Picking Up the Crumbling Pieces
The sixth and final installment in a series of web-only articles on the subprime/securitization crisis
This is a web-only article from the website of Dollars & Sense: The Magazine of Economic Justice available at http://www.dollarsandsense.org
This is a web-only article, available only at www.dollarsandsense.org.
Subscribe Now
at a 30% discount.
The time has come to wrap up this series on the subprime/securitization crisis. Not because the crisis is at an end, or has even come to a turning point (only the most tendentiously ideological—or simply disingenuous—have gone that far), but because it has reached a juncture at which its contours will de determined as much, at least, by possibly unforeseeable future government actions as prior economic or financial events which may require elucidation. Accordingly, in this final installment, I would like to focus on the medium- and longer-term significance of the crisis, and specifically on what I see to be the essential issues that must be dealt with comprehensively if effects of the crisis are not to result in serious long-term economic weakness, or even become transformed into the component parts of a new, and even more potentially devastating, bubble.
Before I do this, however, I’ll review the most important developments since the last installment appeared on the eve of the U.S. elections. One year ago, on the same Martin Luther King, Jr. holiday weekend, that the Federal Reserve, responding to the crash of the monoline bond insurers’ (sellers of insurance on company debt, the outlook for which was becoming rapidly dire given declines in several economic indicators) shares, coordinated the first of what would become a routine series of historically large interest rate cuts. And what do we see one year on? Another working holiday weekend for Fed and Treasury officials in this country, responding to the stubbornly deteriorating situation at Citibank and Bank of America with the designing of plans to somehow ring-fence toxic assets once and for all, most likely via the establishment of a “bad” or “aggregator” bank. Such a bank would, at taxpayer expense, and with the aid of a lot of debt guaranteed by the government, buy the same dodgy assets banks are reluctant to part with (because an understandable lack of demand among private investors would almost certainly guarantee rock-bottom prices and, in turn, large revisions downwards on the asset side of banks’ balance sheets, making further sell-offs of their already distressed equity a near-certainty).
Meanwhile, in the UK, the admission of a staggering loss in 2008 of up to £28 billion (US$40 billion) by Royal Bank of Scotland dragged UK financials lower despite another weekend announcement of a major initiative (prompted in no small part by the former) by the government to prop up RBoS with an equity injection and steps to guarantee new securities backed by mortgages and other assets. Other steps tabled by the Brown government included a voluntary scheme to insure potential losses to banks on bad assets (crafted along the lines of the U.S. moves to save Citi and BoA) and forcing the banks, in return—somehow—short of full nationalization, to resume lending to beleaguered consumers and businesses. In the United States, the incoming Obama administration seems to be trying to square this circle, too.
At this point, governments are playing a particularly dangerous game: if they continue to increase their stakes in banks, private investors (including already hobbled pension and endowment funds) will fear that their holdings will be “diluted,” because their share of equity will decline as the state’s share grows, as the latter surely must if the toxic assets are to be taken off the banks’ books at the truly dismal prices many now suspect they are worth (and as banks issue new equity in the race to maintain capital levels in an atmosphere characterized by rapidly falling asset values). In a way, we are facing the same situation, writ large, that, as the Financial Times noted, held when Fannie Mae and Freddie Mac found themselves under attack last summer (remember Secretary Paulson’s “bazooka”?); but, last summer, very few people thought the potential losses the banks and near-banks could suffer was anywhere near what has turned out to be the case. So the authorities are finding themselves pressured to ring-fence the bad assets once and for all, even though private investors run away every time they make moves in this direction; but if governments don’t step in, the toxic assets will not be removed from bank balance sheets, as the prices they could fetch could well result in losses that would send the same investors heading for the door anyway. It is partly in order to forestall this inexorable dynamic that banks continue to hoard capital and fail to pass along the funds they are receiving from governments as loans to consumers and businesses. For ideological and other reasons, most policymakers keep the option of full nationalization at arm’s length, but even leftists must acknowledge that wiping out shareholders via full nationalization could have punishing effects on the pension funds of ordinary workers (not that this is reason enough not to nationalize, in and of itself). Still, that’s no excuse for the sweetheart deals governments have cut with banks, which don’t offer the public a voice in the running of the banks they are saving. And it doesn’t alter the fact that the banks may be worth precious little, anyway. Expect more chaos in the banking sector, no matter what the authorities do.
