By V Anantha Nageswaran
On September 19th, the U.S. Treasury Secretary Paulson issued a statement in which he said that the Federal government “must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy”. He called it the ‘Troubled Asset Relief Program’. Many have taken to abbreviating to TARP and from there, it is a short leap of imagination to call it a TRAP. The government had sent the legislation to the Congress for approval and it might be approved any time soon. We have something to say about it later.
But, even before the bill is passed and its ramifications known, stock markets around the globe heaved a sigh of relief and rallied hard towards the end of last week. It is a delightful irony that most markets showed a flat profile from Friday, September 12th to Friday, September 19th at the end of an unprecedented week. It is not so much the news of the proposed U.S. government bailout that stock market investors welcomed. The squeeze on short-sellers that regulators around the world applied worked its magic.
Short-selling banned but SEC created the conditions
Bulls are taken by their horns but I do not know how bears are tamed. Try banning short selling. Well that is what authorities in the U.S. and the UK did on Thursday. UK banned all short-selling of financial stocks up to January 2009. The Securities and Exchange Commission (SEC) in the US banned all naked short-selling in all stocks. Hedge funds have to swear under oath their short positions. Canada, Germany, Ireland, Holland, Taiwan and some others have joined. That is a shame. There was no reason for many authorities to impose restrictions on short-selling. It is not only unprecedented but also largely unnecessary. Even now, with history and experience behind us, human beings remain capable of making collective mistakes. That is scary.
Forgotten in this persecution of short-sellers is a matter of tiny detail that in 2004, the SEC made two important changes to its rules on the amount of leverage that broker-dealers could take on. One, it removed the discounts (haircut) it applied on the assets that these institutions own, in calculating their net capital. Two, it allowed five broker-dealers to increase their leverage from 12:1 to 40:1. Those five were Merrill, Lehman Bear Stearns, Goldman and Morgan Stanley. Three of them are not around any more.
(Source: The Big Picture)
It is not clear what role the institutions themselves played in this rule change. It appears that the retribution for the egregious errors of the regulators and the regulated entities would be paid by the shortsellers who seek to throw a spotlight on such behaviour. Strange are the turns that American capitalism has taken in the last few years.
Banning short-selling is to akin to blaming the mirror for the ugly image. But then, these days, one is a suspect capitalist if one does not cheerlead rising asset prices even if the means are not exactly fair. Steve Randy Waldmann asks if selling short into a financial panic was not done, then isn’t going long into an asset price bubble equally wrong. In their defense, of course, authorities are justified in doing so if they suspect financial terrorism akin to the unusual activity seen in airline and financial stocks before the 9/11 terrorist attack in New York. But, Carl Sagan, as quoted by Paul Kedrosky of ‘Infectious greed’ says that extraordinary claims require extraordinary evidence. The authorities have not produced any.
However, for this writer, conviction remains firm that any recovery in global equities and the U.S. dollar would eventually turn out to be a comic interlude in an, otherwise, tragic drama except that the comic interlude could last long enough to make us all feel like we were watching a new play all over again.
Incentives to take on excess risk remain
Some argue that there is nothing called a stable financial system. As long as human greed and fear exist, financial systems would periodically become unstable. According to them, it is just in the nature of things for financial systems to fall into crises. The only avoidable cause, in their view, is to avoid reckless monetary and credit expansion that many central banks either deliberately or unconsciously permitted in the last several years (See, for example, Michael Pettis). Such excessive monetary and credit expansions do not end without extracting their price in terms of financial institutions’ failures and economic stagnation or worse.
Of course, while monetary policy and regulatory prudence is at the heart of the stability or instability of the financial system, that does not mean that other known or identified problems should not be addressed. Some of them might end up vastly amplifying the consequences of monetary excesses. One such problem is the role of incentives and reward-punishment structures in the financial industry. Simply put, far too little punishment is directly borne by the wrongdoers for their errors. Most executives are rewarded for successes or with golden parachutes if they fail while losses are borne by the shareholders and the society at large. That applies to executives at the top and at other levels. Returns are rewarded while risk is socialized and worse, since it appears with a lag, it is not even recognized and traced back to the acts of omission and commission. Even in late-2007 well after the crisis had broken out, compensation packages were not tailored to incorporate risk considerations in evaluating executive performance.
In fact, incentives in the financial industry need to be addressed not just for reasons of financial system stability alone but also to ensure a fair deal to shareholders and clients of such institutions. Nick Leeson, who was responsible for the collapse of the Barings bank in Singapore, writes that he was offered five credit cards as soon as he had returned from Singapore, having been responsible for incurring GBP862 millions of losses in 1999 (See The Guardian).
U.S. Treasury announces a plan on Saturday
In an email exchange with friends in the industry in April, when I was asked whether the world would unravel via inflationary boom and bust or through a straight deflationary bust, I said that the outcome would eventually be deflationary and that, in the interim, inflationary solutions would be attempted. In other words, we would get there finally but through an inflationary route.
