[R-G] [BillTottenWeblog] The Great Crash of 2008

[Bill Totten]

The world's financial institutions are gripped by fear, yet policymakers
can do nothing. They are ignorant of how banks now work and have to take
poacher-turned-gamekeeper Henry Paulson at his word.

by James Buchan

New Statesman (September 25 2008)


Of all the phantoms conjured from the financial depths in the past ten
days, the most ghastly appeared on the dark Wednesday, 17 September,
when interest on the short-term obligations of the United States
government, the one-month Treasury bill, turned negative and became a
penalty. Such terror had overtaken the markets that they were willing to
suffer a loss on their money in the hope that, in the deep bosom of the
US Treasury, some of it would be kept safe.

Yet the terror of that day was not just to do with loss: money lost, job
gone, wife fled, house foreclosed, sailboat beached. It was an elemental
panic, such as overran the financial markets on 19 October 1987, the day
the Dow Jones Industrial Average fell 23 per cent. It was a recognition
that the world is not as we have been told and that the conception of
value that lies at the root of modern society is, and has always been, a
fiction.

In this panic, there is no reality in the sense of actual existence to
prices and Lehman Brothers Holdings can be worth $15 billion on Monday
and nothing at the weekend. The world is held together only by instances
of agreement between two or more people. It is an education that
everybody should pass through, and my generation has done so twice, in
1987 and 2008. It is as if the gods of financial markets have been
reading Hegel, and learnt that "through repetition, that which at the
beginning appeared as merely accidental or possible, is confirmed as a
reality".

Not that governments are thinking much about Hegel. Like generals
fighting their grandfathers' wars, policymakers are haunted by the
Depression of the 1930s, where a crash in financial markets was
transformed by selfish national policies into a collapse in world trade,
and unemployed men walked in droves from Sydney to Melborne, shooting
rabbits for food.

Andrew Mellon, the former investment banker who was US treasury
secretary at that time, thought to break value down to a sort of puritan
or moral core. He is said to have burst out to President Hoover:
"Liquidate labour, liquidate stocks, liquidate the farmers, liquidate
real estate! It will purge the rottenness out of the system. High costs
of living and high living will come down. People will work harder, live
a more moral life. Values will be adjusted, and enterprising people will
pick up from less competent people."

His reincarnation, Henry Paulson (also once a star investment banker),
has opted instead for expediency in which pure fear cuts through all
moral entanglements. He has won over the administration and some
supporters in Congress to his colossal plan to take $700 billion or more
of bad loans on to the Federal government's books. It is the equivalent
of the entire US budget for social security. In promoting his plan,
Paulson said: "I am convinced that this bold approach will cost American
families far less than the alternative - a continuing series of
financial institution failures and frozen credit markets unable to fund
economic expansion. The financial security of all Americans ... depends
on our ability to restore our financial institutions to a sound footing."

Ben Bernanke, chairman of the Federal Res erve, was crisper: "There are
no atheists in foxholes and no ideologues in financial crises".

In effect, the US public will recapitalise the silly bankers at a cost
of perhaps $2,000 per American adult and child, maybe much more, maybe
much less. In Britain, the authorities are reluctant to wield what
Paulson calls the "bazooka", trying to ensure instead that the banks
continue to do business with one another. Banks, under the so-called
special liquidity scheme, can shore up their creditworthiness by
exchanging their questionable mortgage securities for Treasury bills,
securities that carry the faith and credit of the UK, which has never
failed.

Already, GBP 100 billion has been drawn and nobody knows how much more
will be required for both schemes. In truth, bankers have little clue
now what they have (assets) or what they owe (liabilities). AIG, the
insurance group that all but bankrupted itself insuring bank loans
against default, asked the US authorities at the weekend of 13-14
September for $20 billion, then for $40 billion and finally $85 billion.

What are we to make of a banking business that must be recapitalised by
the public every generation? That, like the nuclear power industry,
holds a gun to the public head two or three times each lifetime? And in
the intervening periods treats the public like poor relations?

In all the commentary on the crisis, certain facts have been thought too
elementary for consideration, so I shall consider them. The first is
this: the business of banking is not profitable (as you have been told)
but miserably unprofitable. It is this unprofitability rather than the
idiocy or wickedness of bankers that makes the enterprise so unstable.
The arrogance of bankers, their extravagant rewards and public
philanthropy, are the abstract counterparts of the massive architraves
and pediments of the old bank architecture, such as the Barclays Bank
headquarters in Norwich. How could they not be safe as houses?

The fundamental business of taking in money and putting it out again
earns a wafer-thin interest margin and will only keep bankers in luxury
if it is conducted on a colossal scale. Even the most prudent banks
borrow ten times their own capital, while investment banks (who do not
take deposits from the public) borrow very much more: Lehman Brothers
thirty times, and even the respectable Goldman Sachs 22 times. At that
extent of what is known in the US as leverage, a small fall in values
wipes out the bank's capital, leaving its lenders exposed to loss, and
their lenders likewise in a daisy chain of failure. Commercial banks are
not well-managed institutions and investment banks (with the exception,
it is said, of Goldman Sachs) are not managed, in the industrial sense,
at all. An unsupervised trader can wipe out a bank's entire capital, as
in 1995 at Baring Brothers, or so terrify management that they reverse
his trades at fire-sale prices, as at Société Générale last February.