And then there’s the balance sheet of the Fed (and eventually, in all likelihood, the Bank of England as well): on the asset side, it has become truly bloated, as the Fed took the banks’ assets on its books (via the Term Auction Facility) and financed the swap-lines thrown to a group of developing countries threatened by capital flight late last year. And it sold off nearly half its Treasury bonds to finance the expansion. But it has now stopped these sales (for fear of potential inflation), and is relying on deposits from banks, now paid with interest, to make up the deficit. This is another reason why banks won’t lend. In this way, as Menzie Chin of the website Econobrowser puts it, the Fed’s loans, are now bypassing the banks, and going straight to the private sector. But what are the risks?
Back when the Fed held $800 billion in Treasuries, these were a liability of the Treasury and an asset of the Fed. In effect, the Treasury’s nominal obligation was one for which taxpayers would never owe a dime. Now that more than half of those securities have been lent or sold off by the Fed, and the Treasury has borrowed a half-trillion extra to make it work, that’s little more than a trillion extra for which the taxpayers are potentially on the line. If the loans and other assets the Fed has acquired with those funds do not make a loss, then all is still well and good. But if the Fed’s loans do not perform...the Federal deficit will rise by the amount of interest the Treasury owes on a trillion dollars of new debt.
The bottom line, according to Chin? “...Bernanke has made a gamble with something approaching $2 trillion. If the gamble wins, taxpayers owe nothing. If the gamble loses, taxpayers are committed to borrow a sum equal to any losses and start making interest payments on it.” And this was written back in December.
The newer initiatives have come into play only after the U.S. authorities, in another major departure, committed themselves to what is known as “quantitative easing” and a “zero interest rate policy” (or ZIRP) in yet another desperate, but more-or-less vain attempt to get banks to lend again. Interest rates in the United States were reduced to a range between 0% and .25% in December, and, given even a slight measure of inflation, that means real rates amounted to nothing, or would become negative. Under such circumstances, monetary policy focused on interest rate reductions ceases to be an option (you can’t cut rates below 0%), so monetary authorities focus on boosting bank reserves to increase lending (the amount of bank lending is dependent on how much capital banks must hold in reserve by law; so if more assets are made available to the banks, or if the kinds of assets they are allowed to count as reserves changes, or if banks are allowed to exchange certain assets for more liquid or secure ones, this should, in theory, result in an increase in loanable funds, even though the cost of capital—or interest rate—does not change). A similar strategy was employed in deflation-hobbled Japan, with limited success, in the 1990s, and the fact that the U.S. authorities committed themselves to the ZIRP and quantitative easing was probably the most important development in the post-Lehman phase of the crisis. Thanks to the policy, LIBOR and commercial paper rates and market activity began to revive, but remained elevated compared to plummeting U.S. government debt yields (which actually turned negative in late 2007: investors were paying a premium to hold U.S. short-term paper, rather than receiving positive yields). But banks continued to hold onto the cash, convinced that without a resolution of the bad-asset pricing issue, they could be subject to continual writedowns of their assets and subsequent runs on their stock—or even deposits.
U.S. government debt yields fell, and prices gained (though yields have since reversed course and are now moving upwards) across the yield curve (the time spectrum of maturities, ranging from 1 month to 30 years) because, in spite of a U.S. fiscal outlook that found itself deteriorating rapidly and seemingly exponentially with each bailout and stimulus package announcement, U.S. dollar assets were seen as the only safe investment vehicle in a still aggressively-deleveraging world in which heavily indebted hedge funds especially were being forced to sell assets and buy dollars to pay off record redemptions and prime brokers (who demanded more—much more—collateral to back the outsized loans hedge funds required to power the excess returns they promised impatient and overcharged investors), which skyrocketed in the fourth quarter of 2008. Even German government bonds, hitherto considered a haven for those obsessed with financial rectitude and stability, were being dropped in favor of the greenback. Only one currency proved relatively immune: the Japanese yen (again, powered to no small degree by the winding down of the yen carry trade, which many hedge funds and other investors used to ramp up returns): but yen strength only accelerated a truly breathtaking collapse of the Japanese export sector and industrial production, and this at the same time as U.S. dollar strength was cutting into the gains U.S. export growth had registered against the general economic decline of 2008. Meanwhile, the British pound found itself in free fall. Not that sterling remains a particularly important reserve currency. But Britain’s multinational banks receive deposits from all over the world, and concern is growing that foreign liabilities of these banks, whose equity is falling at the same precipitous rate as their U.S. multinational cousins’ is, and whose assets are also declining in tandem, might experience a run if sterling-denominated investments fall much more. Such flight would only deepen the sterling crisis, and Britain only has some $60 billion in foreign exchange reserves. But the collapse of British multinational banks would leave a simply irreparable hole in an international financial system that has already seen the demise of many of its most important players. This, too, is a situation that could turn nasty in the months ahead.