In that sense, the Paulson plan is not a surprise. It was always on the cards. Policymakers are not going to give up without a fight. Under the plan known informally as TARP, the Treasury is authorized to purchase USD700 billion worth of mortgage-backed securities from U.S headquartered institutions at an unspecified price and price mechanism. Decisions made by the Treasury under this special legislation have no judicial recourse. The Treasury would buy assets issued or originated on or before September 17th. By Monday (Sept. 22nd), this has been extended to non-America headquartered institutions and to many types of assets including commercial mortgages and non-mortgage assets. Macroman might succeed in selling his wooden cabinet to the U.S. government, after all!
For now, the proposal has no provision to help homeowners who are struggling to keep up with their mortgages. Also missing is any proposal to re-capitalize institutions that might find themselves undercapitalized once the Treasury buys its assets over at a price that could be less than the price at which the institution carried the assets on its books. Those wanting to understand these issues better could see here and here.
Further, the stunningly simple and yet sweeping nature of the authorization sought from the Congress has made many compare this to the “Authorization for Use of Military Force, the infamous bill that gave the Bush administration the green light to invade Iraq” (see NYT). In fact, some find it plausible that the U.S. government allowed Lehman Brothers to fail to bring the system to the point of total collapse so that Congress could be steamrolled into authorizing the Treasury to do as it pleases, without judicial review.
Regardless of the merits of such a hypothesis, the mere possibility of it should make Congressmen move cautiously on the proposal and build in safeguards against abuse of power.
Different problems if the plan works
Even as a plan that focuses on the financial system, it is incomplete. The million-dollar question is if this plan would boost loan demand. The hope is that as mortgage rates come down, households would be able to refinance their mortgages and thus find the wherewithal to continue to spend. U.S. households have zero savings rate and those born around the World War II face immediate retirement. They need to save. To the extent any reduction in rates alleviates their conditions without a change in behaviour, global imbalances would remain. The U.S. would be saving too little and Asia too much. Second, return to spending habits by U.S. households would boost commodity prices and thus raise the specter of inflation all over again. Even if inflation were to return slowly in the U.S., it might return faster in Asia where the economies have barely cooled and where policy, on average, is still too loose. The world has, for the moment, run out of resources to support synchronized growth. Oil and gold have jumped already on Thursday and Friday.
If, unfortunately, inflation returned to the U.S., what happens to interest rates and would households really benefit then?
Then, there is the question of how the Treasury would find the money to do this. As a perceptive hedge fund insider pointed out, it was one thing for Asian nations to buy Treasuries and mortgage agency debt and accumulate reserves when they were deemed AAA credits. Can they do so even now and how would their public react? Of course, it is a stretch to think that most East Asian nations respect popular wish but it is not a stretch to state that they would fear the inflationary consequences of going back to reserves accumulation and thus entrench currency weakness.
Truth and reconciliation in America
Steve Randy Waldman’s two thoughtful pieces on his blog, ‘Interfluidity’ titled ‘To whom and for what’ (September 19, 2008) and ‘Inequality and credit crisis’ (August 31,2008) are worth reading. He also makes a compelling case for truth and reconciliation in America. Not just billions of dollars have been lost but also trust in America. He says that the process of rescuing financial institutions with government money should be transparent and institutions must come clean on the models and the prices that they had used in their books until the Treasury bought them over. This would enable the world to know whom to deal with in future and whom to avoid. He is right but the chances of this happening are fairly slim, however.
The mood in the financial market now is not to ask these uncomfortable and important questions. Whatever makes them live for another day is good enough now, for the industry and for investors. Once Congress approves this bill, investors, instead of feeling chastened, might feel that they have survived a bad crisis and that could embolden them to take on more risks unless regulators begin to take their jobs seriously. That is why I feel that stock markets, in the next few months, would do well. Reality would begin to bite again in 2009, as expectations are too high for economic growth and corporate profits. Enduring floor stock markets is a long-way off. Hopes over the miracles expected of the plan would turn to disillusionment. Market turmoil would return.
It is important to remember that what have been impaired are not just mortgage related assets but also trust in the U.S. financial system and capitalism, across the world. The consequences of that are not easily identifiable and would linger on long after this crisis is over. It is equally important to remember that the Treasury rescue plan contains nothing to repair the impaired trust and integrity.
A year ago, in an interview to Bloomberg, I had said that, by the time the crisis ended, the world of investors would be sick of stocks and real estate. Judging from the market reaction in the last two days, we are far from that point. I stand by that forecast. To that, I would add two more: by the time this is over, the U.S. dollar would no longer be the world’s reserve currency and America would have lost its AAA credit rating.
(These are Dr Anantha Nageswaran’s personal views)