Even at that level of leverage, profitability is still too low and banks
have sought ways to expand their lending through various legal and
quasi-legal means. (J K Galbraith used to say that as the speculative
waters subside, all manner of crimes are revealed to an astonished
public view.)

In a regulatory filing, AIG made no secret that some of its credit
insurance instruments were designed to help banks evade restrictions on
their lending. Another tactic was to combine packets of loans into
interest-bearing securities and sell them on to other investors. This
allowed banks to replenish their funds and originate more loans, but at
the risk of spreading the default far and wide - which is why bad debts
in run-down cities in the Midwest affected investors in London,
Frankfurt and Tokyo.

Too many banks

The second point follows from that. The banking system is not
undercapitalised for the ordinary purposes of trade, as Paulson would
have us believe, but overcapitalised to the point of obesity. A brief
walk down the high street of a county town reveals that. It was the
genius of the short-sellers, or bears, to recognise that there are far
too many banks and bankers for the use of the public - and for this
insight, like Cassandra, they are hated and shunned. Paulson wants to
maintain the banking industry in its bloated condition for fear that an
orderly reduction in banking will turn into a rout. We will then be
plunged back into the days of the Hoover administration, when 11,000
banks closed their doors for ever and business simply stopped. Yet
Paulson's attempt to maintain the banking system at the extent or level
of 2005 or 2006 may not be successful.

The reason is that the run on the banks which started at Northern Rock
in Newcastle in September 2007 has unfolded at a time of rising, not
falling, incomes and profits. The last phase of mortgage lending in the
US and UK, and also in countries such as Spain and Ireland, was never
likely to be repaid even in golden days. In the ordinary rhythm of trade
and business, business activity will eventually contract or already is
contracting. As industrial companies fall into loss and individuals lose
their jobs, debts of a more solid character than 110 per cent
loan-to-value mortgages will fall into arrears. Unable to raise capital
in the markets, banks will once more need public support, or will fail.
The Paulson "bazooka" and the swap arrangements at the Bank of England
may expand to the point when they impair the credit of the nation,
expressed in its currency's exchange-rate. And what of poorer or less
sophisticated countries who are also unable to borrow? While all eyes
have been on London and New York, the Russian stock market has halved.
This is the nightmare of the 1930s where the engine of world trade
simply peters out.

Yet policymakers are constrained by their ignorance of financial
markets, have no ideas of their own, and must take the
poacher-turned-gamekeeper Paulson at his word. In Britain, new Labour
shed its ancestral scepticism of the City more comprehensively than,
say, the reformed German Social Democrats. As the intoxication recedes,
Labour must recall in hot flushes its excruciating naivety. Peter
Mandelson's "We are intensely relaxed about people getting filthy rich"
is as embarrassing as Gordon Brown's hero-worship of the US central
banker, Alan Greenspan, whose stock has fallen faster than Lehman
Brothers common.

Yet if the financial chaos spreads out into the tangible world of job
centres and shuttered factories and empty office blocks - a world where
men and women, unlike bankers, must live with the consequences of their
folly - politicians will demand their pound of flesh. In the US, both
presidential candidates Barack Obama and John McCain are mining a
popular hatred of the East Coast money men that goes back deep into the
19th century. They will place restrictions on bank lending and
securities underwriting just at the point where there is no lending or
underwriting of securities. Bowing to the winds of change, both Goldman
Sachs and Morgan Stanley have abandoned their privileged position as
investment banks and submitted to regulation by the Federal Reserve,
right there alongside First Farmers & Merchants of South Succotash with
its 600 checking accounts.

William McChesney Martin, the Federal Reserve chairman in the 1950s and
1960s, used to say that the job of the central banker is "to take away
the punch bowl just as the party gets going". Greenspan, who at two
decades at the Federal Reserve accommodated the banks in all they
required, conspicuously failed to do so. In these circumstances, there
will be a call for returning central banks to political control.
Margaret Thatcher always opposed independence of the Bank of England,
because it seemed to her an admission of political failure. She also
doubted - and even her enemies would not disagree - "whether we had
people of the right calibre to run such an institution". These central
banks, once returned to political control, will find it hard to resist a
little inflation to lighten the burden of public and private debt.

The melancholy aspect of the crisis lies not in the humbling of proud
men such as Dick Fuld of Lehman Brothers or Greenspan himself, but in
our ignorance. An entire epoch of finance passes in which we lived, but
did not understand. Truly, as Hegel said, philosophy comes too late to
teach the world how it should be, and Minerva's owl begins her flight
into gathering darkness.

James Buchan is the author of Frozen Desire: an Inquiry into the Meaning
of Money (1997)


http://www.newstatesman.com/business/2008/09/banks-financial-paulson-public


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