On other fronts, corporate debt yields were spiking upwards, as the outlook for company profits—and hence potential bankruptcies—worsened considerably. Declines in consumer sentiment and health (especially in the outlook for mortgage and credit-card debt, real estate values and pension fund holdings, but also in record falls in consumption, even during the Christmas holiday; and this despite historic falls in commodity prices, especially oil) only accelerated this process. Eventually, the highest-rated corporate debt yields started to fall back to earth, prompting keen investor interest, but this only decreased the likelihood that the up to $1.3 trillion—close to 10% of GDP—in U.S. Federal (never mind state and local) debt forecast for 2009 (with similar forecasts for years after that, according to the Congressional Budget Office) would find sufficient buyers. Meanwhile, the outlook for huge amounts of corporate debt due to come to maturity in 2008 became worse as the likelihood of rollovers on the part of cash-hungry investors fell. But emerging markets were perhaps the hardest hit of all. Many of these economies were now shut out of debt markets at the same time as global investors were pulling dollars out in repatriation moves. This only depressed their currencies all the more, which sometimes led to rating downgrades that made essential borrowing still more expensive. More and more nations, from the desperately poor to former high-flyers like Latvia, and even Ireland, found themselves approaching the IMF.
Regarding bailouts, the U.S. auto industry received a lifeline, albeit a very frayed one, from the Bush administration, which essentially tided it over until the new administration could be saddled with the problem, but only after forcing unionized U.S. autoworkers to accept truly onerous conditions—a far cry from the treatment of the nonunionized banks. A stimulus package focused on infrastructure spending, retrofitting government buildings with green technology, improving health care information technology, and—to keep recalcitrant Republicans on board—tax cuts was proposed, and shortly thereafter upgraded in terms of potential price, from $750 billion to at least $825 billion, and the release of the second installment of $350 billion from the original TARP allowance was approved by the Bush administration. In addition, other industries, from car parts suppliers to real estate brokers, ramped up their lobbying efforts to get a piece of the action. Elsewhere, the UK, Germany and Japan more reluctantly signed off on their own, huge stimulus packages, amounting to hundreds of billions of euros, pounds sterling, and yen more of debt to be thrown on global markets. This option was not available to places like Iceland, never mind Turkey or Ukraine.
Global trade, meanwhile, suffered massive declines in volume, with trade finance continuing the slump that became apparent in the autumn. The cost of commissioning ships became negligible, and while the writing of trade letters of credit revived a tad, trade figures for major exporters (and the industrial activity underpinning it) collapsed in country after country. To add insult to injury, pirate attacks on ships off the coast of the busy horn of Africa decreased activity (and increased shipping and insurance costs) all the more.
And if this weren’t bad enough, there were the scandals: Bernard Madoff’s $50 billion Ponzi scheme led what, according to a Financial Times report, constituted a growing number of confessions of fraud (as declining asset values and increased redemption requests reveal more such schemes) that put hedge funds in particular, which had contributed to such funds, in an even more impossible position. And B. Ramalinga Ramu’s $1 billion scam at Satyam, a major Indian outsourcing firm, a sector in which a large premium is put on trust in dealing with sensitive information, cast further doubt on a financial system that was receding from concerns about its own deficits in this regard. And it certainly didn’t do much to assist gigantic India in its increasingly futile attempt to evade the crisis.
