predicted Financial Storm Has Arrived / Aug 29

[Anthony Fenton]

ZNet Commentary
The Predicted Financial Storm Has Arrived August 29, 2007
By Gabriel Kolko

Contradictions now wrack the world's financial system, and a growing  
consensus exists between those who endorse it and those who argue the  
status quo is both crisis-prone as well as immoral.  If we are to  
believe the institutions and personalities who have been in the  
forefront of the defense of capitalism, we are on the verge of a  
serious crisis-if not now, then in the near future.

The International Monetary Fund (IMF), the Bank for International  
Settlements, the British Financial Services Authority, the Financial  
Times, and innumerable mainstream commentators were increasingly  
worried and publicly warned against many of the financial innovations  
that have now imploded.  Warren Buffett, whom Forbes ranks the second  
richest man in the world, last year called credit derivatives-only  
one of the many new banking inventions-"financial weapons of mass  
destruction."  Very conservative institutions and people predicted  
the upheaval in global finances we are today experiencing.

The IMF has taken the lead in criticizing the new international  
financial structure, and over the past three years it has published  
numerous detailed reasons why it has become so dangerous to the  
world's economic stability.   Events have confirmed its  
prognostication that complexity and lack of transparency, the  
obscurity of risks and universal uncertainty, especially regarding  
collateralized debt and loan obligations, will cause a flight to  
security that will dry up much of the liquidity of banking.  "
Financial innovation itself," as a Financial Times columnist put it,  
"is the problem". The ultra-creative system is seizing up because no  
one understands where risks are located or how it works.  It began to  
do so this summer and fixing it is not very likely.

It is impossible to measure the extent of the losses.   The final  
results of this deluge have yet to be calculated. Even many of the  
players who have stakes in the countless arcane investment  
instruments are utterly ignorant. The sums are enormous.

Only a few of the many measures give us a rough estimate:

The present crisis began-it has scarcely ended there--with subprime  
mortgage loans in the U.S., which were valued at over $1.3 trillion  
at the beginning of 2007 but are, for practical purposes, worth far,  
far less today. We can ignore the impact of this crisis on U.S.  
housing prices, but some projections are of a 10 percent decline- 
another trillion or so.  Indirectly, of course, the mortgage crisis  
has also brought many millions of people into the larger financial  
world and they will get badly hurt.

What the subprime market did was unleash a far greater maelstrom  
involving banks in Germany, France, Asia, and throughout the world,  
calling into question much of the world financial system as it has  
developed over the past decade.

Investment banks hold about $300 billion in private equity debts they  
planned to place-mainly in leveraged buy-outs. They will be forced to  
sell them at discounts or keep them on their balance sheets-either  
way they will lose.

The near-failure of the German Sachsen LB bank, which had to be saved  
from bankruptcy with 17.3 billion euros in credit, revealed that  
European banks hold over half-trillion dollars in so-called asset  
backed commercial paper, much of it in the U. S. and subprime  
mortgages.  A failure in America caused Europe too to face a crisis.  
The problem is scarcely isolated.

The leading victim of this upheaval are the hedge funds. What are  
hedge funds? There are about 10,000 and, all told, they do  
everything. Some hedge funds, however, provided companies with  
capital and successfully competed with commercial banks because they  
took much greater risks.   A substantial proportion is simple  
gamblers; some even bet on the weather--hunches.  Many look to their  
computers and mathematics for models to guide their investments, and  
these have lost the most money, but funds based on other strategies  
also lost during August.  The spectacular Long-term Capital  
Management 1998 failure was also due to its reliance on ingenious  
mathematical propositions, yet no one learned any lessons from it,  
proving that appeals to reason as well as experience fall on deaf  
ears if there is money to be made.

Some gained during the August crisis but more lost, and in the  
aggregate the hedge funds lost a great deal-their allure of rapid  
riches gone.  There have been some spectacular bankruptcies and   
bailouts, including some of the biggest investment firms.  Investors  
who got cold feet found that withdrawing money from hedge funds was  
nigh on impossible. The real worth of their holdings is hotly  
contested, and valuations vary wildly.  In reality, there is no way  
to appraise them realistically-they all depend largely on what people  
want to believe and will take, or the market.

We are at an end of an era, living through the worst financial panic  
in many decades. Now begins global financial instability.   It is  
impossible to speculate how long today's turmoil will last-but there  
now exists an uncertainty and lack of confidence that has been  
unparalleled since the 1930s-and this ignorance and fear is itself a  
crucial factor.  The moment of reckoning for bankers and bosses has  
arrived. What is very clear is that losses are massive and the entire  
developed world is now experiencing the worst economic crisis since  
1945, one in which troubles in one nation compound those in others.

All central banks are wracked by dilemmas.  They have neither the  
resources nor the knowledge, including legal powers, to remedy the  
present maelstrom.  Although there is clamor from financiers and  
assorted operators to bail them out, the Federal Reserve must also  
weigh the consequences of its moves, above all for inflation. Then  
there is the question of "moral hazards."  Is the Federal Reserve's  
responsibility to save financial adventurers from their own follies?   
Throughout August the American and European central banks plunged  
about a half-trillion dollars into the banking system in an attempt  
to unfreeze blocked credit and loans that followed the subprime  
crisis-an event which triggered a "flight to safety" which greatly  
reduced banks' willingness to loan. In effect, the Federal Reserve  
relied on banks to restore confidence in the financial system,  
subsidizing their efforts.

Central banks' efforts succeeded only very partially but, in the  
aggregate, they failed: banks and investors now seek security rather  
than risk, and they will sit on their money. The Federal Reserve  
privately acknowledges its inability to cope with an inordinately  
complex financial structure.  European central bankers are in exactly  
the same dilemma: they simply don't know what to do.

But this scarcely touches the real problem, which is structural and  
impinges wholly on the way the world financial structure has evolved  
over the past two decades. As in the past, there is a critical split  
in the banking and finance world and each has political leverage  
along with clashing interests. More important, central banks were not  
designed to cope with today's realities and have neither the legal  
powers nor knowledge to control them.

In this context, central banks will have increasing problems and the  
solutions they propose, as in the past, will be utterly inadequate,  
not because their intentions are wrong but because it is impossible  
to regulate such a vast, complex economy-even less today than in the  
past because there is no international mechanism to do so.    
Internationalization of finance has meant less regulation than ever,  
and regulation was scarcely very effective even at the national level.

Not only leftists are naïve but so too are those conservatives who  
think they can speak truth to power and change the course of events.   
Greed's only bounds are what makes money.  Existing international  
institutions-of which the IMF is the most important--or well- 
intentioned advice will not change this reality.