So, in the end, equity prices worldwide gave up virtually all the gains they had registered since authorities saved the global financial system from total collapse in October. And, lest we forget, U.S. GDP declined at an annualized 5% rate in the 4th quarter, with other important economies registering awful performances as well (even places like China and Brazil slowed precipitously, though their growth rates—according to sometimes doubtful official figures—remained well in positive territory). In the end, and taking into account developments going back one year ago, the crisis has been characterized above all by the ever-diminishing effects of ever-larger government programs that are designed to contain a crisis they continually seem to lose ground to anyway. What might the minimum requirements be to escape from—or truly tackle in the first place—such a situation?
The first, and most important, requirement must certainly involve a powerful revival of productive investment. The first decade of the twenty-first century was distinguished by massive investments in dud or plainly unproductive assets (the wacky dot.com investments that proliferated at the end of the dot.com boom in the case of the former, and the subsequent torrent of investment into the real estate sector regarding the latter). And substantial expected financial gains from even the more productive types of investment, such as IT applications in financial services or retail, though originally conducive to massively increased sales and revenues for firms that implemented them, will, after the crashes in the consumer markets and the debt markets that underpinned the former, never be realized.
But, in addition to the fact that major productive advances need to be made, such advances must be of a kind that has been in all-too short supply in the last few decades: that of the non-labor saving variety (and especially of the sort that does not rely on opportunities to exploit global labor arbitrage differentials that are, in turn, enabled by the existence of opportunities for regulatory arbitrage). If indebted consumers in essential developed countries are to deleverage and, indeed, restore savings levels to levels more appropriate especially for ageing societies (not to mention ones with stubborn current-account deficits and blighted manufacturing sectors, and especially as corporations drop or even renege upon their pension obligations), and if consumers in developing countries with fraying, minimal, nonexistent, or simply corrupt and inefficient social safety nets and public provision of services are ever to part with their excess savings, the double assault on labor in both worlds characteristic of the era of global labor arbitrage, which has provided so much of the boost to corporate profitability that has become expected by investors in recent years, will have to come to an end—and soon. On top of this, many communities will have to be rebuilt and retrofitted as clean productive units, rather than primarily as sites of wasteful consumption, and the costs of this reconstruction internalized.
Needless to say, how this is to occur in a climate characterized above all by unprecedented amounts of credit contraction and likely financial re-regulation, which will invariably reduce profit margins of a sector that accounted for an outsized share of corporate profits in the U.S. and the UK, anyway, in the last few years (up to last year), is anyone’s guess: the deep declines in profit margins, not to mention likely spikes in corporate bankruptcies (especially with less and less finance being available for firms to enter bankruptcy proceedings) will ensure that employment opportunities created by the implementation of massive government programs will be severely challenged merely to keep pace with the level of job losses. And if opportunities for productive investment continue to stagnate, and firms must rely more-and-more on rent-seeking and arbitrage to survive, never mind to thrive (and firms in many industries, especially but not limited to retail, have forgotten all about profits to focus on the race for market share as industry shake-outs continue), lower productivity levels and declining employment rates may well continue to play off on each other in a particularly nasty negative spiral.
Some would point to the pledges by President Obama and other leaders to invest in green technologies and health care IT as examples of the sort of productive investment that will also employ lots of people (as much of this work cannot be outsourced). But opposition to these programs is already growing in Congress, and the Obama environmental initiatives are nowhere near large enough to deal seriously with plausible forecasts concerning the impact of climate change, anyway. Such half-way measures could well be among the first to be curtailed or shrunk if the economic situation deteriorates even more, and more and more communities and lobbies have to queue up for government support—and this as government debt continues to pile up. And the fact that global tensions are bound to rise as economic distress spreads inexorably through the globalized world, and will indeed be freshly set off the moment recovery takes place, as the race for declining natural resources becomes acute again (and even before that in the case of foodstuffs, concerning which many countries are experiencing difficulties securing letters of credit essential for trade, even as prices languish), guarantees that military lobbies will constantly be present at the very front of those lines.
One other major precondition for sustainable recovery would seem to be the removal of unregulated financial firms (especially hedge funds) from the interbank and short-term bond markets. The fact that many of the structured investment vehicles set up by the banks that financed hedge funds did so with short-term paper is reason enough for this. For the selloffs by exotic hedge funds contributed in no small part to the shutdown of plain vanilla money market funds in September and October; and it’s hard to argue why a basic lubricant of the monetary system should be so caught up with, or even dependent on, the performance of funds that cater to the atrociously wealthy. And this is just in keeping with a more fundamental insight: that credit-financed investment is not the same as investment backed by savings, either in terms of perceived risk, or, eventually, in terms of performance. Here’s how it was done, in the words of Nouriel Roubini, way back in 2007:
First, you take a bunch of shaky and risky subprime mortgages and repackage them into residential mortgage backed securities (RMBS); then you repackage these RMBS in different (equity, mezzanine, senior) tranches of cash CDOs [Collateralized Debt Obligations] that receive a misleading investment grade rating by the credit rating agencies; then you create synthetic CDOs out of the same underlying RMBS; then you create CDOs of CDOs (or squared CDOs) out of these CDOs; and then you create CDOs of CDOs of CDOs (or cubed CDOs) out of the same murky securities; then you stuff some of these RMBS and CDO tranches into SIV (structured investment vehicles) or into ABCP (Asset Backed Commercial Paper) or into money market funds. Then no wonder that eventually people panic and run - as they did yesterday—on an apparently “safe” money market fund such as Sentinel. That “toxic waste” of unpriceable and uncertain junk and zombie corpses is now emerging in the most unlikely places in the financial markets.
Second example: today any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times. At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity. So we got an overall leverage ratio of 100 to 1. Then, even a small 1% fall in the price of the final investment (CDO) wipes out the initial capital and creates a chain of margin calls that unravel this debt house of cards. This unraveling of a Minskian Ponzi credit scheme is exactly what is happening right now in financial markets.
But extracting highly-leveraged investors from the money markets will not be an easy task, and implies, in the absence of complete restructuring of the entire financial system, a considerable slowdown in economic activity. As David Roche wrote in the Wall Street Journal:
Second, the world economy has become accustomed to using $4 to $5 of credit for every $1 of GDP growth. Even if this profligate use of capital is halved, it still means credit expansion of 10%-15% is needed to achieve real GDP growth of 2%-3%. The recapitalization of financial institutions so far is only enough to maintain existing credit assets, but not expand them; ergo the credit crisis continues.
Third, the balance of power in global trade and monetary matters will have to change. As things stand, recovery is impossible without a revival in the U.S. housing market (which would put a floor under house prices and thereby end price declines on banks’ assets). How a recovery in the U.S. housing market is supposed to jibe with the increased savings and decreased imports required for the rebalancing of global imbalances is beyond me. Meanwhile, China, Japan, Germany and other big-surplus exporters are being exhorted to increase domestic consumption. But China has already suffered from a crash in share prices and the bursting of a construction bubble, so a rapid transition from an export-led model to a consumer-based one seems unlikely in the short term, even if the government has large fiscal means at its disposal. As for the other Asian exporters, the declines in their exports and industrial production have been nothing short of cataclysmic. The Economist presents a few of the astonishing details:
In the fourth quarter of 2008, real GDP fell by an annualised rate of 21% in South Korea and 17% in Singapore, leaving output in both countries 3-4% lower than a year earlier. Singapore’s government has admitted the economy may contract by as much as 5% this year, its deepest recession since independence in 1965. In comparison, China’s growth of 6.8% in the year to the fourth quarter sounds robust, but seasonally adjusted estimates suggest output stagnated during the last three months.
Asia’s richer giant, Japan, has yet to report its GDP figures, but exports fell by 35% in the 12 months to December. In the same period, Taiwan’s dropped by 42% and industrial production was down by a stunning 32%, worse than the biggest annual fall in America during the Depression.
And Yves Smith, from the fantastic site Naked Capitalism, refers to Frank Veneroso for these mind-numbing facts and figures:
Economies (not one, but several) suffering from calamities like these can hardly be considered as promising candidates for a consumption boom. And in addition to Asia, Eastern European economies, many increasingly indebted to Western banks (many Eastern Europeans took out loans from expanding Western European banks, denominated in euros, to buy property) as their currencies plunge, are becoming increasingly fragile—and restless. Meanwhile, even in hyper-repressive China, protests are mounting, and the easiest and fastest way for the government to even try to keep a lid on things is to make use of what is already in place, namely the export sector. In fact, governments worldwide are increasing supports to industries characterized by huge overcapacity levels, like the auto industry, on top of using the size of bailouts as a kind of competitive advantage in a kind of postindustrial race to the bottom. Developments of the latter sort, which include the UK’s adoption of national deposit insurance in response to a similar Irish nationalization in October, and which was itself one-upped by Secretary Paulson a few weeks later, have led some commentators to speculate that a new kind of protectionism is at work, in which government lending to distressed forms and industries will lead inevitably to a bias towards domestic assets. Such “credit protectionism” as it is called, doesn’t seem so much of a whinge due to the fact that, as we have seen, developing countries are already finding themselves shut out of credit markets whilst developed ones dump unprecedented amounts of debt on global markets.
Finally, there is the question of the sustainability of the huge U.S. budget deficits. Many economists claim that, as they stand now, at 7-10% or so of GDP, they remain within manageable limits, especially if the Fed and Treasury can manage to isolate and sell off all the bad stuff. But even if this is successful, the Fed and Treasury will be setting themselves up for a truly Sissyphean task when recovery ensues: for they will have to withdraw these unprecedented stimulus injections from the economy in the twinkling of an eye, to prevent an uptick in inflation that could conceivably lead to investors selling off all that debt (which loses value when inflation rises). Withdrawing a stimulus when many will still be suffering will be a political feat of the first order, especially if trade barriers are to be dismantled at the same time. And, needless to say, an overly- hasty tightening could, on the other hand, result in a so-called W-shaped recession, with another severe downturn following a weak recovery. And with China just as panicky at the thought of capital flight, the scope for error becomes vanishingly small: any such flight would certainly have an impact on Chinese demand for U.S. debt, though it’s hard to say exactly how. Still, another source of severe uncertainty is the last thing the global economy needs right now, especially one that can hang over its head for the critical next few years.
But in the end, we are faced with not one, but two more specific economic contradictions within the present system that must be vigorously resolved if there is to be sustainable recovery, regardless of whether or not the three more general issues I mentioned earlier, and which I see to be essential to recovery, but would require nothing short of a radical restructuring of the economy, are implemented: revival of the U.S. housing market (to complicate matters further, as Treasury yields rise as government debt swells, or as economic recovery begins, or both, this will serve to make mortgages, which are tied to Treasury yields, more expensive, potentially choking off recovery in that sector) in a time of unprecedented consumer retrenchment and global imbalance reversals, and the conversion of export-surplus countries to consumer-led ones even as growing industrial overcapacity leads to mounting job, income, and asset losses. Predictably, no one on the international stage is volunteering to take the first major step toward confronting this double dilemma. And there doesn’t seem to be a Keynes out there to provide a theoretical means to tempt global elites with a vision of a salvaged, invigorated capitalism. Only the vague, and increasingly desperate, intentions—not even so much plans anymore—of President Obama and other potentates.
I’ll close this series on a personal note. I’ve never believed that the attainment of socialism was remotely likely in my lifetime, but looking at the increasingly intractable nature of the contradictions mounting up as the crisis deepens, and considering how little time there is to face up to severe challenges (not to mention the retarded pace at which corrupt global institutions and elites tend to deal with such problems), I’ve never considered it so necessary, either. Though I despair at the endless complexity any kind of viable socialism will have adapt to in the modern world, the fact that capitalism has taken so many out of utter poverty in the last several decades only to dump many of them back into it, and this notwithstanding several major technological revolutions it has fostered, but increasingly failed to implement (I’m speaking of information technology and biotechnology now) profitably, prompts me to favor the inevitable uncertainty of the future over the totally unnecessary chaos of today. Accordingly, I can do no better to close this series than to evoke the following lines by way of a desperate hope that this crisis can lead to something better:
The centralization of the means of production and the socialization of labor reach a point at which they become incompatible with their capitalist integument. This integument is burst asunder. The knell of capitalist private property sounds. The expropriators are expropriated.
But let’s just make sure that the nationalizations and bailouts, or expropriations, if you will, aren’t made merely to hand the goods back to the people who got us into this mess in the first place once the dust clears.
